Run, Forrest, Run

Summary

• The crux of the issue really boils down to the company’s ability to manage its spending and dividend distribution levels.
• Washington Prime estimates that its share of additional capital investment will be approximately $300 million to $350 million to transition this real estate "with a three-to-five-year investment horizon".
• I am fairly confident that the shares have not yet priced in that possibility or the likely notion of a dividend cut.
• I'm downgrading shares in Washington Prime to a Strong Sell.
• This idea was discussed in more depth with members of my private investing community, Intelligent REIT Investor. Get started today »

One of my favorite movies of all-time is "Forrest Gump," and if you've seen the movie, I am sure you can remember how Forrest escapes the bullies chasing him, revealing his speed. Forrest's friend, Jenny Curran, was trying to help and to warn of the bullies chasing him, she warned, "Run, Forrest, Run".

That's precisely why I used the title to my article today, I want to provide a harbinger for investors and heed caution for shareholders (and prospective shareholders) of Washington Prime (WPG).

Photo Source

Before getting started, let me explain the reasoning behind my article: CBL Properties (CBL) and WPG are yielding double-digits, and when I see yields in excess of 10%, I am cautious.

A few days ago, I wrote on CBL and in that article I explained, "I'm downgrading CBL to a Strong Sell", and recently Michael Boyd explained that "For the common equity to be worth $0, the portfolio would have to trade at a blended 12% cap rate."

I'm astonished to see the number of articles on Seeking Alpha where writers are suggesting CBL as a BUY (speculative or not) after a dividend cut, let alone, multiple dividend cuts.

For CBL, my STRONG SELL, is the best way I can describe the shares of the company. It's my job, as an analyst, to steer investors to safety, and I would be remiss to provide readers and investors with any rating other than that.

The crux of the issue really boils down to the company's ability to manage its spending level and dividend distribution level, and if you are not addressing these with the worst case in mind, you aren't truly an investor, you are a speculator.

Washington Prime Is "Grinding It Out"

First off, I want to give credit, when credit is due.

Washington Prime is doing a good job at managing its portfolio risk. For example, since 2014 the company has had 2.3MSF (nearly 10% of inline space) "succumb to the black cloaked, scythe wielding, grim reaper known as bankruptcy" (CEO's words from Investor Presentation), and in spite of this the company has "evidenced minimal variance as it relates to operating metrics". Between 2014 and 2018, comparable occupancy decreased by less than 200 basis points:

Furthermore, Washington Prime has leased over 2.7 million square feet as of August 31 (includes anchor and office space, as well as leases, signed post-closing period). Year-to-date, leasing continues to be robust with total leasing volume for the portfolio totaling over 2.7 million square feet through August 31.

In Q2-18 the company's occupancy on a portfolio basis was flat with both Tier 1 (92.8%) and Open Air (95.1%). Also, in-line sales per square foot for both Tier 1 and Tier 2 assets, which in Q1-18 exhibited their highest year-over-year growth over the previous five quarters, continues to improve with an overall 50 basis points increase year-over-year to $377.

So in the context of "grinding it out", I think it's important to recognize Washington Prime's management team for leasing space and managing the "black cloaked, scythe wielding, grim reaper known as bankruptcy".

The Big Elephant in the Room

Washington Prime owns 109 assets comprised of 60 million square feet:

Redevelopment and resultant adaptive reuse is one of Washington Prime's "most intriguing value propositions". In 2017 the company allocated $87 million to redevelopment with plans to allocate $100 to $125 million to redevelopment in 2018. As of JUN 30 2018, redevelopment includes 43 projects underway ranging from between $1.0M and $60M (with an estimated average ROIC is ~10.0%). The company has allocated nearly 90% of redevelopment capital to Open Air and Tier One assets since the beginning of 2016.

Currently Washington Prime has 28 department store boxes in the Tier One and Open Air portfolios which the company believes will need to be repositioned. This includes Sears (SHLD) (other than those owned by Seritage) and Bon-Ton Stores (OTC:BONT).

Of the 28 locations, Washington Prime owns all but three spaces and is currently in various stages of active planning and negotiations or commitments to replace or redevelop 24 of these locations.

To put this into perspective, revenue derived from the 28 boxes equates to only 1.7% of total annualized revenue for the combined Tier One and OpenAir portfolios. Washington Prime estimates that its share of additional capital investment will be approximately $300 to $350 million to transition this real estate "with a three-to-five-year investment horizon".

But wait? What if Sears goes away sooner?

As I said earlier, before jumping on the mouth-watering 13.7% dividend yield, shouldn't the investor consider the effects if Sears goes under?

As you can see, Washington Prime has 13 Sears stores and 36 JC Penney stores, and in the likely event of Sears filling bankruptcy, Washington Prime will not have a "three-to-five-year investment horizon".

And remember, it's not just the 28 departments stores and $300 to $350 million of capital to be invested, but the "intrinsic volatility within the Tier Two portfolio". As the company points out, "these assets are subject to a much higher risk-adjusted ROIC threshold" before the company "would even consider allocating a marginal unit".

Again, I will point out that Washington Prime's management team has done a good job disposing of the Tier Two assets, the company has sold to third parties or gave back to lenders 13 assets during the previous 24 months. The Tier Two assets now represent around 10% of core NOI, compared to 25% two years ago.

Run, Forrest, Run

So why am I applauding Washington Prime for "grinding it out" while simultaneously voicing my "Run, Forrest, Run" harbinger?

As noted above, the double-digit yield suggests Washington Prime is a risky trade, and the earnings multiple validates the danger.

Source: Rhino Real Estate Advisors

Given the tools that Washington Prime has today, I believe management is doing a good job; however, my concern is what management does when Sears files bankruptcy? I am fairly confident that the shares have not yet priced in that possibility or the likely notion of a dividend cut…

In Q2-18 Washington Prime reported FFO per share of $0.37 and reaffirmed year adjusted FFO guidance of $1.48-$1.56 per share.

Keep in mind, Washington Prime has maintained a $.25 per square quarterly dividend since listing shares, and the big difference between FFO and AFFO is that the AFFO metric subtracts (from FFO) improvements such as tenant allowances.

So, many analysts and some companies began to report "Adjusted Funds from Operations" (or AFFO). The biggest change by far that AFFO makes to FFO is to subtract recurring capital expenditures. Since AFFO is designed to be a closer proxy for actual normalized cash flows per share, a common computation of AFFO might appear as follows:

FFO - Straight Lined Rents - Recurring CapEx + Equity-Based Compensation + Lease Intangibles + Deferred Financing Cost

In a recent article, PendragonY explains that "management has plans to spend as much as $205 million on redevelopment and other capital projects. I think it's reasonable to estimate that $100 million or so of those funds will come out of operational cash flow." He is essentially providing us with a proxy for Washington' Prime's cash flow per share:

Source: PendragonY

Simply out: PendragonY is suggesting that after $250 million redevelopment costs, Washington Prime's dividend coverage will be just over 100%. Keep in mind, the company plans to spend $300 to $350 million on 28 department store retrofits over the next three-to-five years and plans to allocate $100 to $125 million to redevelopment in 2018.

Washington Prime has approximately $440 million of current available liquidity when considering cash on hand and capacity on the credit facility (excludes another $44 million of proceeds from the remaining Four Corners' outparcel transactions and $30 to $35 million from planned mortgage financing, which collectively will put the company in a position to have over a $0.5 billion of liquidity).

Again, management has done a very good job of allocating capital - along with free cash flow after payment of the dividend, the company has ample capacity for its current redevelopment pipeline. However, if Sears files bankruptcy, Washington Prime will be forced to cut its dividend, and I do not believe that this has been priced in yet.

In the words of Forrest Gump, "Stupid is as stupid does" and while I certainly recognize that there's money to be made investing in shares on Washington Prime, I believe strongly that there is considerable downside ahead. I'm downgrading shares in Washington Prime to a STRONG SELL, based solely on the lack of dividend safety. And I'll conclude this article with quote from Forrest, "That's all I have to say about that."

STAY TUNED for the Spooky REIT List in October. Boo!

Author's note: Brad Thomas is a Wall Street writer, and that means he is not always right with his predictions or recommendations. That also applies to his grammar. Please excuse any typos, and be assured that he will do his best to correct any errors if they are overlooked.

Finally, this article is free, and the sole purpose for writing it is to assist with research, while also providing a forum for second-level thinking.

Source: FAST Graphs and WPG Investor Presentation.

Analyst’s Disclosure: I am/we are long ACC, AVB, BHR, BPY, BRX, BXMT, CCI, CIO, CLDT, CONE, CORR, CTRE, CXP, CUBE, DEA, DLR, DOC, EPR, EQIX, ESS, EXR, FRT, GDS, GEO, GMRE, GPT, HASI, HT, HTA, INN, IRET, IRM, JCAP, KIM, KREF, KRG, LADR, LAND, LMRK, LTC, MNR, MPW, NNN, NXRT, O, OFC, OHI, OUT, PEB, PEI, PK, PSB, PTTTS, QTS, REG, RHP, RLJ, ROIC, SBRA, SKT, SPG, SRC, STAG, STOR, TCO, TRTX, UBA, UMH, UNIT, VER, VICI, VNO, VNQ, VTR, WPC. 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.

Comments

[Brad Thomas]

"The market acted as expected and that's why there is value and return here."

Where can we buy your crystal ball?

[jbbson]

The same place you buy yours, of course.

[jbbson]

Our thesis on this company is working out about as planned. It was obvious revenues would drop as they exited bad tenants and bad properties. The market acted as expected and that's why there is value and return here.

It seems we may have touched bottom as the final capitulation of the sears space is now under way and new revenues from their on-going modernization are begining to come in. The space is being developed into todays market and it's reasonable to expect todays returns. There is nothing sky high about WPG or their plans.

They are well prepared for the future and they have a lot of opportunity in front of them.

[egga]

Do you like the WPG commons or preferrds better? Im starting to buy a little of the preferred. The extreme yield on the commons make me nervous

[jbbson]

@egga

I only have the common but I am interested in the preferred having read CWM theory on high yield and common stock vs. preferreds.

[Safed]

Looks like the analysis was totally wrong.

[StrattonOakmont]

How so? Both are down...lol

[The Mac]

as is the whole market.

whats your point?

[StrattonOakmont]

The analysis wasnt wrong

[jbbson]

More on Mr. Confortis main point:

Conforti: "We need to disabuse the farcical notion of a Sears bankruptcy filing (whether or not it comes to fruition) will come as a surprise to us. We have taken the appropriate financial, operational and strategic measures, and as a result regard such events as an opportunity.”

[Brad Thomas]

Conforti said in a press release....

“We’ve worked diligently to address unproductive department store space over the previous couple of years and recent reports of an imminent Sears bankruptcy filing shouldn’t come as a surprise to any landlord unless they own a few Zayre or E.J Korvette locations trapped in a space-time continuum where the Sansabelt clad relax on shag carpeting, illuminated by the warm glow of a lava lamp while they drink Tang and vodka and listen to The Moody Blues.”

Hmmmm....maybe I'm trapped in a space-time continiuum with my warm glow lava lamp drinking Tang....

I give it to Lou, he has memorized more synoyms than most ... LOL

seekingalpha.com/...

[jbbson]

Looks like you used google? lol

I think his point was - he made it once, than "again an again an again and again" - people that don't understand what they are doing are indeed living in another world.

[lford]

Brad,
Lou appears to be very smart, a talented real estate executive, and his analogy was not a synonym. WPG has been very good to me this year for a 26% positive return, including dividends and trades, and my reduced position currently has a small capital gain, so perhaps I am biased.

[Pablomike]

I was indeed LMAO when I read that quote yesterday. Painted quite a picture. I see the open shirt with the gold chain dangling.

[jbbson]

The percentage of WPG space occupied by sears is above 10% I believe. The percent of income they contribute to WPG is under 1%.

This is the gold mine WPG is working.

A quick Duck Duck search (stay away from porn riddled, virus filled google): "WPG terminates sears lease" will yield a lot of insight on how fast and focused they are on this. The message from WPG is the redevelopments will take on a mixed use including residential, retail, entertainment and food. Once they redevelop to the highest and best use, which isn't sears, this space will be contributing immensely to WPGs bottom line.

[egga]

What do people think would a moderate recession do to a retain REIT like WPG? (Im really asking, not being sarcastic.) The market seems to be expecting a recession real soon looking at the share price of F and the like

[dbdaw]

Kind of disappointing WPG and CBL so far both down less than 5% given the news about Sears. Will be interesting to see where they close today.

[slow1234]

@dbdaw read between the lines, not just the head lines .. headlines just fit the narrative not the reality

[PendragonY]

Its still pretty early in the day.

[slow1234]

@PendragonY I have been betting that SPY will close the year flat to slightly down and WPG slightly up. Depending on the timing of the earnings (CBL's in fact) I suspect there may be an opportunity ahead in the next couple of weeks ...

[Brad Thomas]

Sears arranges financing for a potential bankruptcy filing after 125 years in business

www.cnbc.com/...

[PendragonY]

Ruh Roh. The tide seems to be going out, I guess we will see who has been swimming naked. Folks holding CBL and WPG will certainly be hating life unless Sears makes this payment on Monday.

[slow1234]

gents,

mr Hedge guy may be using the upcoming 134 mil payment as a lever to restructure the 1.1 B due in 2019/2020 time frame.

To wit " that would include shaving more than $1 billion from Sears’s $5.5 billion debt load, selling another $1.5 billion of real estate and divesting $1.75 billion of assets, including the Kenmore appliance brand, which he has offered $400 million to buy himself."

So ultimately you have mr "grind it out" ops guy who operates like a vulture fund trying to picking the carcass (re: BonTon) and mr hot shot hedgey who has the creditors on the barrel.

Would not be surprised if WPG picks up some stand alone SEARS properties and hands the keys to the lender on others.

I smell opportunity here GLTA ..

[Pablomike]

Brad,
The presser says he is asking for money. Is it a given he gets it??

[konez]

Thanks to all for the great information and analysis. Beats Wall Street research ! Question to the group. Aside from wpg and cbl which other mall reits could face serious liquidity problems over the next few years? I was looking at ROIC and noticed they have a lot of grocery anchored power centers that I thought might face increasing risk as grocery starts migrating online more significantly over the next few years. Thanks!

[umiami]

The shifting of grocery online seems mostly to be ordering online for pickup which should mean the stronger stores survive. The Amazon/Whole Foods combination has been way overhyped

[The Mac]

i personally would never order groceries online, as i cant see what im actually buying.

[PendragonY]

"i personally would never order groceries online, as i cant see what im actually buying."

For canned goods, dry goods, and paper goods and possibly even frozen foods that doesn't matter. But yeah, don't see getting meat or produce or bread this way.

[Brad Thomas]

I will only take credit for steering yield chasers to safety ;)

[SeeItSkiIt]

Earnings later this month. Liked that the qtr numbers and what the CEO had to say. Odd to see a contributor take credit for a stocks decline. EGO anyone?

[dbdaw]

Thanks Brad

[Brad Thomas]

dbdaw - 25% chance its 2018, 50% its 2019, 20% chance its 2020, and 5% chance its 2021

Caveat Emptor: High-Yielding Mall REITs

www.forbes.com/...

[dbdaw]

Brad - It seems your bearishness on WPG is based heavily on your belief that Sears will go bankrupt sooner than is expected - would you care to put a "by date" on Sears bankruptcy?

[Brad Thomas]

@Beyond Saving

Morningstar:

"We expect mall tenants to continue to exercise their rights under any co-tenancy clauses to renegotiate their leases or exit malls altogether as department-store anchors close. Morningstar will provide further alerts on Sears, which has 206 locations backing 236 CMBS loans with an aggregate allocated principal balance of $12.09 billion, as additional information becomes available. "

[Brad Thomas]

Beyond Savings - in my experience, many co-tenancy clauses contain strict re-leasing language, such as

if the anchor space is not re-leased to a suitable tenant within a certain time frame (12-24 months) the tenant has a right to terminate the lease and/or go to reduced (50%) rent deduction."

Also, to accurately model loss of rent one must also take into account the operating costs such as taxes, insurance, CAM, etc..and then if two anchors vacate (ie JCP)....maybe the highest and best use become a flea market...Take it from me, co-tenancy can be painful and with many of these older leases (Sears and JCP) the tenant has most of the leverage...

[Beyond Saving]

"if the anchor space is not re-leased to a suitable tenant within a certain time frame (12-24 months)"- Exactly my point. WPG has a time period to cure, that is standard in every contract. And it is also quite common to have a clause requiring the tenant to show that their sales have actually declined.

WPG intends on replacing EVERY Sears in their inventory in 3-5 years. So if they liquidate in July of next year, they are 1 year in. In 24 months, you are now at 3 years- the earliest target to be finished replacing EVERY single Sears. So if SHLD files bankruptcy in Q1 of next year, WPG should be able to re-lease a very significant portion of the spaces before co-tenancy clauses kick in. If not, then they don't have a prayer of completing in their stated time-frame. So far, WPG has not demonstrated that kind of incompetence. Forget the co-tenancy clauses, if a significant number of the spaces remain vacant for over 2-years, the entire bull thesis for redeveloping malls is bust. 2-years is a long time for a well funded national REIT to search for tenants for malls with $400/sq ft in sales. (It is actually much longer than 2-years because despite your assertions that WPG is not "prepared" they are in negotiations for 23 of the 28 big box stores in their tier 1 portfolio- a good year before the clock even starts ticking on co-tenancy clauses)

"Also, to accurately model loss of rent one must also take into account the operating costs such as taxes, insurance, CAM, etc..and then if two anchors vacate (ie JCP)....maybe the highest and best use become a flea market..."- I included taxes and insurance. I allowed about $6-$7 million to come up with the $20-$25 million figure. Again, that is probably dramatically overstating reality because unless you believe management outright lied in their conference call, they are in negotiations for leasing 23 of the spaces. One of those spaces, Fairfield Commons, WPG literally is kicking Sears out because they've already leased the space.

You're worrying about the pennies in a $350 million project. And they are pennies that probably won't be lost anyway.

[PendragonY]

"WPG intends on replacing EVERY Sears in their inventory in 3-5 years."

And what happens if they don't HAVE 3 to 5 years? And what about what happens if some other chains close more stores than anticipated?

[Beyond Saving]

"And what happens if they don't HAVE 3 to 5 years?"- They do. Assuming SHLD bankruptcy in January of 2019, which we ought to be able to agree is the earliest likely date (even Sears brings in extra cash flow for the holidays), it will be July when the first BK liquidations start. From the actual closing date, they have 12-24 months before co-tenancy clauses start kicking in. So before the co-tenancy clauses kick in, they are at least 2-3 years into the 3-5 years. Like I said above, to be done in 3 years, WPG REQUIRES SHLD to seek bankruptcy in January.

If they do get hit by a few co-tenancy issues, it will be a few of their lower priority malls, not their entire portfolio. They will be relatively small compared to the $300-$350 million they are deploying. Does it make a material difference if WPG loses $10 million in rent at some point over the next 3 years? Not really.

"And what about what happens if some other chains close more stores than anticipated?"- They prioritize.

[konez]

I would like to hear people’s opinions on the impact of triggering co tenancy clauses as anchor tenants go BK. Sounds like could be a problem. Also for what is it worth I have heard that WPG is acting as a franchisee in order to fill space. If true sounds desperate and risky.

[Beyond Saving]

WPG guided for $3-4 million in 2019 due to the BONT bankruptcy, assuming that none of the stores were filled and that the co-tenancy provisions actually kick in. It isn't enough that the stores are vacant, the tenant has to also demonstrate that they have an actual financial decline in their monthly sales. Co-tenancy provisions are meant to protect tenants from actual financial harm, not just award reduced rent because an anchor is closed. Often, the contracts are written in a way that their rent changes from a fixed rate to a percentage of monthly sales (or a lower base + percentage).

So there are a few things we would need to consider. We can guesstimate that SHLD would have 3x the impact of BONT, due to their larger size and the stronger likelihood of being included in co-tenancy clauses. Say $12 million/year, that is about 1.7% of annual revenues.

The actual impact would be somewhat less because we know WPG is ready to pull the trigger to redevelop some of the Sears stores and that SRG is ready to redevelop some of theirs. For several malls, the process will be started before the liquidation sales start like the redevelopment announced for Fairfield Commons. seekingalpha.com/...

Then, even for the malls that are lower on the priority list, the tenants have to show actual financial damage. How many people go to the mall to shop at Sears? Very few. Are most Victoria Secret and Bath & Body Works customers going to decide NOT to go to those stores because the Sears is closed in the mall? At least some tenants with co-tenancy clauses are unlikely to see a drop in sales. Some with overlapping products might actually see an increase in sales.

Sears is failing because people don't want to shop there. You can probably count the number of people who go to the mall specifically to shop at Sears on your fingers. So in the "worst case scenario" where Sears closing causes drastic drops in sales for the whole mall and WPG and SRG fail to redevelop any of the locations before the co-tenancy clauses kick in, you are looking at an impact in the low teens, plus the $6 million or so of direct rent, plus the property expenses currently paid by SHLD. Call it something like $20-$25 million- approximately 3-3.5% of revenues.

In reality, it will likely be dramatically less than that because some locations will be redeveloped very quickly, and some (I'd argue most) tenants won't see an actual decline in sales.

[The Deacon]

For those that like to debate the value of lower tier malls and compare them to the value a CBL or WPG are carrying their books, here's links to two articles on a sale of a mall that just closed. Took 3 years to sell at almost a 40% discount to asking price. The mall had a major redevelopment before it listed..

santamariatimes.com/...

santamariatimes.com/...

[thebroker8829]

Wow!!! 40% - That's almost a BOGO sale!!!

[Frontrange]

Well . . does depend on what the carrying value for the specific asset is.

The offer price on the mall was 100/ft and the purchase price was 65/ft (without a parking structure as w/o tenant owned boxes).

The median carrying value for the Tier 2 assets on WPG balance sheet (as of last year's 10k) was 63/ft. The non-core assets were carried at 48, 25, and 56 respectively.

[Beyond Saving]

From the article-"“We’ve described the property as an opportunity to continue adding value and re-positioning the mall,” Voorhees said. “[It’s] 72 percent occupied which provides an immediate opportunity.”"-

That fact alone makes it difficult to comp to anything WPG owns. There is a huge difference in value for a mall that is 90%+ occupied and something 72%. A mall at 72% is clearly distressed, many bears treat WPG malls as if they are distressed when by and large they are not.

[Brad Thomas]

"but what is next? "

We don't know when Sears will file....that's the big elephant....is WPG prepared? Will JCP close more stores and Is WPG prepared?

[Frontrange]

That's not new information . . .

It is a rate of change issue . . do the closing become worse than last 2 years or not. At least for the sector.

As far as WPG I think the bigger issue is individual mall tipping points . .i.e. when does a Tier 1 Mall tip over to Tier 2 or non-core? E.g. is the Mesa Mall at risk for becoming one a dead mall or not. I'd guess there are probably 1/2 dozen or so malls in WPG portfolio in that position. Looking over carry value and occupancy rates, I'd flag: Bowie MD, Edison FL, Grand WV, Mesa CO, Melbourne FL, Southern Town IA as the interesting cases to prove or disprove WPG management ability.