A Tale Of 3 Retail REITs: Part 3

Summary

• SPG is the best positioned retail REIT in terms of balance sheet and property quality and diversification, giving it economies of scale and network effect competitive advantages.
• Despite being one of the few retail REITs to experience strong FFO growth last year, SPG's underlying numbers reveal that its business model is not exempt from industry headwinds.
• With a dividend yield at right around 5%, SPG isn't expensive, but it isn't cheap either.

Highly regarded Simon Property Group (NYSE:SPG) enjoys best-in-class assets, financial strength, and management. However, its heavy exposure to malls and struggling big box retail chains prevent me from viewing it as a buy until a more attractive dividend yield is offered.

In my previous two articles in the series (part 1 and part 2), I found both Kimco (KIM) and Tanger (SKT) to offer attractive and sustainable dividend yields with a considerable growth runway. While their businesses are certainly faced with challenges, my analysis concluded that their steep sell-offs were both overblown, providing an opportunity to lock in long-term lucrative, growing, and sustainable income with the additional potential for considerable principal upside. While SPG is every bit their equal, if not superior, in its balance sheet and management, its primary asset class (big box malls) appears to be facing stronger headwinds (due to excessive e-commerce exposure as evidenced by struggling tenants like Sears, Macy's, etc.) than the recession and e-commerce resistant focuses of KIM (grocery-anchored community town centers) and SKT (outlet centers). While, SPG has also sought diversification in outlets (30% exposure), it does not enjoy the same scale, network, and specialization advantages as SKT in the space, while still being exposed to the same challenges confronting the space. Furthermore, the market has not discounted shares to the same extent as it has KIM's and SKT's, leaving its dividend yield a bit low (and its potential downside a bit large) considering the risks facing the REIT:

SPG data by YCharts

SPG Dividend Yield (TTM) data by YCharts

Mall counterparts Washington Prime Group (WPG) and CBL Properties (CBL), with lower overall property quality and significantly higher balance sheet risk, have priced in the significant risks facing malls, and while there is good reason for SPG to command a significant premium to WPG and CBL, there are signs underneath the surface that operations could turn negative at SPG eventually as well, which could lead to a steep decline in share value, without a highly attractive dividend yield to make holding worthwhile.

CBL data by YCharts

In short, SPG is still exposed to the same increasing mall leasing pressures as its peers caused by the overbuilt state of retail real estate in the U.S. The REIT's narrowing leasing spreads, rising occupancy cost ratios, decelerating sales per square foot growth all point to pricing power shifting to tenants. Furthermore, despite its better performing properties, it still has several major tenants that are experiencing declining sales, expect to close stores, and/or are in a state of transition (including Macy's and Sears). Given the recent sell-off in income-oriented securities such as bonds, REITs, and MLPs amid rising interest rates, a REIT yielding 5% or less should be a strong growth REIT and/or face little to no risks to be competitive with alternative investment opportunities. However, SPG's decelerating property performance and exposure to struggling tenants implies that its growth upside is limited. Additionally, its management recently announced that it isn't involved in M&A despite record-low property valuations, lending further evidence to the poor growth environment in its industry. This is especially telling given Simon's cash-rich position due to its ~65% payout ratio and robust balance sheet. Rather than pursuing growth, SPG is instead playing defense by investing its resources in redevelopments while struggling to easily dispose of its weaker properties. Sounds a bit like the same issues confronting WPG and CBL doesn't it?

Investor Takeaway

While SPG is certainly in much better shape than WPG and CBL, its dividend yield is also 1/3-1/4 their size. SPG boasts premier Class A properties, yet its exposure to big box retailers is forcing it to devote excess funds to engage in the same redevelopment and repurposing activities as its lower classed counterparts while trying, somewhat unsuccessfully, to dispose of weaker performing assets. All this while it is clearly facing a shifting balance of pricing power with its tenants.

I am not saying SPG is going to go bankrupt, or that it is even on the verge of experiencing a decline in income; I am simply pointing out that SPG is not the power growth machine with clear skies ahead that its dividend prices it to be (relative to its peers). Sure its payout ratio is pretty low, but there is a reason those funds are being withheld from shareholders (and it isn't for M&A either). I currently rate SPG a hold, and view retailers offering a higher yield with near-peer balance sheets and management teams without big box mall risk (e.g. KIM and SKT) a much more attractive buy at present.

Analyst’s Disclosure: I am/we are long CBL, WPG, SKT, KIM. 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.