Significant Mispricing Among Retail REITs

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Includes: ADC, BRX, KIM, SKT, SPG
by: Dane Bowler
Summary

The headwinds facing retail have sent the sector down significantly relative to the broader REIT index.

While the sector level movement seems to be appropriate, individual security pricing has gotten out of whack.

We go over which have become overvalued and which are opportunistic.

With so much fresh news hitting each day, it is often easy to lose sight of the big picture. To regain this perspective, we like to take a step back and examine some of the bigger moves over a long stretch of time. While many REIT sectors have had big moves, today I want to focus on retail.

REITs as a group have been volatile in the short term, but fairly steady with a consistent upward trajectory over a full 5 year period. Retail REITs were in lock step with the broader index until October of 2016 where there was a clear inflection point.

Source: SNL Financial

We all recall what happened: The narrative shifted away from cheap gasoline prices fueling retail sales and toward e-commerce killing retail.

In October 2016, the fundamentals had not changed, it was merely the outlook on long term fundamentals that changed. Since current fundamentals remained healthy, FFO/share held strong. This meant the price dip seen in retail REITs created a negative divergence in their FFO multiples.

Source: SNL Financial

When future growth rates are harmed, the impacted companies should trade at a lower multiple. Thus, the market largely got it right at a broad level. However, the market's pricing mechanism does not seem to have held up at a more granular level. It is easy to translate a macro level thesis such as the "death of retail" into the pricing of the category of retail. It is much harder to translate a macro level thesis into the pricing of a specific stock. Invariably, certain names slipped through the cracks.

The lump-in effect

When trades are coming from a top down directive, companies that share a category are often lumped together. Allow me to illustrate this with Tanger (SKT) and Kimco (KIM).

Like much of retail, Tanger has significantly underperformed the broader REIT index.

Source: SNL Financial

Similarly, its FFO has held up better than its price, causing a drop in LTM FFO multiple from 22X to about 11X.

Source: SNL Financial

Kimco seems to have suffered a similar fate, dropping in tandem with retail and falling to an FFO multiple just over 10X.

Source: SNL Financial

I believe these companies have traded on the macro forces with little attention paid to company specific fundamentals. The pricing performance was similar while the fundamental performance has been divergent. Specifically, Tanger's fundamentals have deteriorated with same store NOI growth dropping significantly and even turning negative in recent quarters.

Source: SNL Financial

In contrast, Kimco's fundamentals remain strong with consistently positive deltas in same store NOI.

Source: SNL Financial

I would consider Tanger's drop in FFO multiple to be appropriate, while Kimco seems to have been unfairly punished. We consider KIM to be quite opportunistic at current pricing as its strong operations and balance sheet are not reflected in its market price.

Another company that has been unfairly punished from the same lump-in effect is Simon Properties (SPG). If one were to look at SPG's fundamentals in isolation the stock would clearly be up. Leasing spreads remain favorable and FFO/share is climbing at a good pace both in recent history and in consensus projections.

Source: SNL Financial

It seems unusual that a stock going from FFO of $10.49 in 2016 to FFO of $12.57 in 2019 would be down, yet it is down in absolute terms and has substantially underperformed the REIT index.

Source: SNL Financial

I believe SPG being lumped in with retail is causing the market to view it as a risk play, but the numbers suggest it should be viewed as a growth play. Given the drop, SPG is now a growth company available at the price of a value stock.

False dichotomy

Free-standing single tenant retail has somehow avoided being considered retail and the stocks have almost entirely evaded the dip. Perhaps the reason for this is that free standing retail is often leased in a long term, triple net fashion. As such, the reduced retail space demand of today's environment has not yet shown up in the numbers. The reports only show the contractual rent bump of roughly 1% annually as the renewals are just a minor fraction of leases in any given period.

Eventually, contracts expire and leases will be subject to market rates. On lease turnover, free standing retail will look a lot like the rest of retail and I do not want to be subject to that risk without a commensurate discount. Agree Realty (ADC) has been the biggest beneficiary of this false dichotomy between retail and single tenant retail. It has risen with impunity as its peers have fallen.

Source: SNL Financial

Agree's biggest tenant is Walgreens at 7.6% of revenues as of 3/31/18, and Amazon is now in the pharmaceuticals business with its acquisition of PillPack.

ADC is a good company that has generally made the right decisions, but the environment is going to be quite challenging going forward and there is absolutely no discount baked into the stock price to account for the diffic ulties it will face.

Real Dichotomy

Grocery is an area that despite repeated efforts has not been penetrated by e-commerce. I think there are real barriers that will permanently keep e-commerce at a low market share relative to brick and mortar grocery:

  1. Cost of delivery: Food is bulky relative to its sale price and many products require special care (temperature sensitive or fragile).
  2. Customers want to see and select the food.
  3. Last minute grocery runs: delivery cannot be fast enough in a cost effective manner

As such, I think it is unfair for grocery focused REITs to be lumped in with the rest of retail as their businesses are not subject to the same degree of risk. Brixmor (BRX) has declined materially with the sector.

Source: SNL Financial

We see this drop as inappropriate as its fundamentals have not taken a dip and we see growth going forward with projected re-leasing spreads in the double digits.

Brixmor is intelligently responding to the mispricing by becoming net sellers and using proceeds to buy back some stock.

Conclusion

E-commerce is a persistent and real threat facing brick and mortar retail. This threat, however, has not been priced in appropriately at the company specific level, leading to significant mispricing. We are avoiding companies that do not trade at a discount as these have enhanced fundamental risk without offering any additional reward to investors willing to take on that risk.

Among the stocks that have become discounted, we are selecting those with the strongest fundamentals. I believe SPG, KIM, and BRX will come out ahead.

Disclaimer: This article is provided for informational purposes only. It is not a recommendation to buy or sell any security and is strictly the opinion of the writer. Information contained in this article is impersonal and not tailored to the investment needs of any particular person. It does not constitute a recommendation that any particular security or strategy is suitable for a specific person. Investing in publicly held securities is speculative and involves risk, including the possible loss of principal. The reader must determine whether any investment is suitable and accepts responsibility for their investment decisions. Dane Bowler is an investment advisor representative of 2MCAC, a Wisconsin registered investment advisor. Commentary may contain forward looking statements which are by definition uncertain. Actual results may differ materially from our forecasts or estimations, and 2MCAC and its affiliates cannot be held liable for the use of and reliance upon the opinions, estimates, forecasts and findings in this article.Positive comments made by others should not be construed as an endorsement of the writer's abilities as an investment advisor representative.

Disclosure: I am/we are long BRX, KIM, SPG. 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.

Additional disclosure: 2nd Market Capital and its affiliated accounts are long SPG, KIM and BRX. I am personally long SPG, KIM and BRX.