With CBL & Associates (CBL) common stock now in full-blown disaster mode as all faith erodes in management - I suspect the tenant over billing legal settlement and subsequent dividend suspension is weighing heavily on sentiment - we have been seeing renewed investor interest in another distressed mall player: Washington Prime Group (WPG). Will these new shareholders find safe harbor here or are they setting themselves up for another disaster? I've got some thoughts, but first, I wanted to speak on this rotation move that is clear on Seeking Alpha message boards.
Am I surprised by it? No. Because the long-term story on malls (or retail in general) is to a large degree based on whether a secular shift is underway, I think investors tend to naturally move to the next riskiest play when the story at the bottom gets broken. Think of this as similar to how bulls on a company might move up the capital structure from the equity to bonds as a company becomes stressed. For perspective, I tend to view this area of the REIT market in this way:
Those that have followed my work in this space know that I'm bullish on one portion of the least risky (at least relatively) side of this chart: shopping center REITs. That area is characterized by above-average cap rates, fat premiums, and - perhaps most importantly - positive trends in same-store net operating income ("NOI"). This is an aspect I want to touch on today and emphasize because as fellow contributor Ian Bezek points out, Washington Prime and other REITs have long gotten a lot of love on Seeking Alpha based on one metric: low funds from operations ("FFO") multiples. There are massive pitfalls embedded in that which need more clarification.
The Pitfalls Of FFO
FFO is, by far, the primary metric used for valuing REITs. Unlike other sectors that have their own valuation lingos (e.g., distributable cash flow ("DCF") for MLPs), FFO does have a hard definition, being defined by the NAREIT organization as GAAP net income excluding depreciation and amortization attributable to real estate, gain/loss on asset sales or changes of control, and impairment write-downs. While not mandated within published news releases or within SEC filings, substantially, all publicly-traded REITs stick to this definition strictly.
Why does this matter? Because unlike DCF or other metrics, there is no "maintenance" or "sustaining" capital expenditure component. In other words, there is no adjustment for the expenses of keeping real estate in substantially similar shape from year to year. This is despite the fact that maintenance charges are quite often built into tenant rents. FFO, by its nature, overstates dividend coverage as a result - particularly in areas of real estate like malls where common area maintenance ("CAM") and other expense reimbursements are a larger portion of overall revenue. Consider Washington Prime as an example, from their most recent 10-K:
Tenant reimbursements consist of 26% of revenue. Compare that to say, office player Vornado Realty Trust (VNO) with 11% of revenue coming from reimbursements or on the far end of the equation, Safehold (SAFE) with less than 3%. This is an earnings quality issue.
Getting granular, Washington Prime booked $191mm in tenant reimbursements in 2018. Of that, fee buckets such as real estate taxes are expensed in the year incurred. This should create equal and offsetting entries in revenue and expense on the income statement. However, not all charges are expensed. Any property costs that are capitalized - generally those with greater than one year of useful life such as remodels, parking lot repaving, or another structural repair - would instead flow through as depreciation and amortization.
FFO, by way of its calculation, gives REITs full credit for all revenue booked but backs out the entirety of depreciation and amortization charges. As a result, capitalized maintenance and sustaining costs are fully backed out to find FFO. This is why Wall Street often uses their own adjusted funds from operations ("AFFO") figures in their models that try to control for this dynamic. I got a lot of questions in my REIT Outlook for 2019 research note on the statement that analysts had forecast more than two dozen REITs that would not cover dividends with true FFO. That list included Washington Prime but also others like Pennsylvania Real Estate Investment Trust (PEI) and Kimco (KIM). This is why.
The Retort and The Numbers
Most commercial real estate investors counter this weakness in FFO by pointing to a few things:
- Property values - both structure and the underlying land - tend to rise in value over time.
- Likewise, rents on a property that remain in substantially the same condition also tend to rise over time.
- Particularly, for less capital intensive areas of real estate, the above two facets more than offset that weakness.
The above points rely firmly on the tailwinds to commercial real estate that has existed over the past thirty to forty years... tailwinds that might not hold as firm going forward. It is no surprise that the growth in values in real estate has coincided with the multi-decade bond bull market that has existed since 1981. Property valuation, in general, is pretty consistent in that:
Cap Rate = Risk Free Yield + Required Risk Premium
- Cap Rate: Net Operating Income yield on an investment
- Risk Free Yield: "Riskless" return on money in the market
- Required Risk Premium: Demanded premium to risk free rate
In other words, cap rates are a function of the so-called "risk free rate" (generally the 10yr Treasury acts as a proxy) and investor perception of risk. Over the past thirty to forty years, demanded risk premiums have stayed (relatively) stable in a cyclical pattern. When times are good, risk premiums contract (2007). When times are bad, risk premiums expand (2009).
However, the risk free rate (indicated by Treasury yields) has steadily fallen. 10yr Treasuries, once above 10%, now yield 2.5%. A property that once had 250bps of average risk premium now sells at a cap rate of 5%. In 1983, that cap rate would have been 13%.
Steadily falling bond prices have forced positive trends for commercial real estate valuation. If you told property investors in the 1960s and 1980s that cap rates in some sectors would eventually be as low as 4%, you likely would have gotten laughed out of the room, yet that is the situation the market is in today.
Malls Have Been Different
However, malls do not fit the above at all, currently. Property values have been collapsing here in the United States over the last several years despite investors benefiting from the longest-running economic expansion in history. Same-store net operating income ("SSNOI") figures have continued to comp flat and/or negative despite massive investment in the form of capital expenditures.
Washington Prime Group itself readily admits that SSNOI will be roughly flat over the 2014-2019 period even among its "core" properties (2019 Citi Conference, Slide 8). Adjusted for inflation, the earnings power of the asset base is weaker today than it was five years ago. Of note, this does not include what management calls "non-core" properties (assets that are not Tier One and Open Air) and makes no adjustment for survivorship bias. Include that and the story is weaker. Interestingly enough, Washington Prime will, once again, alter its definition of "core" properties in 2019 (excluding Tier One) in order to juice its reported figures.
Because of all of this, my view is that all capital expenditures used to improve properties needs to be backed out. Maintenance and/or sustaining capital expenditures, by their definition, are what is required to keep earnings power stable. The company has poured hundreds of millions into its assets over the last five years in order to keep comps flat. What would have happened without that spending?
The difficulty here is that properties have moved in and out of the owned pool of properties all the time. A mall that was included in same-store comps in 2016 might not be there today. This also means that capital expenditures spent on that property, which might have been recovered in an asset sale, should not be counted against the company in a fair and reasonable adjustment model. I included an adjustment factor in capital expenditures to control for this based on reported data below.
*Source: Author calculations.
Since 2014, Washington Prime has invested nearly one billion dollars back into its current core property portfolio. Backing out that money and it becomes clear that there has been a steady degradation in true FFO coverage of the dividend over time. 2019, however, looks incredibly poor. Yes, CEO Lou Conforti did his best to explain these issues on SSNOI growth:
As mentioned previously, if you isolate lost rents and applicable cotenancy impact from the Bon-Ton, Sears and Toys "R" Us bankruptcies, we're expecting to see growth of approximately 1.5% at the midpoint of our range… Assuming tenant bankruptcies stabilize and borrowing any extraordinary circumstances, we would anticipate comp NOI growth in 2020 to be between 2% to 3% within our Tier 1 and Open Air portfolios.
If they can hit that and return to 2.5-3.0% comps, then, yes, market fears will subside. However, there is no getting around the fact that 2019 guidance was quite weak. Goldman Sachs analyst Caitlin Burrows already zeroed in on this aspect in the Q4 conference call, stating that "…based on the pieces of guidance that you guys gave as it relates to FFO and then CapEx and then redevelopments then it does seem like that the ability to cover the dividend in 2019 is kind of not there." That's true and illustrated above.
The market just is not buying what Lou Conforti is selling right now. That is probably for good reason. Washington Prime has missed initial same-store guidance (given in Q4 of the prior year) in 2016, 2017, and in 2018. That's a heck of a track record. Why should the market believe 2019 and 2020 guidance is reasonable to achieve?
If this is an execution story, past execution certainly does not give much credence to the story at this REIT. I would encourage investors that are considering an investment here to go backwards and fact check prior management bullishness versus what was actually achieved forward results.
As far as the dividend, unfortunately, I think management has backed themselves into a corner on the dividend payout and might be reticent to cut where they can (dependent on taxable income). With leverage creeping into the 7s next year on clear weakness - Moody's recently did a rather unprecedented multi-notch downgrade into junk - this is not where I would want to be invested. Be careful.
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Disclosure: I am/we are short WPG. 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.