REIT Rankings: Retail REITs
In our REIT Rankings series, we introduce and update readers to each of the commercial and residential real estate sectors. We rank REITs within the sectors based on both common and unique valuation metrics, presenting investors with numerous options that fit their own investing style and risk/return objectives. We update these rankings every quarter with new developments for existing readers.
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Retail REIT Sector Overview
One of the four major real estate sectors, the retail real estate sector can be divided into two subsectors: enclosed mall REITs and open-air shopping center REITs. Combined, retail REITs comprise roughly 12-15% of the major real estate indexes (VNQ and IYR) and are tracked by the Benchmark Retail Real Estate ETF (RTL).
In the Hoya Capital Mall REIT Index, we track the seven mall REITs, which account for roughly $60 billion in market value: Simon Property Group (SPG), Macerich Co. (MAC), Taubman Centers (TCO), Tanger Factory Outlet Centers (SKT), Pennsylvania REIT (PEI), Washington Prime Group (WPG), CBL & Associates (CBL).
In the Hoya Capital Shopping Center REIT Index, we track the eleven largest shopping center REITs, which account for roughly $50 billion in market value: Regency Centers (REG), Federal Realty (FRT), Kimco (KIM), Brixmor (BRX), Weingarten (WRI), American Assets (AAT), Retail Properties of America (RPAI), SITE Centers (SITC), Acadia Realty (AKR), Urban Edge (UE), and Retail Opportunity Investments (ROIC).
After a development boom during the 1990s and early 2000s, very little new retail space has been created since the recession. Despite that, the US still has more retail square footage than any other country in the world. Elevated levels of store closings in recent years, spurred by the rise of e-commerce, have created ample "shadow supply" of recently vacated space which has negatively impacted retail REIT fundamentals. There has been a significant divergence in fundamentals and stock performance between higher-productivity retail REITs and lower-productivity retail REITs since the end of the recession. Within the open-air shopping center category, there has been a sharp bifurcation between higher-quality grocery/hardline retail-anchored assets and the more ubiquitous "power center" assets with significant softline (clothing & specialty) retail exposure. Within the mall sector, there has been a bifurcation based on location and tenant mix with high-productivity assets significantly outperforming lower-productivity portfolios.
Bull and Bear Thesis for Retail REITs
While retail REITs get more than their fair share of negative headlines, there are a handful of reasons to be bullish on the long-term prospects for the retail REIT sector. Recognizing the challenges of the pure-play online retail strategy, more retailers have embraced the "brick and clicks" omnichannel retail strategy, including e-commerce giant Amazon (AMZN). There's been very limited new construction of retail real estate space over the last decade and high-productivity retail REITs continue to find accretive yields in redeveloping vacated store space into higher-value mixed uses, including multifamily and experience-based retailers. Powered by tax cuts, a robust labor market, and a reacceleration in job growth, 2018 was the best year for total retail sales since 2012 and the best year for "brick and mortar" since 2015.
While the "retail apocalypse" may have been exaggerated, retail REITs continue to be challenged by broader secular headwinds, pressures that have intensified in 2019. Store closures have surged this year as retailers deal with a myriad of pressures including tariff concerns, rising minimum wages, and excess inventory. Downsizing retailers have focused their investment on higher-performing stores and have continued to close weaker-performing stores in lower-tier malls and retail centers. As we often discuss, valuations can be self-reinforcing in the REIT sector and cheap REITs tend to stay cheap as low equity valuations make it more challenging to raise the capital needed for redevelopment and external growth.
As we discussed in our update last quarter, we've generally become quite a bit more bearish on the retail sector over the last year, given the disappointing fundamental performance amid an otherwise ideal macroeconomic backdrop. With near-perfect conditions for retail outperformance, we had expected the recently underperforming retail REITs to turn a corner last year, but the particularly weak operating performance from lower-quality retail REITs dragged on the indexes. The road gets far tougher this year as store closings have picked up once again following a relative reprieve last year. Coresight Research has tracked more than 7,000 closings so far this year, already outpacing the full-year count for 2018, and estimates that up to 12,000 could announce closings by year-end if margin pressures continue.
Macro Retail Sales Trends & Outlook
Earnings results from retailers over the past quarter were generally weaker-than-expected with apparel retailers seeing the worst earnings season performance since the end of the recession, citing a combination of weak store traffic, margin pressures, and weather-related issues. After reaching the fastest rate of growth since 2012 in the middle of last year, retail sales growth has generally moderated over the past several months and data was weak in April. On a trailing-twelve-month basis, total retail sales slowed to 4.3%, retreating from the 5.5% peak rate achieved last August. Non-store (e-commerce) retail sales also slowed to the slowest rate in two years.
For retailers, the more significant issue over the last two years has not been on the demand-side, but rather on the expense-side. Before even considering the margin hit from tariffs and excess inventory, labor costs have risen considerably over the last two years as eighteen states raised their minimum wage in 2018 and many cities (largely in already high-cost markets) have raised minimum wages over the last two years, oftentimes far above market rate, which has begun to result in retail job cuts and store closures. Hourly earnings surged to 5% in early 2019, outpacing the roughly 3% growth in retail sales, while retail has been negative on a year-over-year basis for all of 2019.
While the majority of the store closings (on a square footage basis) over the last five years were concentrated in the anchor and big-box space, more than half of the store closings so far in 2019 have been in the specialty categories, indicating that smaller businesses have been hit especially hard by minimum wage pressures. While hardline and food retailers tend to be somewhat immune from e-commerce related disruption, softline and specialty retail categories are generally more at risk. During the so-called "retail apocalypse" of 2016-2017, these categories were particularly weak but recovered nicely in 2018 before turning lower again over the last two quarters.
The rate of e-commerce market share growth is particularly relevant to the retail REIT sectors, as well as the flip-side of the coin, the logistics and distribution-focused industrial REIT sectors which stand to benefit from growth in e-commerce, which we discussed in our recent report, Industrial REITs: Not Tired of Winning. E-commerce remains a relatively small slice of total retail sales at roughly 10% but represents nearly 20% of at-risk categories which exclude automotive, gas, and food. The relevant statistic to watch, in our view, is the rate of e-commerce market share gains. From 2013 to 2016, e-commerce market share gains were accelerating, corresponding with calls for the retail apocalypse, but have moderated over the last two years as brick-and-mortar retailers found relatively more success in attracting customers through the doors.
Retail REIT Fundamental Performance
Despite the strongest year for brick-and-mortar retail sales since 2012, retail REIT metrics have generally softened over the last several quarters. While 1Q19 earnings were marginally better-than-expected on relatively low expectations, full-year guidance may be difficult to achieve if recent retail trends continue. According to NAREIT's T-Tracker, same-store NOI growth across the retail REIT sector slowed to barely above 1% in 1Q19 on a TTM basis, well below the 2.7% REIT average. Open-air shopping center REITs have been the relative outperformers within the retail sector since 2017.
Retail REITs were the lone major real estate sector to see negative occupancy in the first quarter, dipping 40 basis points on a year-over-year basis, and given the store closings outlook for the rest of 2019, there may be more pain ahead, particularly in the mall segment. The sector has seen generally declining same-store occupancy since peaking in 2015 at above 96.5%. The decline in occupancy is likely understated, however, as retail REITs have actively "recycled" underperforming properties and held low-occupancy properties for sale, outside of the same-store metrics.
Diving deeper into the sub-sector level, the bifurcation between top-tier and lower-tier mall REITs continues to widen. As we pointed out last quarter, a new and unexpected bifurcation has emerged: between REITs and their tenants. High-productivity malls reported a 7.8% rise in tenant sales per square feet in 1Q19, but just a 1.5% rise in same-store NOI growth. Low-productivity mall REITs have seen a similar, although less pronounced, gap in performance. On the positive, leasing trends at the three high-productivity mall REITs continues to be quite strong at more than 15% while the average and lower-productivity REITs have seen a 4.2% decline in leasing spreads, suggesting more pressure on same-store NOI ahead.
In the shopping center segment, we've noted a similar bifurcation between the higher-quality grocery and hardline retail-anchored centers compared to the more ubiquitous power center portfolios. For now, it appears that much of the pain from big-box store closings may be in the rear-view for the sector as leasing spreads have accelerated modestly over the last several quarters. Small-shop occupancy, which has been one potential upside catalyst that we have been discussing for several years, remains stubbornly low and looks unlikely to fully recover this cycle given the minimum wage pressures discussed above.
A sharp disconnect has persisted between private market valuations of retail real estate assets and the REIT-implied valuation, forcing retail REITs to be net sellers of assets for nearly a half-decade. Despite their initiatives to trim their portfolios and take advantage of this disparity, mall REITs still trade at an estimated 20-30% discount to private market values while Shopping Center REITs trade at a more modest 5-15% discount to NAV. However, with relatively few transactions of retail assets, particularly in the mall category, analysts have questioned whether the NAV discount is really as wide as these numbers suggest. Shopping Center REITs sold a net $4.5 billion in assets over the last year, the most on record.
While mall REITs have also been net sellers since 2015, there has been limited transaction activity across the mall sector over the last half-decade. A relatively less liquid market than the shopping center sector, REITs own more than half of all malls across the United States, and individual assets rarely change hands. Over the last twelve months through 1Q19, mall REITs sold a net $500 million in assets.
The saving grace of the retail REIT sector over the past half a decade has been record-low new development. Significant amounts of "shadow supply" from recent and future store closings persist across the sector, however. New supply growth has averaged less than 0.5% of existing stock per year since the recession, helping the industry absorb this ample "shadow supply" from vacated stores. For several high-productivity retail REITs, particularly Simon, Regency, and Taubman, redevelopment remains a substantial source of untapped long-term value. Top-tier retail assets are ideal for the “live-work-play” mixed-use residential expansion and there are a handful of highly successful redevelopments from these three higher-productivity REITs.
We think that high-quality shopping center REITs would be the place to "hide-out" within the retail sector during this potential "double-dip" in macro retail fundamentals. Outside of the highest-quality mall REITs - Simon, Taubman, and Macerich - we think that the mall sector remains largely "uninvestable" for the average nonspeculative investor who for several years have been lured in by double-digit dividend yields and supposedly wide NAV discounts.
Retail REIT Stock Performance
The retail REIT sector underperformed for the third straight year in 2018 with the shopping center sector dipping 15% on a total-return-basis while the mall sector fell 7%. Since the start of 2016, the shopping center has accumulated 32% in underperformance relative to the NAREIT All Equity REIT Index while malls have underperformed by a cumulative total of 25%.
2019 hasn't been much better for the retail REIT sector. While the shopping center sector has enjoyed the tailwinds from the REIT Rejuvenation, jumping nearly 16%, the mall sector remains the lone REIT sector in negative territory. By comparison, the SPDR S&P Retail ETF (XRT) is up by 2% this year. Dipping by 5% so far this year, mall REITs are underperforming their next closest real estate sector - hotels - by a rather staggering 15%.
Diving deeper into the data, we see that the smaller mall-based and outlet-center REITs have been responsible for much of the underperformance with CBL, Tanger, and Washington Prime dipping by double-digits so far this year.
Valuation of Retail REITs
As they have for most of the past half a decade, retail REITs screen as fairly attractive across most traditional REIT metrics. Mall REITs are the "cheapest" REIT sector based on Free Cash Flow (aka AFFO, FAD, CAD) while Shopping Center REITs trade at parity with the REIT average. For the past five years, however, investors would have been better off investing in the most "expensive" retail REITs in the sector, which have significantly outperformed their "cheaper" peers. Retail REITs continue to trade at a wide NAV discount, but as discussed, with the limited number of private market transactions, estimates vary widely.
Dividend Yield of Retail REITs
Based on dividend yield, mall and shopping center REITs rank towards the top, paying an average yield of 5.8% and 4.5%, respectively. Both retail REIT sub-sectors, however, pay out in excess of 90% of their free cash flows towards dividends.
Within the sector, more than other REIT sectors, investors need to be cautious not to fall into common "value traps" by assuming that high dividend yields can offset declining price returns. As we've pointed out for the past several years, despite paying double-digit dividend yields, REITs like CBL, PEI, and WPG face strong headwinds and there's certainly no "free lunch" in equity investing.
Similar themes apply to the shopping center, where we note quite a bit of divergence in dividend yield, which is inversely related to the quality of the underlying portfolio. Brixmor pays the highest yield at 6.3% while American Assets pays the lowest yield at 2.5%. Several REITs are paying dividend yields above their 2019 free cash flows, so investors should expect more modest dividend growth from these REITs in future years.
Bottom Line: Fears of Retail Apocalypse 2.0
Amid the strongest year of brick-and-mortar retail sales growth since 2012, Retail REITs appeared to be turning the corner last year. Suddenly, there are fears of another “retail apocalypse.” Store closings have unexpectedly surged in 2019 as the combination of higher minimum wages, tariff-related cost pressures, and heavy discounting have pressured margins at softline and specialty retailers.
More than 7,000 store closings have been announced this year, already topping 2018 total. Research firm Coresight projects up to 12,000 closings by year-end, potentially a new post-recession record, and primarily concentrated in the mall-based categories. The bifurcation between top-tier and lower-tier retail REITs continues to widen as retailers focus investments into the highest productivity locations. Grocery-based and hardline retail categories have been the standouts.
While first-quarter earnings were solid for retail REITs, 2019 is shaping up to be a tough year. Mall REITs are the lone real estate sector in negative territory YTD. We think that high-quality shopping center REITs will be the place to "hide out" within the retail sector during this potential "double-dip" in macro retail fundamentals. Outside of the highest-quality mall REITs - Simon, Taubman, and Macerich - we think that the mall sector remains largely "uninvestable" for the average nonspeculative investor who for several years have been lured in by double-digit dividend yields and supposedly wide NAV discounts. We continue to reiterate that "yield-chasing" has historically been an underperforming strategy in the REIT sector with "low-yield" as a factor seeing sizable total return outperformance compared to higher-yielding REITs.
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Disclosure: I am/we are long VNQ, SPG, REG, TCO. 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.
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