Seeking Alpha

Your REITs Will Vanish

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Includes: CDR, KIM, MAC, NNN, O, PEI, REIT, SKT, SPG, TCO
by: Jussi Askola
Summary

The number of publicly traded REITs dropped from 1994 to 2010.

Here we look at retail REITs during this period.

We discuss how they vanished and consequences for both common and preferred shareholders.

We conclude that the safety of REIT investments has always been high and has increased since 2001.

Co-produced with R. Paul Drake

The general investing public has limited familiarity with REITs. They are often considered an “alternative” investment and viewed with suspicion.

Here we focus on Real Estate Investment Trusts that invest in real property. These are known as Equity REITs, eREITs, or most often just REITs. (Mortgage REITs, or mREITs, are quite different businesses and carry more risk.)

On top of that, the claims of REIT advocates (like us) that REITs almost never go bankrupt seems crazy. This is even more true once one sees the plot in Figure 1.

Figure 1. Number of REITs vs year, from 1972 through 2018, by type. Chart by Brad Thomas, based on data from NAREIT.

The number of REITs jumped rapidly after 1992, when Taubman Centers (TCO) invented the modern REIT corporate structure. It is known as the UPREIT structure, in case you want to dig into it.

The number reached almost 180 within a few years but then dropped by more than 50 through the depth of the Great Recession. Since then it has increased back above 180, and has been relatively steady recently.

A potential REIT investor might well wonder: What was going on after 1994? Did those REITs really not go bankrupt? What happened to them?

More importantly, the investor would wonder: what happened to the investors in those REITs? Let’s take a look.

A Tabulation of Defunct Retail REITs

We happened upon an academic paper whose primary focus was the impact of tenant bankruptcies on REIT share prices. It discussed 64, retail-oriented REITs in existence prior to 2010.

Among those that still exist today are Simon Property Group (SPG), Taubman, Macerich Company (MAC), Realty Income (O), Pennsylvania REIT (PEI), National Retail (NNN), Tanger Outlets (SKT), Cedar Shopping Centers (CDR), and Kimco (KIM).

Of relevance here, the paper found that 32 retail-oriented REITs became defunct from 1994 through 2010. This group represented most of the 50 REITs that vanished during this period. It will be our focus here.

One has to wonder what happened to the 50% of all retail REITs that became defunct in those years.

NONE of these 32 REITs went bankrupt. Only General Growth Properties (GGP) did that, a few years later, under the unique stresses of the Great Financial Crisis in the presence of very high leverage.

The case of GGP turned out well for shareholders. They declared bankruptcy in 2009, were bought out in 2010 at a value exceeding their 2008 book value.

Table 1 shows these 32 REITs. One can see there what makes REITs vanish. For the most part it is mergers or acquisitions, which accounted for 23 of them. Another 5 went private, although sometimes not for long.

A total of 4 of these REITs liquidated during this interval, stimulated by the recession that followed the end of the dot com madness.

Table 1. Retail REITs that became defunct during 1994-2010. Information based on analysis by author of information from SEC:Edgar.

Fate of Common Stock

In mergers and acquisitions, common stockholders receive cash or value established through the process. They are nearly always treated well, relative to wherever the stock price is at the time of the change.

We did not try to find specific details about this aspect. The potential for mergers or buyouts is part of almost any investment.

In liquidations, the common shareholders receive whatever value is left after debt and preferred stocks are paid off. This can be quite small.

Table 2 identifies the four liquidations. These all were triggered by the dot com bust. Prime Retail went from a 12% profit in 1999 to a 17% loss in 2000. With their 68% leverage, they had to liquidate. The common shareholder got no dividend after 1999 and eventually received $0.17 per share.

Table 2. Fate of common stocks in liquidations. Information based on analysis by author of information from SEC:Edgar.

Malan Realty had operating losses above 25% in 2001 and 2002, and their leverage grew to 84%. Common dividends were reduced and apparently shareholders ended up with a few dollars per share.

Burnham Pacific had less leverage, though it was still high at 52%, but had a 33% operating loss in 2000. The common shareholders got no dividend after 2000 and eventually received $1.42.

Philips International was expanding like mad into 1999, and had 62% leverage. They immediately went into liquidation mode, and ultimately distributed $18 per share. This exceeded the share price during 1998 and 1999, and so this one case was a very successful liquidation.

In sum, out of 64 retail REITs active during the subject period, 4 liquidated, all in the wake of the Recession of 2000-2001. In three of these cases the common shareholders lost substantially all value.

Two aspects of this period are notable. First, the average Funds From Operations of retail REITs did not drop significantly during that recession.

Second, the average leverage of all REITs at that time was higher than it has been ever since, save during 2009-2010. Figure 2 illustrates this.

It seems that a few weak REITs were unable to survive the loss of income in the recession. In more than one case, the bankruptcy of K-mart played a role. In contrast, no REIT has been forced into liquidation by the bankruptcies of major retailers recently, including Sears.

Figure 2. REIT leverage. Debt to Market Assets (light blue) and Debt to Book Assets (dark blue) are shown against year from 2000 to 2019. Source: NAREIT

Fate of Preferred Stocks

Preferred stocks have a par value (typically $25), which they pay when called. Any dividend on common stocks must be cut to zero before the dividend on a preferred stock can be cut. All the unpaid dividends on a “cumulative” preferred stock must be paid before common-stock dividends can resume. In a bankruptcy, preferred stockholders stand above the common stockholders and below the bondholders.

Table 3. Fate of preferred stocks of REITs that vanished. Information based on analysis by author of information from SEC:Edgar.

A number of the now-defunct REITs had issued convertible preferred stocks. The shareholder has the option to convert such stocks to common stocks at some price. They behave as a strange combination of a bond, a stock, and an option. We recommend that individual investors avoid them.

In the prospectus for any offering of preferred stock, the rights of the shareholder are spelled out. These do differ from one case to the next. Of particular importance are the provisions related to liquidation and to change of control. Typically, the holders of cumulative preferred stock are promised the par value when REITs go out of operation.

Table 3 shows the fate of the preferred shares, in the 13 cases for which preferred shares existed. In 12 of these cases, the preferred shareholders were cashed out or otherwise well treated.

In contrast, one case is notorious. Prime Retail, Inc, began liquidating in 2000. Quite a few of their assets were acquired by Chelsea. The rest eventually were merged into Lightstone Corporation. [Both Chelsea and Lightstone were later absorbed into Simon Property Group (SPG).]

The merger with Lightstone violated the terms of the prospectus for the cumulative preferred shares, despite some legal challenges. The par value of all the preferred shares was $25. Eventually the holders of non-convertible, Series-A shares received $18.40/share, those of the convertible, Series-B shares received $8.17, and the common shareholders received $0.17.

REITs and Their Preferred Shares Are Safer Now

REITs and their managers learned a lot from the recession of 2000-2001. Among other consequences, they responded on average by beginning the decrease of leverage with time that has continued to the present.

One sees the effects of this in the response to the Great Recession when, despite substantial operating losses by many retail tenants, none of the retail-oriented REITs were forced into liquidation because of declining income. As noted above, GGP did declare bankruptcy, but this was a result of bad timing when the credit markets froze up.

Even today, despite the persistent bankruptcies of many retail tenants, one sees that the operating results of existing retail-oriented REITs have remained more or less flat. While the absolute number of retail bankruptcies is large, their fraction of total retail companies remains quite small.

The mall REITs are most affected. They are making lemonade out of lemons, having success in repurposing the spaces that have become available into more profitable and diverse uses.

If one avoids the landmines of excessive leverage, management misaligned with shareholder interests, and insufficient capital to support renovations, we believe even this sector is quite safe. For similar reasons, REITs broadly are safer investments than the common stocks of many firms.

The preferred shares of REITs are much safer still.

Conclusions and Portfolio Implications

The main outcome of this look at a slice of REIT history is that, with one exception to date, REITs do not go bankrupt. But they do sometimes liquidate, selling off their assets.

In the dangerous period after 1999, 4 of 64 retail REITs liquidated. In three of those cases, holders of the common stock got little from the liquidation.

It is interesting that there were no liquidations following the Great Recession. (GGP was bought out of its bankruptcy.) This suggests that the experience of 2000-2001 induced the remaining REITs to get their houses in order. Their subsequent reductions of leverage is a big part of that.

Considering the number of retail REITs in operation, the failure rate for the common stock during 1994-2010 was less than 0.5% per year. For bonds, this would be an investment-grade level of performance. We are not suggesting that REIT common stock is a “bond substitute” (whatever that actually means). But REIT preferred stocks come close.

Amongst the preferred stocks, there is one notorious failure in 13 cases where retail-oriented REITs became defunct. There are many more cases of successful preferred stocks from REITs that continued in operation. It is clear that such failures are rare.

In a future article we will look more broadly at REITs that liquidated, seeking clearer overall evidence regarding how preferred stocks in REITs have performed when things went badly. These cases can be hard to find; we welcome specific examples in the comments.

As we discussed previously, we estimate that no more than 10 REITs have failed to redeem their preferred stocks, ever. This makes (equity) REIT preferreds as safe as mid-range, investment-grade bonds.

Disclosure: I am/we are long 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.