By Samuel Smith
Pennsylvania Real Estate Investment Trust (PEI) is a high-yield stock with a lot going for it. Three of the biggest reasons to buy the stock include the fact that (1) PEI's portfolio is rapidly improving through enhanced quality and diversification, (2) it balance sheet is on sound footing, and (3) its valuation is dirt cheap as it trades at a deep discount to NAV and its dividend yield stands at nearly 13%.
At nearly 13%, PEI is one of the highest-yielding stocks in our entire coverage universe. You can see the full list of our high-dividend stocks with 5%+ yields here.
That being said, there remain several reasons not to buy the stock as well: (1) as a mall REIT, the business is lumped in with a broader industry that faces massive disruption and an ongoing wave of store closures with seemingly no end in sight, (2) its properties are not the highest quality in their industry, leaving them exposed to competition, and (3) the dividend is thinly covered, leaving it little margin of safety in the event of further industry headwinds and/or a recession.
PEI is a publicly traded real estate investment trust that owns and manages quality properties in compelling markets. PREIT's robust portfolio of carefully curated retail and lifestyle offerings mixed with destination dining and entertainment experiences are located primarily in the densely populated eastern U.S. with concentrations in the mid-Atlantic's top MSAs. Since 2012, the Company has driven a transformation guided by an emphasis on portfolio quality and balance sheet strength driven by disciplined capital expenditures.
The Bull Case
Reason #1: Improving Portfolio Quality and Diversification
The main reason that PEI looks attractive today is the fact that management has very effectively executed on its strategy to "focus on creating thriving and evolved environments with retail at the core." Since taking over in 2012, PEI's current management team has achieved the following results, which speak for themselves:
Their accomplishments include completing department store repositioning projects, which means they have: successfully re-positioned 13 former department stores with over 25 tenants, no remaining unleased anchor spaces in the core portfolio, among the lowest Sears (OTCPK:SHLDQ) exposure in the sector as well as ownership of 2 of Macy's (M) select group of growth stores, and driven traffic up over 7% during the Easter season at properties where anchors have been replaced.
Additionally, management enjoys an extensive multifamily opportunity which allows for the creation of a powerful mixed-use platform. Due to PEI's presence in densely populated markets, the company has identified significant opportunity to add over 5,000 multifamily units and over 2,000 hotel rooms to its properties. This points to the next phase of the company's portfolio improvement program in which it executes densification projects to capitalize on amenity-rich environments to create interconnected, vibrant communities and in the process harvests up to $300 million in value (almost 60% of its current market cap) through land sales.
The company also has high-impact redevelopment projects coming online this year as Fashion District Philadelphia opens in September and Woodland Mall is scheduled to open in the fourth quarter. Fashion District Philadelphia - a joint venture with Macerich (MAC) already has over 85% of its space committed with key tenants such as City Winery, AMC (AMC) (shockingly, the only theater in downtown Philadelphia), Round One, Nike (NKE), H&M (OTCPK:HNNMY), and Ulta Beauty (ULTA). Woodland Mall has a similarly promising outlook with key tenants Von Maur, Urban Outfitters (URBN), REI, Black Rock Bar & Grill, and The Cheesecake Factory (CAKE) already lined up.
Looking at the broader portfolio, diversification is rapidly improving. Over 50% of 2018's executed leases for future occupancy are with non-apparel tenants such as health & fitness, off-price, dining, entertainment, and arts & crafts. While not all of these are e-commerce proof, some are and the remainder increase the breadth of appeal that PEI's shopping centers offer to customers and should therefore increase their foot traffic and eventually, sales per square foot.
Already, core mall portfolio sales per square foot have reached $525, making the company increasingly closer to being considered a Class A mall REIT like MAC, Simon Property Group (SPG), and Taubman Centers (TCO), rather than a class B mall REIT like Washington Prime Group (WPG) and CBL Associates (CBL). In fact, looking at the portfolio's comparative demographic profile reveals that PEI has a higher average population in a 15 mile ring around its properties than SPG does and its average household income in that 15 mile radius is higher than MAC's. With core mall total leased space standing at 96.6% as of the end of the first quarter and 93% of GLA from the 2017-2018 bankruptcies retained or replaced, the portfolio's health appears strong.
A final plus for the portfolio is that it is quite small compared to other mall REITs. Aside from making them a more likely buyout candidate, it also benefits them by making them nimble, focused, and able to react quickly to further disruption and evolution in the industry.
Reason #2: Sound and Flexible Balance Sheet
Another reason to buy PEI today is due to its sound and flexible balance sheet that gives it the resources it needs to keep its properties attractive in the face of disruption while also enabling it to invest in diversification, densification, and growth initiatives.
In the first half of this year alone, PEI had liquidity of $205 million at the end of 2018 and so far this year has generated over $70 million in incremental liquidity. Additionally, management expects to raise up to $300 million from monetizing multifamily land values over the next few years. In 2020, the company forecasts growing NOI by $26 million - $36 million. Combining $200 million of incremental proceeds from land monetizations with $30 million of NOI growth would reduce the Net Debt to EBITDA ratio by 2 entire turns. Perhaps most important of all is the fact that there are no material debt maturities until 2021.
With most of the portfolio redevelopment work already finished or nearing completion, PEI appears to have plenty of liquidity to meet its needs.
Reason #3: Dirt Cheap Valuation
Despite its balance sheet and property portfolio showing signs of strength, PEI is on sale by virtually every metric. The entire retail industry has been marred by fears of e-commerce disruption leading to declining occupancy rates, loss in pricing power, and ultimately credit downgrades and a credit crunch for retail landlords. Unfortunately, PEI has been punished by association rather than through any demerits of its own. As a result, this has created an opportunity for investors to buy shares on the cheap.
Shares currently trade at a little over 5 times 2019 FFO and offer a dividend yield that is over three times what it was just two and a half years ago despite the portfolio and overall health of the REIT improving during that time period:
Data by YCharts
While the headwinds are very real, PEI's stable balance sheet and stable portfolio situation do not warrant such a steep discount. This is especially true when taking into consideration the growth projects coming online later this year as well as the potential to monetize multifamily land that will also increase foot traffic to stores in the future.
As the graphic below depicts, just taking in the low end estimate value of the company's top 5 properties plus the multifamily land value reveals that shares trade at a 50% discount.
The Bear Case
Reason #1: Retail Headwinds
As already mentioned, retail real estate in the U.S. is going through a rough period right now. U.S. retail shopping centers are significantly overbuilt as the ratio of retail space to population in the U.S. is twice what it is in Canada and four times the rate in Germany. Adding to the pain is the fact that e-commerce is on the rise, with giants like Amazon leading the way and leading to increased brick-and-mortar retailer bankruptcies despite a growing economy. Interest rates are also rising (some estimates indicate that every quarter point increase in rates may result in millions of dollars in lost value, depending on the retail real estate portfolio size).
These factors create an environment that decreases pricing power for retail landlords and, therefore, encourages retail REIT CEOs to sell off properties rather than acquire or develop additional ones, leading to shrinking cash flows per share and a reduced growth outlook as well.
A final headwind for retail real estate is that, by many metrics, we are late in the expansion phase of the economic cycle, and if/when a recession hits, certain types of retail businesses will certainly be among the most heavily hit, especially those already struggling in the current robust economy. In fact, most retail REITs had to slash their dividends significantly during the last recession.
Reason #2: Not a True Class A
Making matters worse for PEI is that its properties are fairly illiquid. This is due to a combination of the aforementioned retail headwinds and the fact that its properties are not yet true Class A mall assets. While institutional investors still have strong interest in Class A mall assets as evidenced by recent joint venture stakes being purchased in malls at Brookfield Property Partners (BPY) as well as the announcement of the exploration of such sales during MAC's Q1 earnings call, this demand is lacking in lower quality mall assets. Even PEI's CEO admitted that their properties have no real comparables in recent market transactions to truly understand their cap rate value.
While management tried to make their portfolio look like Class A in their latest investor presentation (see the chart below), their releasing spreads and sales per square foot clearly lag Class A peers.
They are certainly head-and-shoulders above their Class B peers across the board, but they still lack the resilient re-leasing spreads and sales per square foot of the institutional quality Class A assets.
Given this fact, other than their multifamily land sales, they lack the ability to tap into their portfolio for additional liquidity. If a severe recession and/or further retail headwinds hit, this could prove to be a significant problem for their already thinly covered dividend...
Reason #3: Thin Dividend Coverage
As the previous point mentioned, their dividend - while certainly attractive at present - has a high yield for a reason. Not only was it cut dramatically in 2009 from $2.28 per share (it currently stands at $0.84 per share), but it remains at risk today. This year, the projected funds available for distribution (PEI's equivalent of free cash flow) payout ratio is likely to be over 100%, meaning that the company is counting on its projected NOI growth in 2020 and beyond to make the dividend sustainable.
While this is certainly possible for the reasons mentioned previously, it does assume that a recession does not hit in the near term and that retail headwinds are truly on the way down (which has yet to be born out in the facts). It also assumes that the company can truly derive the monetization that it expects from its multifamily land sales in the near future, which may or may not come to fruition.
While management has doubled down on the safety of its dividend and believes that the Funds Available for Distribution payout ratio will come down to the mid-80s in the coming years, analysts were not buying it on the Q4 earnings call:
You're probably mid-20s, $1.20s (FFO) this year all right which means your AFFO's probably gone from $1.25 to somewhere in the $0.60 to $0.70 range. Why do you have comfort with the dividend? Why wouldn't you rightsize the dividend to your actual cash flow to a payout ratio that back in 2016 made sense. Your leverage is too high, you have other issues that may come about.
The analyst went on to challenge management's optimism used to justify the dividend level by saying that they are "way overpaying" the dividend this year and that it was imprudent for them to bleed cash given the illiquidity of their properties and the uncertain retail environment facing the company. In just three years' time, the company's FFO has fallen from $1.9 to ~$1.25, implying that the negative momentum may not be over.
From a numbers perspective, he makes an excellent point. Funds Available for Distribution will likely come in between $0.65 and $0.77 this year against a $0.84 dividend. Assuming a similar FAD margin rate on FFO moving forward, PEI would need FFO to increase by $0.20 in 2020 (~16% growth rate) just to reach a 100% payout ratio. Given the retail headwinds, the uncertainty of the economic picture, and the company's recent FFO per share trend, it seems to be a bit far-fetched, if not foolhardy for management to continue paying its current dividend. Ultimately, management's only response was that the gap would be bridged by land sales.
Regardless, investors should be mindful that the dividend yield is not fully covered by free cash flow and therefore is not as attractive as it first appears.
Taking the factors discussed thus far into account, PEI bulls have the following arguments in their favor:
- The continued growth in NOI and sales per square foot at PEI's properties means that they are becoming increasingly valuable economically, even as lower quality malls die off. This results in a virtuous cycle for the company as competition from weaker properties will continue to subside over time, enabling PEI's properties to grow even stronger and the landlord to have even more cash flow to reinvest in the properties to make them even more attractive to tenants and shoppers.
- The location of many of its properties in prime real estate in densely populated and economically vibrant communities will help insulate them from the effects of e-commerce while also making the land extremely attractive for redevelopment into alternative uses such as multifamily, storage, hotels, office space, health campuses, lifestyle and fitness centers, and entertainment.
- The company's balance sheet will enable them to continue pouring money into improving their properties, thereby competitively positioning them against alternatives for current and potential tenants.
- The high quality of the current properties will enable them to have stronger bargaining power with tenants. As a result, they should be better able to backfill vacancies from bankruptcies with strong, growing retailers and e-tailers that will remain in business for a while, bringing them savings in future capital expenditures and vacancy losses. Furthermore, they should not have to spend as much in capital expenditures if they do not want to on redevelopment and repositioning projects, since their property quality gives them a position of strength in bargaining with current and future tenants about new leases. This is already displayed through the fact that they have been able to attract such large interest in multifamily development projects on the land adjacent to their shopping centers and malls.
- Property income and foot traffic should increase in the coming years as unpopular dead and dying department store businesses are replaced with more popular young, growing, and diverse retail, entertainment, service, and lifestyle businesses.
These positive trends in the company's property portfolio should generate solid growth in the years to come as:
- Expiring leases are replaced with higher rent leases and the bankruptcy watch list indicates a continued decline in retailer bankruptcies and store closures among PEI's tenant list.
- Asset sales will have a minimal impact moving forward and falling interest rates enable them to keep financing costs low.
- Low-margin and unpopular anchors such as Sears, JCPenney (JCP), and Macy's will continue to be replaced with higher-margin attractive tenants as redevelopments get completed. Between the increases in occupancy rates, the higher rental revenues, increased foot traffic expected from these projects, and the resulting improving pricing power, FFO will significantly increase as will the company's intrinsic value (through both cash flow and more attractive cap rates on its properties due to their improved state).
- The company's investments in redevelopments and developments come online, bringing in new cash flow.
Given all these factors, we believe that PEI should be able to achieve a growth rate in the low single-digits annually, assuming that a significant recession does not hit and that e-commerce headwinds do not continue to escalate beyond current expectations. If either of these alternative outcomes become reality in the near future, the PEI will likely have to cut its dividend, which would likely cause its share price to crater further.
Since the outcomes are so binary, we view this stock as highly speculative and therefore take a neutral stance on it.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.