Dominant Secondary Retail Assets And Washington Prime Group Are Relevant

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About: Washington Prime Group Inc. (WPG), Includes: BPR, CBL, MAC, PEI, SPG, TCO
by: Marel.
Summary

Arguably, the US is over-retailed. However, the 12 largest Metropolitan Statistical Areas (MSAs) exhibit more than 2 times the retail GLA per capita compared to the rest of the US.

Many secondary MSAs are underserved. It's not just about the big cities.

Adjusted for the cost of living, assets located in secondary MSAs look relatively attractive. Constituents in many secondary MSAs have greater purchasing power when compared to primary MSAs.

Class A assets (often referred to as A-Malls) are concentrated within primary MSAs, while secondary catchments cater for differentiated goods/services and are usually referred to as B/C malls.

Be wary of generalizations. Class A malls do not serve the majority of the US population. B/C malls also have strong competitive advantages. It really depends on local dynamics.

First off, below is an interesting graph of the S&P versus mall REITs going back to the early 2000s, which I borrowed from Rida Morwa's recent article. I believe the graph is self-explanatory.

relative performance mall REITs vers S&P

I was actually doing a deep dive in the history of mall REITs, and I'm glad Rida and his team wrote the article on WPG, MAC and mall REITs in general, which has many historical references, including Woolworths. I actually read many articles written in the late 1990s talking about the collapse of retail and malls, having the same negativity as many of the articles we read today. To be fair, one major difference today is technology, but I believe an omnichannel balance will eventually be reached. For example, the fastest-growing online segment is "click and collect", which requires physical stores, many e-tailers are opening brick-and-mortar stores, etc. The world is not binary, and I am generally against an "either/or" mentality.

Retail is going through a major transformation. Many traditional enclosed malls are converting into mixed-use, lifestyle-oriented town centers with open-air components, i.e., hybrid. Mall owners have dramatically increased exposure to restaurants, gyms, entertainment concepts, etc., and have decreased exposure to legacy retail, particularly apparel. As such, when one invests in a mall company today, it is an investment in a mixed-use destination/town center. Many even have tenants, such as co-working, sports facilities, hotels, and some are even building residential units in the parking lots.

There is a lot of bias that only A-malls will survive the so-called retail apocalypse, whilst B and C malls will vanish. I beg to differ. I actually think that A-malls will survive, but so will many B and C malls, especially the ones which are proactive in participating in the above-mentioned transformation. In general, I don't like to label malls assets simply as A, B, C, D, etc. While there is merit in this categorization, the ranking criteria (usually weighted on sales psf) fail to capture several local dynamics. Not all A-Malls are necessarily market dominant assets. In many instances, B and C malls can have stronger durable competitive advantages (the only player in town etc.) than A-Malls. It really depends on local dynamics, and therefore, assets should be analyzed on a case-by-case basis.

Washington Prime Group (WPG) has conducted an interesting study in defence of dominant secondary retail assets. Unfortunately, this study has received limited attention from the investment community. This study, which is buried in the Presentations & Webcasts section of WPG's website, was updated in June 2019 and is broken down into three parts.

1. Secondary markets are not as over-retailed

Most think that the US is over-retailed and this supply is evenly distributed across the country. This is not the case. The 12 largest MSAs exhibit more than 2 times the retail GLA per capita compared to the rest of the US (54.9 SF versus 26.8 SF). While certain secondary MSAs are similarly over-retailed, many secondary MSAs are underserved and rely upon regional retail venues which often capture a two- or three-county catchment.

Retail GLA per capita USA

Source: (1) US Census Bureau; (2) CoStar Group data; (3) WPG June 2019 research findings, slide 2

Bottom line, the US is over-retailed in many parts, but primary MSAs even more so. Don't disregard secondary MSAs. Many people live there and have needs that are served by their local malls, etc. It's not just about New York or Los Angeles.

2. Adjusted for cost of living, assets located in secondary/smaller markets look attractive

Common belief suggests that the average household income of the MSA served by a retail venue should significantly exceed the national average in order for the asset to be characterized as successful. This is why mall companies choose to locate in high-income areas and look at metrics such as average household income, among other things. However, one should also consider the cost of living, as measured by the cost of living index (COLI). Interestingly, there exists a meaningful income "boost" to constituents residing within MSAs with lower COLI adjusted scores, as they benefit from greater purchasing power when compared to primary MSAs. In other words, whilst income matters, the cost of living also matters. Taking both into account, many B and C malls might actually be better-positioned. After COLI adjustment, normalized household incomes suggest constituents residing within WPG's catchment benefit from comparative income increases compared to primary MSAs.

COLI / incomes USA

Sources: (1) US Census Bureau; (2) 2018 Council for Community and Economic Research (ACCRA) Survey; (3) WPG June 2019 research findings, slide 3

Bottom line, after COLI adjustment, assets located in markets such as Johnson City, TN and Kokomo, IN also look attractive. Again, it's not just about New York or Los Angeles.

3. Class A malls do not serve the majority of the US population

Common wisdom dictates that "Class A" and "dominant" are interchangeable when referring to retail venues with $500+ sales psf. However, Class A assets do not serve the majority of the US population. Around 30% of the population situated within the largest 12 MSAs is served by 118 Class A assets, while the other 70% of the population is served by just 105. No doubt, sales psf is an important factor, however other determinants need to be factored in, such as catchment radius competition proximity, COLI and occupancy efficacy.

Class A vs US population

Source: WPG June 2019 research findings, slide 4

WPG's assets are an average 36-minute drive time to the nearest competitor and around an 85-minute drive time to the nearest Class A asset. 85 minutes drive time is quite a bit, so visits to Class A assets are less frequent, meaning that much of the shopping is done locally.

Drive time to nearest A mall

Source: WPG June 2019 research findings, slide 4

drive time to nearest competitor WPG

Source: WPG June 2019 research findings, slide 4

What's more, in secondary MSAs you cannot always have Apple (AAPL), Tesla (TSLA) or Louis Vuitton (OTCPK:LVMHF) stores. As such, it is logical that sales psf are destined to be lower, but so are the rents retailers pay. Ultimately, what matters is the tenancy occupancy cost. In Q2 earnings, WPG reported Tier I sales PSF increased 3.3% to $410 and Tier I occupancy cost decreased 40 basis points to 11.7%. Both metrics are heading in the right direction.

Bottom line, Class A assets do not serve the majority of the US population. Again, it's not just about New York or Los Angeles. Looking at sales psf is not always the best indicator. Other metrics need to be considered, such as tenancy occupancy cost.

Conclusion

Be wary of generalizations. Whilst I believe A-malls are well positioned, and I have invested in A-malls, including Simon Property Group (SPG), Macerich (MAC), Taubman Centers (TCO) and Brookfield Property REIT (BPR), I also believe that many B malls will emerge stronger. It's not just about New York and Los Angeles. Assets located in markets such as Johnson City and Kokomo can also do well. The world is not binary, and not all people live in the big cities or primary MSAs. Not all B-malls can have Apple, Tesla and Louis Vuitton stores (note that these stores tend to inflate sales psf). Despite all the negativity, WPG reported increased sales PSF and decreased occupancy cost. Both metrics are heading in the right direction. In other words, many retailers are profitable in WPG's assets. Sales don't lie, and they have been quite resilient the past few years, even in B malls. It's another indication that we live in an increasingly omnichannel world where both online and brick-and-mortar can, and will, coexist. No doubt, FFO at WPG has taken a hit due to anchor vacancies and co-tenancy matters. These will eventually get cured, and it seems to be a function of time and the rate of additional bankruptcies. Other than that, the strategy of converting traditional malls into mixed-use town centers seems to be working, with the new tenant base heavily weighted towards lifestyle tenants (restaurants, gyms, etc). As a matter of fact, the majority of WPG's vacant department stores have now been addressed. This is something that A as well as B/C mall companies have accomplished in the past few years, whether it's SPG, MAC, TCO, Pennsylvania Real Estate Investment Trust (PEI), BPR, WPG or even CBL & Associates Properties (CBL). Also, what I like about WPG is the large number of unencumbered assets and the charismatic and creative CEO. The lenders and private markets in general seem to give more credit to mall assets compared to the public markets.

Disclosure: I am/we are long WPG, WPG.PH, WPG.PI. 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.

Additional disclosure: I am also long SPG, MAC, TCO, PEI, BPR, CBL-E, CBL-D.