Mall REITs: Only The Strong Shall Survive

Summary

• The stars aligned for a blowout holiday shopping season, and it delivered. Shoppers returned to brick-and-mortar retailers, sending sales higher by 4-6% above 2016.
• The strong holiday season, however, came after a rough year for retailers. For the first time since the end of the recession, more stores closed than opened in 2017.
• The flurry of store closings fueled a profoundly negative narrative that surrounds brick-and-mortar retail. While “bad news” makes headlines, the strong underlying data is becoming hard to ignore.
• The bifurcation between top-tier and lower-tier mall REITs continued in 4Q17. High-productivity mall REITs reported another solid quarter, while lower-productivity malls continue to struggle.
• To the victor go the spoils. While top-tier malls continue to enjoy solid fundamentals and a pathway for continued growth, lower-tier malls are in an all-out fight for survival.

REIT Rankings: Malls

In our REIT Rankings series, we analyze one of the fifteen real estate sectors. We rank REITs within the sectors based on both common and unique valuation metrics, presenting investors with numerous options that fit their own investing style and risk/return objectives.

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Mall REIT Overview

Mall REITs comprise roughly 12% of the REIT Indexes (VNQ and IYR). In our Hoya Capital Mall REIT Index, we track eight malls, which account for roughly $90 billion in market value: CBL & Associates (CBL), GGP, Inc. (GGP), Macerich Co. (MAC), Pennsylvania REIT (PEI), Simon Property Group (SPG), Tanger Factory Outlets (SKT), Taubman Centers (TCO) and Washington Prime Group (WPG).

Above we note the characteristics and strategy of each mall REIT. More than other sectors, it's critical to note the "quality focus" of these REITs. There has been a significant divergence in fundamentals and stock performance between higher-productivity malls and lower-productivity malls since the end of the recession.

Top-tier malls, as measured by tenant sales per square foot, continue to perform well across all metrics including tenant sales, average rent, and occupancy. Downsizing retailers have focused their investment into higher-performing stores and have continued to close weaker-performing stores in lower-tier malls. Amid the unusual binge in retail bankruptcies in early 2017, this bifurcation in performance has accelerated.

Recent Developments and Performance

Mall REITs were among the weakest performing real estate sectors in 2017, dropping 2.7% for the year compared to a 5.2% total return for the REIT index. 2018 hasn’t been too kind to mall REITs so far, either. Malls have fallen in synchrony with the broader sell-off in income-oriented sectors as interest rates have shot higher. Malls have dipped 9.5% compared to the 10.5% decline in the REIT index.

More and more, the mall sector is diverging into two distinct categories with vastly different fundamentals, growth prospects, and share price performance. Over the past 52 weeks, the four lower-productivity malls have dipped an average of 46%. Meanwhile, the four higher-productivity malls have dipped a more modest 15%.

The bifurcation in operating performance between higher-quality mall REITs and lower-quality mall REITs has intensified over recent quarters. The four high-productivity mall REITs reported 4.0% growth in same-store sales, 9.5% leading spreads, and 1.9% growth in same-store NOI. Meanwhile, the four lower-productivity malls reported a 1.1% decline in same-store sales, 1.6% growth in leasing spreads, and a 2.8% decline in NOI. Despite the uptick in store closings in 2017, occupancy remains strong across both categories.

While 4Q17 earnings were generally in-line or slightly better than expectations, the bigger story was the negative outlook for 2018 from the low-productivity REITs. Across the sector, same-store NOI growth has trended down in recent years. The high-productivity malls see similar conditions in 2018 as in 2017 with NOI growth expected to grow in the 2-3% range. For the low productivity-malls, however, 2018 is expected to get quite a bit worse after an already dismal 2017 that saw NOI dip into negative territory, highlighted by CBL's guidance for a 6% dip in NOI.

Over the past quarter and during earnings calls, several key themes are being discussed as new developments have emerged.

Strong Holiday Sales For Brick and Mortar

While the financial media was relentlessly pushing the retail apocalypse narrative, we’ve been discussing for months that, in reality, the stars were aligning for a record-smashing holiday season. The Christmas season was indeed quite merry. Our Hoya Capital Brick & Mortar Index, based on data from the Census Bureau, showed an average 4.3% rise in spending in November and December. Including online sales from brick-and-mortar retailers and in-store pickups (which are ordinarily included in the nonstore category), that growth rate climbs to 4.7%. The strong holiday season was welcome news after a soft spring and summer. For the full year, brick-and-mortar sales grew 2.7%, slowing from the 2.9% growth in 2016.

This data is consistent with other private measures of spending. First Data's SpendTrend Report showed that sales grew 6.2% for the full holiday season, highlighted by solid growth in both the brick-and-mortar and e-commerce categories. Brick-and-mortar sales grew 5.4% compared to 0.1% growth in 2016, highlighted by notable accelerations in the clothing, general mechanize, and specialty retail categories.

Below we show the performance of each individual retail category. Restaurants, furniture stores, grocery stores, and building/home improvement retail sales continue to see solid growth. Even in the “retail losers” category, we’ve seen a recovery in the general merchandise and clothing categories in recent months, which are now in positive growth territory YoY. Out of all of the retail categories, only the sporting goods/books segment has seen negative YoY growth.

Low-Productivity Malls Fight For Survival

To the victor go the spoils. While the high-productivity mall REITs continue to chug along relatively unphased by the uptick in store closings in 2017, the lower-productivity malls are in an all-out fight for survival. As noted above, CBL reported worse than expected same-store NOI in 2017 and issued dismal guidance for 2018. Investors fear that some of these assets could fall into a "death spiral" whereby vacancy levels cross a critical threshold, which leads to further and faster occupancy losses. The value of the mall format is that retailers benefit synergistically from the success and foot traffic of neighboring stores. Retailers are willing to pay a premium for mall space because of these network effects.

For that reason, CBL and other lower-productivity malls have put the focus on maintaining occupancy rather than maintaining rents, a strategy that we think is the right move for long-term viability. While this strategy shifts the negotiating power to the tenants and will result in significant same-store NOI decreases, we think this is in the best interest of long-term shareholders. From the CBL conference call:

"Our leasing strategies throughout the year were concentrated on mitigating rent loss and maintaining occupancy. New leasing efforts targeted a diversification of our tenant base towards nonapparel users as well as renewing and expanding with successful retail concepts."

While we continue to be a believer in the value of the mall format to retailers, it's clear that the low-productivity malls certainly have their work cut out for them. We are watching the 90% occupancy level as a critical threshold. If these REITs can hold above that level by offering rent concessions, we think rental rates will firm up over the coming years. Investors, however, will likely have to endure several more quarters of dismal same-store NOI declines.

NAV Discounts Widen, Increase Probability of M&A

After the most recent round of selling, mall REITs now trade at an estimated 25% discount to private market values. This NAV discount is the widest since the end of the recession for mall REITs and has reignited chatter about possible merger and acquisition activity.

Most notable has been Brookfield Asset Management's (BAM) interest in GGP. According to a Bloomberg on November 7, Brookfield, which currently owns 34% of GGP, held preliminary talks with the REIT to take the firm private at a 10-15% premium to the current share price. In December, the firm made a formal offer of $23 per share which was rejected by GGP. Based on recent reporting, talks are ongoing as Brookfield looks to restructure a bid. Perhaps related to the GGP plan, Brookfield sold its remaining holdings of CBL according to their most recent 13-F filing. The firm had held 7.8% of the firm.

Given the NAV discounts, we would be surprised if we did not see some M&A activity in 2018. We think that all eight REITs are potentially in play and that consolidation could be one way to regain negotiating leverage with retailers.

Mall Valuations Down 10% From Last Year

A number of analysts have published reports in the past quarter estimating a 5-15% decline in private market valuation of mall assets over the past year, attributed entirely to weak trends in "B" and "C" malls. Class "A" malls are widely seen as holding steady. Malls rarely change hands and are quite difficult to value without recent transactions.

Interestingly, the one significant mall transaction last quarter was closed at a solid valuation. Forest City Realty Trust sold 10 class B malls to Queensland Investment Corporation at a 5.1% cap rate. Malls of a similar quality would have an implied cap rate of 6-7% in the public REIT markets. While US REIT investors may have soured on malls, private market investors still see significant value in these assets. The question is: Will private market valuations be revised down, or will REIT valuations be revised up?

2 Reasons To Be Bullish on Mall REITs

1) Perception Doesn't Match Reality

It's important to clarify some misperceptions about the retail space. In pursuit of the "retail is dying" narrative, store openings are rarely reported by financial media outlets, but store closings often get front-page treatment. Anecdotally, we have found that casual observers are somewhat shocked to learn that net new store openings/closings have averaged more than positive 1,000 per year since 2010. 2017, in fact, was the first year since the recession that saw a decline in the number of stores and the decline was quite modest considering the headlines citing a "retail apocalypse." Research from Fung Global shows the recent trends in net store openings and total square footage.

As the pace of store openings has slowed, the productivity of existing space has increased materially over recent years. Each square foot of retail space generated 7% higher sales in 2017 than in 2014. Department stores, which were once the primary attraction of malls, have given way to Apple (AAPL), Tesla (TSLA), restaurants, gyms, grocery stores and healthcare facilities as primary traffic drivers. We continue to hear retailers discuss the importance of the omnichannel retail strategy: reaching the consumer in both physical and virtual formats.

2) Malls Have Successfully Transformed Mall Properties

Redeveloping vacant department store space is perhaps the biggest positive catalyst for the higher-quality mall REITs over the next several years. In-line mall tenants once relied on the department stores to drive traffic to smaller shops. Mall anchors, which were predominantly department stores, had significant negotiating power and were able to command rents that were a fraction of those paid by in-line tenants. These leases remain are slowly resetting to market rates over the next decade, providing a strong tailwind for same-store NOI growth.

This trend has shifted entirely, as department stores are now seen as a drag on in-line mall traffic, and many high-quality mall REITs are eager to get this space back to repurpose and improve in-line sales performance. Operating fundamentals and redevelopment of department stores were the focus of the discussions during REITWeek last year as well. GGP and SPG realize low double-digit returns on vacated department stores. From GGP's last quarter earnings call:

"The recapture, redevelopment and re-tenanting of department store boxes is what we do. We've done over 115 to date. We have no vacant boxes. Each anchor box opportunity is different in its potential economics. What we found is that the tenants of all types want to be located in the best real estate, so when we recapture department store at one of our properties, we generally have it pre-leased prior to redevelopment. Future upside resides all with GGP."

2 Reasons To Be Bearish on Mall REITs

1) Amazon (AMZN) and E-Commerce Continue To Take Market Share

E-commerce is the elephant in the room, however, and will continue to pressure retail categories that are most at risk. Malls, particularly high-end malls located in desirable retail locations, have shifted their tenant mix towards retailers and entertainment establishments that are more "experience-oriented" and have been extensively renovated to make them more inviting as social gathering spaces. Still, e-commerce continues to take market share from brick-and-mortar retailers.

E-commerce represents just over 10% of total retail sales but nearly 20% of "at-risk" categories (total retail minus auto, gas and food). Where will the "at-risk" e-commerce market share top out? Estimates vary widely, but we continue to believe it will be at the low end of the estimates and that physical retail will continue to be the most important channel for retailers for the indefinite future. A report by Fung Global highlights the value that certain brick-and-mortar segments create for consumers to compliment e-commerce. Well-located malls can compete in all four quadrants of the FGRT matrix below.

2) Not All Data Is So Upbeat

While most metrics show solid performance in brick-and-mortar retail sales, there are some data providers that paint a very different picture. RetailNext, a technology company that sells sensors to track store traffic, shows sales down 7.1% and traffic down 7.1% in the holiday period. This data is obviously an outlier among a collection of data showing solid gains in brick-and-mortar sales. As detailed above, US Census data showed a 4.7% rise in sales while FirstData showed a 5.4% rise in sales.

It's also important to note that while brick-and-mortar retail as a whole may be performing well, the retail categories that are predominately mall-based tenants had a very rough 2017. Department store and softline retailers (apparel) closed a combined 4,000 stores last year, which amounts to roughly 3% of the existing stock. While 2018 is widely expected to be a better year for these retail categories, mall REITs remain heavily "overweight" these particular retail segments.

Valuation of Mall REITs

Compared to the other REIT sectors, mall REITs appear cheap across all metrics. Mall REITs trade at the sixth lowest FCF and FCF/G multiples within the REIT sector. Mall REITs trade at the widest discount to private market net asset value.

Within the sector, we note the significant divergence in valuations between the high-quality and the lower-quality mall REITs. CBL and WPG trade at mid-single digit FCF multiples, even after revising estimates significantly lower. The high-quality mall REITs, while trading above the sector average, are also cheap relative to REITs in other sectors.

Sensitivity to Equities and Interest Rates

Mall REITs tend to exhibit more growth-like qualities than other real estate sectors and respond favorably to a strong economy regardless of its impact on interest rates. Mall REITs exhibit above-average sensitivity to the equity market and below-average sensitivity to the 10-year Treasury yield.

We separate REITs into three categories: Yield REITs, Growth REITs, and Hybrid REITs. (Click on each link to read more information about our methodology.) As a sector, mall REITs fall into the Growth/Hybrid REIT category. For investors worried about rising interest rates brought about by stronger economic growth, mall REITs may be well suited to outperform.

Within the sector, we note that CBL, MAC, and PEI have more Growth REIT characteristics while the rest of the sector falls into the Hybrid REIT category.

Dividend Yield and Payout Ratio

Based on dividend yield, mall REITs rank towards the top, paying an average yield 4.8%. They pay out just 76% of their available cash flow, roughly in-line with the REIT average. This relatively low payout ratio leaves mall REITs with enough cash to redevelop and improve existing properties.

Within the sector, more than other REIT sectors, investors need to be cautious not to fall into common "value traps." CBL and WPG, both yielding over 17%, appear to be diamonds in the rough. The valuation analysis above, though, shows that these high yielders have a bleak growth outlook in the near term and could very well see declining free cash flows and declining dividends if the demand for lower-quality suburban mall space doesn't reverse the current downtrend.

Bottom Line

The stars aligned for a blowout holiday shopping season in 2017. Consumers returned to brick-and-mortar stores, sending sales surging higher by 4-6% over 2016. The strong holiday season, however, came after a rough year for retailers. For the first time since the end of the recession, more stores closed in 2017 than opened. The flurry of store closing fueled a profoundly negative narrative that surrounds brick-and-mortar retail. While “bad news” makes headlines, the strong underlying data is becoming hard to ignore.

The bifurcation between top-tier and lower-tier mall REITs continued in 4Q17. High-productivity mall REITs reported another solid quarter, while lower-productivity malls continue to struggle. While top-tier malls continue to enjoy solid fundamentals and a pathway for continued growth, lower-tier malls are in an all-out fight for survival.

As a sector, mall REITs continue to appear attractively valued across most metrics. Of course, this has been the case for most the past two years during which the sector has underperformed the REIT averages. We believe that retailers will continue value the synergistic benefits of the mall format, but 2018 will be a critical year for many malls, particularly the lower-productivity malls fighting for survival. If the surge in store closings in early 2017 was indeed a relatively one-off year, we should expect to see improved results in 2018 and a strong bounce-back in price performance. If not, we may have to reevaluate the long-term viability of lower-productivity malls.

We aggregate our rankings into a single metric below, the Hoya Capital REIT Rank. We assume that the investor is seeking to maximize total return (rather than income yield) and has a medium- to long-term time horizon. Valuation, growth, NAV discounts/premiums, leverage and long-term operating performance are all considered within the ranking.

We currently view the higher-productivity malls- Simon, Taubman, and GGP- as the most attractively valued names within the sector at these levels. For further analysis on all fifteen real estate sectors and how they all stack up, be sure to check out all of our quarterly updates: Hotel, Cell Tower, Single Family Rental, Industrial, Healthcare, Apartment, Mall, Net Lease, Data Center, Shopping Center, Manufactured Housing, Student Housing, Office, and Storage sectors.

Please add your comments if you have additional insight or opinions. Again, we encourage readers to follow our Seeking Alpha page (click "Follow" at the top) to continue to stay up to date on our REIT rankings, weekly recaps and analysis on the REIT and broader real estate sector.

Disclosure: I am/we are long VNQ, SPY, MAA, CPT, OHI, PLD, GGP, STOR, SHO, SUI, ELS, ACC, EDR, DLR, COR, REG, CUBE, PSA, EXR, BXP, EQR, INVH, SPG, HST, TCO, AMT, SBRA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.