Seeking Alpha

Tanger: The 8.81% Yielding REIT Displays A Bearish Short-Term Outlook, But A Reversible One Nonetheless

|
About: Tanger Factory Outlet Centers, Inc. (SKT), Includes: SPG
by: Nikolaos Sismanis
Nikolaos Sismanis
Long only, Growth, growth at reasonable price, long-term horizon
Summary

SKT shows bearish signs regarding its portfolio expansion and its rental income retention.

A potential expansion plan, similar to Simon's should secure a brighter future for the company.

The case for Tanger is reversible, but the recent price drop is justified. However, investors may find profitable opportunities at current prices.

My Thesis

Tanger's (NYSE:SKT) portfolio net operating income is on track to decline in 2019 as the nonstop streak of store closings adds vacancy. Management anticipates 225,000 square feet of stores to close this year, the largest since 2017. Overdue portfolio expansion could help offset weak leasing spreads, vacancies, and 1Q asset sales to stimulate growth beyond 2019. The pure-play outlet REIT has preliminary plans for a new center in Nashville, but it won't begin construction -- which typically takes 12-18 months -- until the site is 60% leased.

The bearish signs

Store closings are hurting Tanger's occupancy in 2019, and pressure may extend in 2020 as retailers refine their footprints further and possibly experiment with locations in non-traditional formats amid broader retail vacancies. Tanger's ability to pre-lease its proposed Nashville site will help prove demand for outlet centers and whether the pause in development is temporary.

Tanger's new-development hiatus may last until late-2021 or even into 2022, the soonest it could deliver a new center in Nashville. Lack of expansion in 2018-20 misses the REIT's long-term target of delivering one or two outlets a year and leaves net operating income growth solely dependent on the existing 14 million-square-foot portfolio. Tanger completed at least one project a year in 2010-17, including four in 2015 alone, as it primarily relies on construction to expand the portfolio because acquisition opportunities are extremely limited for U.S. outlet centers. Tanger's leverage is below average vs. mall REIT peers, leaving development largely contingent on tenant demand.

The REIT's newest center in Fort Worth, Texas, cost about $90 million and had a 10% yield, 300-400 bps higher than national retail cap rates. The graph below depicts the bottomed estimated development costs.

Store Closings Weigh on Occupancy Into 2020

The first real concern of mine comes at the risk of store closings going into 2020. Unlike mall-REIT peers, Tanger has no major remerchandising or redevelopment projects planned and instead is preserving occupancy. Tanger estimates about 225,000 square feet of vacancies in 2019, above 2017's high of 201,000 sq. Ft. and almost double 2018's 126,000 sq. Ft. The forecast doesn't include the more than 20 Dress Barn locations (about 190,000 sq. ft.) in Tanger's portfolio, as these will remain open through Dec. 31, but will likely add occupancy pressure in 2020. Dress Barn represents about 1.9% of annual base rent, or almost 30% of the total amount Tanger gets from its largest tenant, Ascena, the retailer's struggling parent.

Tanger accepted vacancy in 2017 to create room for stronger, higher-rent-paying tenants such as H&M and home product stores, re-tenanting over 247,000 square feet at 10% higher cash rent. Top Tenants at Risk of Reducing Store Count and rental income

Store closings should worry investors. Even if you are not bearish in shopping malls, one must admit that tenants moving away is a dire situation that should signal caution and need for changes in any REIT (more on changes later). For example, Tanger's No. 2 tenant, Gap, is closing 230 namesake stores in the next two years. While it's unclear whether any of this affects the 114 stores (including Gap, Banana Republic, and Old Navy brands, JV assets) in Tanger's portfolio, the tenant represents an above-average 6% of the rent. CEO Steve Tanger is adamant that outlet stores are the retailers' most profitable. He doesn't anticipate Gap closings within the portfolio. The REIT's largest tenant, Ascena (6.5% of rent), is a risk, too, with Dress Barn closings coming soon.

Tanger's outlets average 350,000 square feet each and typically have 80-90 retailers. The REIT's portfolio has almost tripled in size since 2002, to over 14 million sq. ft., even with its late-1Q dispositions. Gap has remained among its most prominent tenants at 7.9% of square footage, or 160 bps more than in 2002.

Reversing the bearish case

Tanger may generate about $100 million in free cash flow this year, similar to 2018 levels, and may earmark capital for additional share buybacks over redevelopment. Despite its history of annual portfolio growth, and peer Simon Property Group's (NYSE:SPG) acceleration of U.S. outlet redevelopment, Tanger has no expansion plans, which is a missed opportunity in our view. What should Tanger do then?

Source: Bloomberg

Tanger should allocate a portion of the $100 million excess cash generated this year to redevelopment projects since its new center in Nashville probably won't open for more than two years. Short-term leases signed in the 12 months ended June 30, covering at least 160,000 square feet, plus about 225,000 sq. ft. in anticipated store closings for 2019, create opportunities to improve tenant mix and raise the rent. Tanger's conservative occupancy preservation focus means it's missing out on more substantial redevelopment opportunities. These are riskier and come with higher costs (including added vacancy), but would demonstrate tenant demand for outlets and upon completion could result in higher rent and shopper traffic.

Simon does it better - puts outlet shopping onlineamid expansion lull

Amid a lull of at least two years in U.S. outlet construction, Simon is embracing technology and the shift to e-commerce by investing $280 million in a venture with Rue Gilt Groupe to offer a platform to outlet-shop online. The partnership marks a critical next phase for Simon's "Shop Premium Outlets" marketplace, which launched for select users earlier in 2019 and may provide an opportunity for further cash flow growth at a time when portfolio expansion is limited. Simon is working on redevelopment projects at three of its U.S. outlet locations, while the vast majority of its new construction and expansion budget for outlets will be used internationally.

Neither of the two largest outlet landlords, Simon and Tanger Factory Outlets, will deliver a new center in the U.S. until at least late 2021. The graph below proves Simon's stagnated U.S. outlet portfolio.

Source: Bloomberg

Tanger must demonstrate the strength of tenant demand for outlet centers by making progress toward the 60% pre-leased target for a new center in Nashville as well as lining up better retailers at higher rents for more than 200,000 square feet of space expected to be shuttered in 2019.

Improving occupancy and raising rent is necessary for Tanger to increase the same-store net operating income in 2020. Followed by two years of declines, and to drive funds from operation growth, that is essential. After all, the REIT probably won't have expanded its portfolio since its last new center opened in late 2017. Tanger expects same-store NOI to fall 1.5-2.25% for 2019, suggesting a worsening in declines in 2H following 2Q's slight decrease, which had marked the fourth straight quarter of improvement. Pressure on occupancy from further store closings and persistently weak rent spreads may be preventing growth in 2H.

Tanger leans on short-term leases to keep vacancy low and centers looking full. These can also buy time to procure long-term, higher-rent tenants, but are hurting near-term rent spreads and NOI.

Simon's expansion budget is an excellent example of a potential SKT one

Simon Property Group is finding opportunities to expand its U.S. outlet portfolio, which is about double the size of Tanger's, but domestic new-construction prospects are slim. Simon delivered a premium outlet in Denver in 4Q and will co-develop a multiphase 566,000-square-foot outlet near the Los Angeles International Airport with Macerich. Construction for the L.A. property is set to begin in early 2020 with completion in late 2021. It may end up being similar to the delivery of Tanger's new center in Nashville, assuming the latter can achieve the 60% pre-leased requirement soon.

Simon's budget is $334 million at its pro-rata share for new outlet development (non-U.S.) and $336 million for redevelopment. Even its outlet-redevelopment budget is dominated by international centers, with only four of 12 projects located in the U.S.

Source: Investor Presentation

Debt-to-Ebitda Well Below Mall REIT

Among all my concerns, there an important positive feature when it comes to Tanger. Tanger's consolidated debt-to-Ebitda ratio remains well below most mall REIT peers, retreating from a high in 3Q16. The pure-play outlet REIT has $1.8 billion in outstanding debt, including its pro-rata share of joint-venture obligations, with less than $60 million due by year-end 2021. Low leverage provides flexibility to fund extremely limited acquisitions, and a development and redevelopment pipeline, which is empty as its planned center in Nashville, is still not operational.

Tanger may use cash for additional share buybacks, after repurchasing 558,000 shares for $10 million in 1H, while it's pro-rata share of debt fell 6.7%. It's authorized to repurchase another $90 million through May 2021The dividend problem

However, a "reverse plan" for Tanger is still pressured by the high dividend. Tanger's better guidance for 2019 funds from operations of $2.25-$2.31 a share still represents an 8% decline at the midpoint vs. 2018, when it rose just 0.8%. This will mark the fourth straight year of slower FFO per-share growth and the first drop since 2011, due to late 1Q asset sales plus additional vacancy. Management expects about 225,000 square feet of store closings this year, following 2018's 126,000 and 2017's above-average 201,000. Vacancy, combined with weak leasing spreads, will push same-store net operating income 1.5-2.25% lower in 2019. Portfolio expansion is on hold, though preliminary plans for a new center in Nashville have been announced. Construction, which typically takes 12-18 months, won't begin until the site is 60% leased. Tanger delivered its newest center in Fort Worth, Texas, in October 2017. The chart below illustrates the slower growth in FFO/share, which is projected to decline next year.

Tanger's uninterrupted string of annual dividend increases since the 1993 IPO extended into 2019 with a 1.4% boost. This is just over half of 2018's 2.2% hike and well below the REIT's 10-year compound annual growth rate of about 6%. Its annualized dividend of $1.42 a share implies a payout ratio of 62%, based on revised 2019 funds-from-operations guidance of $2.25-$2.31 a share. This could leave room for another hike in 2020, even though Tanger's adjusted FFO per share is on track to fall 6.9-9.3% this year, after rising less than 1% in 2018, amid store closings, asset sales, and no portfolio expansion plans. Source: Bloomberg Intelligence

Conclusion

SKT is a fantastic pure mall-play when it comes to its existing cash flow generation and dividend distributions. However, the decline in future development and potential tenants leaving should signal management that an expansion plan should diversify the company. I believe that Simon Property Group is a good example. In any case, the dividend should not be hard to cover. However, it does put a lot of pressure on potential investments in other real estate projects. In my opinion, the stock price decline is well-justified based on future uncertainty. However, it may turn out to be a great investment opportunity for investors who choose to initiate or add to their positions at these levels.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.