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We believe that mall REIT market prices have bottomed, and the recovery is underway. This idea rests on 3 core concepts:
- The fundamental damage was less than it appeared due to redevelopment timing issues.
- The fundamental damage has been less than the market response
- The favorable side of the redevelopment timing is upon us.
Allow us to explore each of these concepts and put it together to form the mall REIT recovery thesis.
Fundamental damage has been less than it appears
If one looks at headline numbers such as revenue, earnings or FFO, mall REIT performance has looked devastating for the past few years. We could use just about any mall REIT to illustrate this concept, but for simplicity, let us use Washington Prime (WPG) to represent the lower end malls, Pennsylvania REIT (PEI) to represent the middle tier and Macerich (MAC) to show the high end.
FFO has fallen significantly for WPG and PEI over the past 9 quarters.
From 2Q17 to 2Q19, FFO fell from $110.6mm to $61.2mm for WPG and from $29.4mm to $19.3mm for PEI. In percentage terms, these are drops of 44.6% and 34.3% respectively.
That looks damning. When combined with the prevailing death of retail narrative popularized by the media, it is easy to assume these losses are related to some combination of tenant bankruptcies and voluntary closures. A deeper look reveals that only a small portion of FFO losses are of this nature.
Same store NOI has dropped less than 10% cumulatively for WPG and less than 7% cumulatively for PEI.
This figure represents the true organic losses sustained by the challenging retail environment.
A majority of the FFO loss has been from asset sales and redevelopment. Both companies are selling their lowest quality properties, which means sales are at fairly high cap rates. The FFO loss from selling these assets is immediate while the FFO gain from reinvesting the proceeds is delayed since redevelopments take up to a few years to stabilize.
The FFO loss from culling the weak properties shows up in the headline numbers while the quality improvements do not. FFO may be 30% to 50% lower for the lower end mall REITs, but the caliber of the remaining FFO is much higher. Sales per foot are up dramatically, and occupancy costs are down, meaning the trajectory of future rent rolls is strongly positive.
Fundamentals have declined for malls over the past 9 quarters, but not nearly to the extent the headline numbers would indicate.
Extreme market response
WPG and PEI are each down nearly 80% over the past 3 years.
The market price fall greatly exceeded the drop in FFO causing substantial multiple declines.
PEI and WPG traded at 12.5X and 7.5X 3 years ago and now trade at 4.5X and 2.5X, respectively.
In summary, the FFO declines were far larger than the fundamental declines, and the market price reaction was far larger than the FFO declines. The price has fallen orders of magnitude further than the fundamentals. These REITs have gotten very cheap.
As a thought exercise, let us consider what should have happened to the trading multiples.
These companies have materially improved the quality of their portfolios and are on the cusp of positive growth. Higher sales per foot and improved outlooks on FFO growth and leasing spreads would normally increase trading multiples, yet both companies are trading at about a third of the multiples at which they traded 3 years ago.
Favorable period of redevelopment and re-tenanting
PEI was the first of the B mall REITs to begin its portfolio transition, and it is now finally reaping the rewards. For the first time in years, the balance has tipped with openings outweighing dispositions. Redevelopments have been money sinks for years with capital being deployed and not yet cashflowing. This too is changing. Now, the majority of the capital has already been deployed so the drain will slow, and we are on the verge of a wave of openings.
This opening spree will be kicked off by Fashion District, a Joint Venture between PEI and Macerich.
Joe Coradino (PEI’s CEO) predicted on the 2Q19 call “Fashion District, which will stabilize at over $18 million of NOI at our share, representing almost 10% of additional same-store NOI”.
As of today, Fashion District is over 90% leased (or in active negotiation), and the redevelopment guidance is becoming a reality.
Woodland Mall’s expansions open on October 12th. This includes Von Maur, Urban Outfitters, Tricho Salon, Williams-Sonoma, Bath & Body Works, Black Rock Bar & Grill, and a Cheesecake Factory.
Plymouth Meeting Mall’s closed Macy’s store has been successfully replaced along with additional tenants joining the fray. DICK'S Sporting Goods (NYSE:DKS) is taking up the anchor roll and is joined by Burlington, Miller’s Ale, and Roll by Goodyear.
Coradino estimates these incremental leases approximate $25mm revenue annually or approximately $30 cents a share. The wave of openings will send PEI’s FFO into positive growth.
WPG is a bit earlier in its transition with its wave of openings scheduled to hit in 2020. They are confident enough, however, to have already issued 2020 guidance showing positive organic growth.
What about the high end malls?
The high end Mall REITs have gotten hit almost as hard by the market’s fury.
MAC and Simon Properties (SPG) are down 63.6% and 30.8% over the past 3 years.
The market response for high end malls is arguably even more out of line with the fundamentals.
Macerich is feeling the effects of the challenging retail environment as growth has slowed significantly, but same store NOI growth has remained stubbornly positive.
I don’t think slowed, but still positive growth warrants a 60% price drop.
SPG has been even more resilient with same store NOI remaining around 2% positive annually.
Putting it together
The precipitous fall in mall REITs was the result of a series of amplifications. The moderate fundamental damage among the B malls was amplified in FFO damage by the timing of redevelopments. The FFO loss was in turn amplified about 3 fold in the market's reaction function as multiples dropped to 1/3 of previous levels on top of the reduction in baseline FFO.
We see the pieces in place for a reversal. PEI is entering the upswing of redevelopments which will go a long way to correcting its FFO declines. WPG is on the precipice of positive fundamental growth which will begin to repair its FFO declines, albeit slower than PEI.
As the FFO turns positive, it is unlikely that the market can continue to trade these companies at multiples that only make sense if they are headed for bankruptcy. Thus, the same amplifications that hit on the way down could apply on the way up. The minor to moderate FFO growth could be met with multiple expansion combining for strong total returns from these beaten down levels.
Given the market’s high conviction in the death of retail narrative, this will be more of a “show me” type of rally. The positive guidance that is already out there has not changed the market’s mind. It will require the actual results. The actual results are coming in the near term. September and October mark PEI’s fundamental turnaround, and early 2020 is slated to mark WPG’s.
Disclosure: I am/we are long PEI, SPG, WPG, MAC. 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: 2nd Market Capital and its affiliated accounts are long PEI, WPG, SPG and MAC. I am personally long PEI, WPG, SPG and MAC. This article is provided for informational purposes only. It is not a recommendation to buy or sell any security and is strictly the opinion of the writer. Information contained in this article is impersonal and not tailored to the investment needs of any particular person. It does not constitute a recommendation that any particular security or strategy is suitable for a specific person. Investing in publicly held securities is speculative and involves risk, including the possible loss of principal. The reader must determine whether any investment is suitable and accepts responsibility for their investment decisions. Dane Bowler is an investment advisor representative of 2MCAC, a Wisconsin registered investment advisor. Commentary may contain forward looking statements which are by definition uncertain. Actual results may differ materially from our forecasts or estimations, and 2MCAC and its affiliates cannot be held liable for the use of and reliance upon the opinions, estimates, forecasts and findings in this article. Positive comments made by others should not be construed as an endorsement of the writer’s abilities as an investment advisor representative.
Conflicts of Interest. We routinely own and trade the same securities purchased or sold for advisory clients of 2MCAC. This circumstance is communicated to clients on an ongoing basis. As fiduciaries, we prioritize our clients’ interests above those of our corporate and personal accounts to avoid conflict and adverse selection in trading these commonly held interests.