In REITs, Bricks And Mortar Wins

by: Brad Thomas

In the retail investing world, it's true that brick and mortar companies have some stiff competition in the form of e-commerce giant Amazon.

Who would have thought that the Oracle of Omaha would be warming up to the Bezos factor?

The mall of the future is going to be an upgrade from the hodgepodge bunch of clothing shops and food courts we know today.

Are you a horse-racing fan?

Before you get upset at me for titling this article "Bricks And Mortar Wins," let me explain that the so-named horse did, in fact, win the Old Forester Turf Classic, the final race before the Kentucky Derby. According to Blood Horse, before the race, Bricks and Mortar had "won three consecutive races." So this latest one makes it four.

America's Best Racing shines further light on the thundering powerhouse, explaining how, "Bricks and Mortar began his career as a three-year-old with a debut victory in February 2017 on the turf at Gulfstream Park," and the win this weekend should put the colt in contention for future races.

Incidentally, he's owned by Seth Klarman, president of The Baupost Group, which is a very successful hedge fund.

Also incidentally, it turns out that Klarman and I have a few things in common. Both of us are value investors who love money-making "bricks and mortar" plays.

It's that last similarity that has me writing this article today.

Photo Source

Buffett Buys Shares in Amazon

In the retail investing world, it's true that brick and mortar companies have some stiff competition in the form of e-commerce giant Amazon (AMZN). That fact came into sharp focus when, late last week, Warren Buffett revealed that Berkshire Hathaway (BRK.A, BRK.B) was officially investing in it.

Who would have thought that the Oracle of Omaha would be warming up to the Bezos factor? Then again, some believe this latest news is an acknowledgement that there's a changing of the guard at Berkshire Hathaway.

As Cathy Siefert, equity research analyst at CFRA Research, explained to CBS MoneyWatch, "It speaks to what we're seeing at Berkshire, the beginning of the changing of the guard, as Warren and Charlie Munger are getting on in years."

Even so, Berkshire Hathaway also has investments in Store Capital (STOR), as well as Seritage Growth Properties (SRG) - two traditional real estate investment trusts that operate off of actual real estate instead of online carts and mouse clicks.

Source: Yahoo Finance

I'm especially aware of this considering how, in September 2016, I wrote an article titled, "I Wonder If Ben Graham Would Have Invested in Store Capital." And then in May 2017, I upgraded the net lease REIT to a Strong Buy.

Then, less than 60 days later, on June 26, Berkshire Hathaway invested $377 million in Store to become a 9.8% owner (at the time). Shares have since grown by over 50%.

Seritage, on the other hand, has underperformed. That's despite receiving the same golden touch - and then some. In addition to a personal investment by Buffett, Berkshire Hathaway agreed in July 2018 to lend it $2 billion in the form of a term-loan facility.

For our part, we haven't been as confident in the Seritage business model, at least not in its current REIT structure. It's hard to think too well of a company that's suspended its Class A and Class C common share dividends for the remainder of 2019. While that certainly frees up cash for redevelopment, it also suggests that the mall sector may be going through more challenging times.

Warren Buffett is obviously an exceptional investor worth studying, but he isn't perfect and we don't always see things from the same exact perspective. So I also want to point out how he owned Tanger Factory Outlet Centers (SKT) - a position I particularly appreciate - many years ago.

As I explained in a 2017 Seeking Alpha article:

In 2000 Warren Buffett increased his stake in Tanger… from 5% to more than 13%. At the time of the initial purchase (by Buffett), Tanger was trading at a lower multiple and the dividend yield was around 12%. Tanger shares grew by over 25% when the legendary investor purchased shares in the outlet REIT.

According to an April 26, 1999 article by Doug Campbell in The Triad Business Journal, Buffett likely purchased shares in Tanger as a fixed income product. In other words, Buffett likely wasn't investing in Tanger as a "buy and hold" investment, but more so as a corporate bond alternative.

Source: F.A.S.T. Graphs

The chart above illustrated the time in which Buffett purchased those shares (in 1999). And as you can see, they were trading at 3.9x price to funds from operations, or P/FFO, with a dividend yield of 11.5% and a 45% payout ratio. You can clearly see the wide margin of safety, as expressed with these traditional valuation metrics.

Now fast-forward 20 years later, when Tanger is again trading at a wide margin of safety…

Source: F.A.S.T. Graphs

Note: Tanger will report Q1-19 earnings at 8:30 a.m. EDT on May 7; we plan to provide Marketplace readers with an update shortly after.

Reading the Tea Leaves

Since most other mall REITs have already reported, we know - yet again - that our theory still holds true… Despite Amazon being Amazon, the best retail real estate operators are doing just fine. It's just that the gap between the strong and the weak in this space is clear.

And it's only growing more clear as time goes on.

Heading into this reporting cycle, we were curious to see how some of these operators - everyone from the premium mall space to the Class-C landlords - were going to speak about the rampant amount of store closures that have shaken out already this year.

It's been reported that more than 6,000 store closures have been announced by U.S. retailers so far in 2019, which is more than all of 2018. Though, instead of the department stores and big-box players going dark, as was the case with Sears and Toys 'R' Us, this year we've seen more in-line tenants like Charlotte Russe and Payless Shoesource biting the bullet.

So really then… How are mall owners faring?

Like we said before, it depends on who you are. Simon Property Group (NYSE:SPG), for example, is doing just fine.

We wrote on Forbes last week about Simon raising its dividend. It's got plenty of redevelopments in its pipeline, which is key in the industry today. If a mall owner isn't renovating an asset, that gives us some reason to worry.

The mall of the future is going to be an upgrade from the hodgepodge bunch of clothing shops and food courts we know today. We want to see these landlords adding office space, apartment complexes, gyms, and hotels, which is exactly what Simon is doing.

Macerich (MAC) is another one with such things in the works. Its executive vice president of leasing, Doug Healy, told analysts on an earnings conference call:

Looking at our industry and leasing in particular, even with the recently announced closures from early 2019 bankruptcies, we remain bullish on retail in both the Class-A mall sector and in bricks-and-mortar stores. We recognize the first quarter had its share of store closure announcements. But we also recognize those announcing store closures had several things in common.

One, their balance sheets were over-leveraged, preventing them from reinvesting in their brand and their business in order to keep them relevant. Two, there was no focus on customer service. And three, there was no focus on providing any kind of in-store experience. … So as a result, these retailers became obsolete.

He had a few more worthwhile mentions to make, including this one:

Unlike the media, we prefer to focus on the positive things happening in our industry. The things you don't readily read about or hear about. For example, Apple, Lululemon, VF Corp, Abercrombie & Fitch, American Eagle and many other retailers continue to reinvent themselves and are thriving. In fact, American Eagle is opening 30 to 40 new stand-alone Aerie stores this year. Abercrombie & Fitch is once again opening kids' stores. The luxury and cosmetic categories remain strong, led by Louis Vuitton, Gucci, Sephora and Ulta cosmetics. Entertainment, food and beverage, and co-working are on fire.

We think Healy was right to speak about all those strengths in retail that do truly get ignored by the media. We also think that Macerich has been able to atTract some of the healthier and growing retailers to its stronger assets, like Tysons Corner Center outside of Washington, D.C.

But then there's also REITs like CBL & Associates (CBL), which is now watching its stock trade near all-time lows. It recently hit $0.99 a share but has since bounced back above $1.

Just between Bon-Ton and Sears, CBL said it's had roughly 40 anchor stores go dark. Obviously then, it's in a much more vulnerable position than some of these other landlords with assets in more urban and affluent areas. And so it needs more capital on its balance sheet to fund the overhauls that some of its malls need.

In its own recent earnings call, CBL's management team told analysts that the company is working on some multifamily projects, deals to bring in casinos, medical uses, self-storage facilities, and grocers to some of its properties. And it's also looking to do more dispositions.

On that call, CEO Stephen Lebovitz specifically said that the company is "doing everything in our power to lease space, replace former anchors, generate other sources of income, reduce expenses and diversify our tenant base."

While we do think the worst of the 2019 store closure news is behind the retail industry, we do know it's not quite over yet. More will continue to drip out. So mall owners are no doubt very busy right now, working to fill boxes and hoping they don't sit empty for too long.

We don't want to ignore any of that. Obviously. Which is why we recently provided Seeking Alpha Marketplace readers with a deep dive analysis of Washington Prime (WPG), explaining how:

…management is citing a return to 2.0-3.0% growth in 2020, but that's assuming the execution of a bold development and re-development plan, and managing legitimate liquidity concerns while remaining cognizant of the fact management has missed estimates for several years running.

But we also don't want to ignore the positive news. As Macerich's Healy mentioned, there are still retailers opening new stores, and we see a lot of that coming from off-price chains and dollar stores, beauty, and the health-and-wellness space.

Finally, Pennsylvania Real Estate Investment Trust (PEI) boosted the mall REIT subsector Friday afternoon with some solid announcements. As the company explained on its earnings calls, it generated Q1-19 FFO per share of $0.26.

That compares with $0.28 per share in the year-ago quarter, but its core mall total occupancy was 94.7%, up 100 basis points from Q1-18. And same-store net operating income, or NOI, rose 2.2%. It also affirmed full-year adjusted FFO guidance of $1.20 to $1.34 per share.

On its latest earnings call, PREIT CEO Joe Coradino said, "The quality of the portfolio has driven our ability to come in at the top end of our peer group with same-store NOI results and to maintain our full-year guidance."

PREIT's densification efforts will likely generate around $150 million to $300 million as it monetizes land for multi-family development.

During the same earnings call, Coradino also noted how the company already has "several institutional investors engaged," something it sees as "a top priority." So no wonder PEI surged Friday afternoon… up 15.6% for the week, as shown below.

Source: Yahoo Finance

A Few Quotes and Some Data

In honor of Seth Klarman and Bricks and Mortar's win this weekend, I decided to provide a few of Klarman's famous quotes alongside some helpful mall REIT data I've put together.

He's a very smart man, as evidenced by statements such as:

The single greatest edge an investor can have is a long-term orientation."

And this one…

Value investing is risk aversion."

And this one…

Ultimately, nothing should be more important to investors than the ability to sleep soundly at night."

And this one too…

Most investors are primarily oriented toward return - how much they can make - and pay little attention to risk: how much they can lose."

Finally, as you can imagine, this Seth Klarman quote is one of my favorites:

Investors should always keep in mind that the most important metric is not the returns achieved but the returns weighed against the risks incurred. Ultimately, nothing should be more important to investors than the ability to sleep soundly at night."

Personally, I couldn't agree more. I'm anxiously awaiting the Tanger results later today (and follow-up earnings call tomorrow). Thanks for reading, and congratulations to Bricks and Mortar and Seth Klarman for the win!

Author's note: Brad Thomas is a Wall Street writer, and that means he's not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, 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.

Disclosure: I am/we are long SKT, SPG, TCO, PEI. 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.