Washington Prime Group Has Many Quality Assets - Case Study Scottsdale Quarter

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About: Washington Prime Group Inc. (WPG)
by: Marel.
Summary

There are several large redevelopment projects underway in Washington Prime's portfolio scheduled for 2019/2020, totaling approximately $215 million with projected yields in excess of 8%.

Scottsdale Quarter represents approximately 1/3rd of the total amount invested in these redevelopment projects.

Note these projects are tenanted, having secured lease agreements prior to commencing construction, i.e., they are not speculative.

Scottsdale Quarter is a prime asset that is overlooked by the market, just like many other assets in the company's portfolio.

This is the first of several articles aiming to shed light on some of the company's misunderstood and unappreciated assets.

Washington Prime Group (WPG) is a retail real estate company that owns open-air retail properties ("Open Air Properties") and enclosed malls ("Enclosed Retail Properties"). The Open Air Properties are performing well, withstanding the so-called "retail apocalypse", with consistently high occupancy rates, resilient average rent per square foot, etc. Arguably, many Open Air Properties are akin to strip malls and lifestyle community centers. On the other hand, several Enclosed Retail Properties got hit by anchor tenant vacancies (predominantly department store chains like Sears) and are now in transition mode. The strategy is to transform traditional enclosed malls into mixed-use, lifestyle-oriented town centers. In fact, lifestyle tenancy accounted for 55% of WPG's new leasing volume. Whilst this transformation strategy appears to be working and positions the transformed malls for long-term success, it also comes at a short-term cost (lost revenue until new projects come on-line).

WPG has a total of 92 key-portfolio properties, comprised of 50 Open Air Properties and 42 Tier 1 Enclosed Retail Properties, with a combined occupancy of 92.5% generating 92.8% of company-wide NOI. Open Air Properties ended Q2 2019 with occupancy of 94.9%, whilst Tier 1 Enclosed Retail Properties ended the quarter with occupancy of 90.5%. WPG also has 10 Tier 2 and 5 non-core properties, assets that it does not believe are worth investing in.

The non-core properties will eventually exit WPG's portfolio. They come with non-recourse mortgages attached, which means that they can be simply passed on to lenders, thus eliminating debt and generating taxable gains (as the carrying value after depreciation is less than the mortgage outstanding), which supports the company's current dividend (due to REIT requirements).

Redevelopment projects = Increased NOI

WPG is currently pursuing eight key redevelopment projects, as illustrated in the table below, each with an estimated investment of $5 million or more. Scottsdale Quarter is by far the largest project, representing almost 35% of the total amount invested. As such, it is worth shedding some light on this project. The company is investing $64.8 million (mid-point of the $59.8-69.8 million range) in Scottsdale Quarter.redevelopment projects

(Source: WPG Q2 2019 supplementary, pg. 16)

Note Scottsdale Quarter is already operational and generating NOI (WPG first invested in the project in 2015). This additional CAPEX relates to growth, more specifically:

  • Ground-level retail in existing residential building
  • Retail and office tenants in mixed-use building
  • New residential and retail development on middle parcel

Note, the $64.8 million investment represents 51% of the project spend, as this is a joint venture (JV) project between WPG and O'Connor (as part of The O'Connor Joint Venture I). Therefore, the combined total investment with the JV partner exceeds $100 million. This is quite a large investment for expanding a center which is already a core asset in WPG's portfolio. The company must see a lot of potential in Scottsdale Quarter given the high-quality nature of the asset.

Scottsdale Quarter

Scottsdale Quarter is located in Scottsdale, Arizona, surrounded by metropolitan Phoenix. It is located in one of the country’s wealthiest communities, centered between the two most luxurious residential areas in the valley: North Scottsdale and Paradise Valley. Known as “the Beverly Hills of the Desert,” Scottsdale is home to some of the most affluent shoppers and is a major tourism destination. It has been ranked 25th among “The 100 Best Places to Live and Launch (a business)” by Fortune Small Business magazine, and Money magazine has included Scottsdale in its “Best Places to Live” over the past few years.

Scottsdale Quarter is an award-winning place to live, work, shop, and play. It has received several local and national design awards. In addition to over 400,000 SF of retail, the mixed-use development includes over 300,000 SF of Class A office space, 275 residential units, as well as a hotel component. As mentioned above, Scottsdale Quarter is a JV between WPG and O'Connor, and it is 95.9% occupied as per the 10-K filing.

Apple (AAPL) is a key retailer in Scottsdale Quarter (photo below).

image 1

Other major tenants include:

Anchors - H&M, iPic Theaters, Restoration Hardware, Apogee Physicians, JDA Software, Starwood Hotels

Key Retailers - Over 80 retailers including American Girl, Apple, Bonobos, Calvin Klein, CB2, Design Within Reach, Drybar, Flywheel Sports, Free People, Intermix, Kendra Scott, lululemon athletica, Pottery Barn, Sephora, Suit Supply, Urban Outfitters, Warby Parker, and West Elm

Dining/Restaurants - True Food Kitchen, Dominick’s Steakhouse, Kona Grill, SOL Mexican Cocina, Eddie V’s Prime Seafood, Brio Tuscan Grille, Grimaldi’s Coal BrickOven Pizzeria, Breakfast Kitchen & Bar, Obon Sushi, Zinburger Wine & Burger Bar

WPG classifies Scottsdale as an "enclosed" mall, whereas in reality it is hybrid...

Scottsdale Quarter is not the typical "enclosed" mall. In the 10-K and quarterly supplemental, WPG classifies Scottsdale Quarter as a "Tier 1 Enclosed Retail Property." This is noteworthy, since many investors (incorrectly and naively) assume that all of WPG's "enclosed" assets are by default low-quality, dying malls. As evidenced from the photos below, this is not a traditional enclosed property and it is certainly not dying. On the contrary, it is prospering.

image 3

int 1 ext 1 ext 2 ext 3

Aerial view of Scottsdale Quarter and surrounding area:

image 2

WPG could do a better job in reclassifying assets like Scottsdale Quarter, as they contain open-air and mixed-use elements, and are hybrid in nature.

Scottsdale Quarter's high-quality status is also reflected in low borrowing costs

As per the latest 10-K, Scottsdale Quarter currently has two long-term loans, with WPG's share of principal balance as follows:

Scottsdale Quarter Loans Maturity Date Interest Rate WPG's Share of Principal Balance
Loan One 6/1/2025

3.53% (fixed)

84,150,000
Loan Two 4/1/2027 4.36% (fixed) 28,050,000

(Source: 10-K, pg. 34)

Given the high-quality nature of the asset, it is possible that WPG can secure additional funds against Scottsdale Quarter in the coming years, providing additional financial flexibility, or even sell the center outright at very low cap rates. However, I want WPG to keep exposure to quality assets like Scottsdale Quarter.

WPG believes in the future of Scottsdale Quarter

It is important to highlight that the redevelopment efforts in Scottsdale Quarter predominantly involve growth initiatives, not addressing bankruptcy headwinds, etc. Specifically, the redevelopment efforts involve the final phase of the significant expansion of the initial development of the project. The first part of the expansion has been completed and consists of buildings on the north and south parcels with tenants such as Design Within Reach, as well as luxury apartment units and office space. Note the word "luxury?" Not something people associate WPG with.

The final component of the expansion will consist of c. 300 new luxury apartment homes and 30,000-35,000 SF of new street-level retail. The street-level retail and luxury apartment units will have substantial amenities, such as new roof-top terraces (overlooking Scottsdale Quarter and the McDowell Mountains) and on-site parking.

WPG has addressed, through executed leases and signed LOIs, more than 80% of the retail space with some first-to-portfolio and first-to-market tenants. Tenants such as Marine Layer are expected to begin opening stores in this final component in Q3 2019.

Conclusion

Scottsdale Quarter is a high-quality, award-winning asset. It is a mixed-use development (retail, residential, office, etc) with a strong open-air component, yet WPG classifies it as "enclosed." I personally don't mind the word "enclosed," but the market seems to mind, big time. There are lots of generalizations regarding enclosed malls, many of which are reaching paranoia levels. Even high-end/Class A mall names like Taubman Centers (TCO) and Macerich Company (MAC) are experiencing massive drops in their share prices, whilst REITs in general are doing very well. As time passes by, mall REITs are increasingly becoming mixed-use given their strategy of transforming traditional enclosed malls into mixed-use, lifestyle-oriented town centers. As such, mall REITs should, in theory, correlate less and less with traditional retail. Never have the breadth of uses and categories been so great in the mall retail space. Now it’s all about restaurants, fitness, theaters & entertainment, value, grocers, experiential, digital, coworking, etc. All this is combined within densification initiatives (multifamily, hotels, self-storage, etc.). Be wary of generalizations. This is the first of several articles aiming to shed light on some of the company's misunderstood and unappreciated assets.

Disclosure: I am/we are long 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.

Additional disclosure: We are also long SPG, MAC, TCO, BPR, CBL-E, CBL-D.