Shopping Center REITs: It Pays To Be Essential

Summary

• Who's "essential" and who's not? Retail REITs have been slammed by the unprecedented coronavirus-related economic shutdowns, adding further pain to a sector already dealing with the ongoing retail apocalypse.
• Unlike malls, the majority of shopping centers remain operational as "essential businesses." However, these REITs are more dependent on now-struggling small business retailers and independent franchises to fill small shops.
• Shopping center REIT fundamentals were actually pretty solid heading into the pandemic. Same-Store NOI growth outpaced the REIT average in 2019 for the first time in nearly a decade.
• The majority (11 of 17) of Shopping Center REITs report earnings this week. Among REITs to already report, 53% of April rent was collected while 54% of tenants were operational.
• Grocery-anchored and high-quality power center REITs will be able to weather that near-term pain, but signs of stress - and dividend cuts - are likely to emerge among smaller names.
• This idea was discussed in more depth with members of my private investing community, iREIT on Alpha. Get started today »

REIT Rankings: Shopping Centers

In our REIT Rankings series, we introduce and update readers to each of the residential and commercial real estate sectors. We focus on sector-level fundamentals, analyzing supply and demand conditions and macroeconomic factors driving underlying performance. We update these reports quarterly with a breakdown and analysis of the most recent earnings results.

(Hoya Capital Real Estate, Co-Produced with Brad Thomas)

Shopping Center REIT Sector Overview

Retail REITs have been slammed by the unprecedented coronavirus-related economic shutdowns, adding further pain to a sector already dealing with the ongoing retail apocalypse. One of the four major real estate sectors, the retail real estate sector can be divided into three subsectors: enclosed malls, open-air shopping centers, and free-standing (net lease) retail. In the Hoya Capital Shopping Center REIT Index, we track the seventeen largest open-air shopping center REITs, which account for roughly $30 billion in market value.

We separate the space into three sub-categories, generally consistent with the ICSC classifications: Grocery-Anchored, Power Center, and Street Retail. The lines between these categories are blurry, however, with many "big-box" retailers like Walmart (WMT) and Target (TGT) now offering full-service grocery offerings. Shopping center REITs have been proactive in recent years in transforming their tenant mix into a more "experience" and grocery-oriented portfolio that is, in theory, less threatened by disintermediation. Roughly half of the retail centers owned by shopping center REITs include at least one full-service grocer. Grocery-anchored centers have historically commanded premium valuations relative to power centers and certainly relative to enclosed malls, a premium that has expanded in recent years.

Open-air shopping center REITs have characteristics that are generally viewed as less exposed to the retail-related headwinds and coronavirus impacts compared to their mall REIT peers. Unlike malls, the majority of shopping centers remain operational as "essential businesses;" however, these REITs are more dependent on now-struggling small business retailers and independent franchises to fill small shops. Below, we present a framework for analyzing the REIT property sectors based on their direct exposure to the anticipated COVID-19 effects as well as their general sensitivity to a potential recession and impact from lower interest rates. Within the COVID sensitivity chart, we note that shopping center REITs are in the "High" risk category, but slightly below Malls and the tourism-sensitive Hotel and Gaming sectors.

With characteristics that blend those of the mall sector and free-standing net lease retail sector, shopping center lease terms typically average 5-15 years at signing and have CPI-based or fixed contractual rent bumps, often along with additional "percentage rent" based on retailer sales. Unlike the mall sector where private market sales are few-and-far-between, the transaction market for shopping centers is significantly more active and shopping center REITs own a far smaller share (5-10%) of total open-air shopping center properties, leaving open the possibility of external growth via acquisitions. The margin profile is similar between malls and shopping centers with cap-ex burdens each well above the REIT sector averages at roughly 20% of annual NOI.

Helping to offset the clear headwinds from the continued uptick in retail store closures, the growing usage of alternative (and higher-margin) "delivery" options including in-store pickup, "curbside" pickup, and delivery-from-store have been a tailwind for well-located shopping center REITs. Shopping center REITs have also seen recent success in "de-boxing" larger vacated store footprints into several smaller store layouts that can command higher total NOI. While nearly 90% of total retail sales are still completed through the traditional brick and mortar channels, e-commerce sales account for roughly a fifth of “at-risk” retail categories, and the market share loss has been most significant for the traditionally mall-based retail categories, including department stores, clothing, sporting goods/books, and electronics retailers.

After a development boom during the 1990s and early 2000s, very little new retail space has been created since the Financial Crisis. Despite that, the US still has more retail square footage per capita than any other country in the world. Elevated levels of store closings in recent years, spurred by the rise of e-commerce, have created ample "shadow supply" of recently vacated space which has negatively impacted retail REIT fundamentals, although shopping center REITs entered the pandemic on far more steady footing than mall REITs. Together with malls and free-standing net lease properties, retail REITs comprise roughly 12-15% of the broad-based Core REIT ETFs and tend to be among the highest-yielding REITs. Investors looking for a pure-play on the retail REIT sector can utilize the Benchmark Retail Real Estate ETF (RTL).

Shopping Center REIT Earnings Preview

As discussed in our Real Estate Earnings Preview, on what will surely be the most newsworthy earnings season for shopping center REITs in at least a decade, we'll hear pivotal information on rent collection and future dividend plans over the next several weeks. Earnings season comes on the heels of the worst retail sales report in history for March, but there were some pockets of strength in the "essential" categories, including grocery stores, general merchandise, and home improvement stores. Despite a rebound over the last three weeks, shopping center REITs enter first-quarter earnings season as the third-worst-performing REIT sector this year, lower by nearly 45% in 2020. At the lows in late-March, shopping center REITs were lower by more than 55% with over half the sector off by 60% or more.

While some REITs provided preliminary updates over the last month, Q1 reports will be the first updates we'll hear from most shopping center REITs, so gear-up for some potentially dramatic post-earnings stock reactions. In addition to rent collection, investors will be keyed-in on novel metrics like the percent of "essential businesses" and "currently open/operational businesses" among the tenant mix. In mid-April, NAREIT published the results of a survey of 44 REITs indicating that shopping center REITs had collected less than 50% of rents during the survey period, which was nearly double the rent collection estimates of mall REITs but slightly below free-standing net-lease retail REITs.

Four REITs have reported thus far while the majority of the sector (eleven of seventeen) will report results this week. Among the four REITs to already report, 53% of April rent was collected while 54% of tenants were open and operational. We expect most REITs to report the percent of "essential businesses" which should correlate closely with the percent open for business. Despite a still-small sample size, clear trends are already emerging: grocery-anchored-heavy shopping center REITs are likely to report significantly stronger rent collection and "essential business" metrics relative to power center-heavy REITs.

Dividend cuts or suspensions are also likely to be a major theme this earnings season and we'll likely see more than half of these shopping center REITs succumb to the growing list of "coronavirus cuts." Despite reporting strong results with 68% rent collection, grocery-anchored-heavy Retail Opportunity (ROIC) announced that it will temporarily suspend their dividend, adding their name to the list which had already included Whitestone (WSR) and Cedar Realty (CDR), which each announced cuts in March. Power-center-heavy Urban Edge (UE) became the fourth shopping center REIT to pause its dividend last week. We've now tracked 28 equity REITs in our universe of 165 names to announce a cut or suspension of their dividends.

We believe that grocery-anchored REITs like Regency Centers Corp. (REG) and Retail Opportunity Trust, as well as high-quality power center REITs like Federal Realty Investment Trust (NYSE:FRT) with strong balance sheets, will be able to weather than near-term pain, but we're interested to see if signs of serious stress emerge among the smaller, more highly-levered names. As of the end of March, 13 of the 17 REITs in the sector had debt ratios above 50% as tracked by NAREIT with 5 REITs above 70%: SITE Centers (SITC), RPT Realty (RPT), Whitestone, Retail Value (RVI), and Cedar Realty. As shown below, there has been a strong correlation this year between debt ratios and stock price performance.

Shopping Center REIT Fundamental Performance

Thankfully, shopping center REIT fundamentals were actually pretty steady heading into the pandemic despite the re-acceleration in store closings and fears of a 'retail apocalypse 2.0' which will likely save the sector from the devastation that is likely to strike mall REITs. Same-store NOI growth outpaced the REIT average in 2019 for the first time in nearly a decade and same-store occupancy ended the year up roughly 100 basis points from the end of 2018. According to NAREIT's T-Tracker, over the last twelve months, shopping center REITs grew same-store NOI by 2.54% compared to 2.12% average growth rate for the REIT sector. Mall REITs, meanwhile, saw same-store NOI decline by -0.50% and will likely see far-worse declines in 2020.

According to Coresight Research and our estimates, while the store closing count surged significantly in 2019, seven of the eight largest contributors to store closings were in the mall category. By comparison, four of the top five contributors to store closings in 2018 were primarily open-air shopping center-based retailers. Before the pandemic, it had appeared that much of the pain from big-box store closings may be in the rear-view for the sector as leasing spreads had accelerated modestly over the last several quarters. All bets are off in the post-coronavirus world, but it's certainly reasonable to believe that the pain felt by mall REITs will likely be far worse than their open-air peers.

Conditions will obviously become far more uncertain and treacherous for retail REITs over the next several months amid the economic shutdowns. Retail sales in the United States dropped by the most on record on a month-over-month basis in March, according to retail sales data released last month from the US Census Bureau. Total retail sales including food service plunged 8.7% from the prior month and were 6.2% lower from last year. On a seasonally-adjusted year-over-year basis, brick-and-mortar sales were lower by -1.8%, sharply reversing the relatively solid month of February in which brick-and-mortar sales rose to the strongest year-over-year rate in nearly two years. E-commerce sales, by comparison, are higher by 9.7% year-over-year.

Coronavirus-related economic shutdowns could deal a devastating blow to many already-struggling retail categories - clothing, electronics, sporting goods/books - after the dust settles. The limited pockets of relative strength with the retail sector - grocery stores, hardware stores, and health/personal stores - were primarily located in strip-center-based properties, but weakness among small-shop tenants - many of which are small businesses and independent franchises - may offset the relative strength among the outperforming "big box" retailers.

Shopping Center REIT Valuations

As they have for most of the past half-decade, retail REITs screen as inexpensive across most traditional REIT metrics, but have produced FFO growth that has lagged the broader REIT averages during this time. Powered by the iREIT Terminal, we note that shopping center REITs trade at 9.5x AFFO multiple, which is below the REIT average of 15.0x AFFO. As discussed in our report Cheap REITs Stay Cheap, REITs in faster-growing property sectors with lower leverage profiles have historically produced better total returns, on average, than their higher-yielding and higher-leveraged counterparts.

A sharp disconnect has persisted between private market valuations of retail real estate assets and the REIT-implied valuation, forcing retail REITs to be net sellers of assets for nearly a half-decade. REITs are at their best when they're utilizing their superior access to equity capital to fuel external growth via accretive acquisitions and development, but limited ability to accretively acquire properties, and with a retail development pipeline that is largely non-existent, external growth has been hard to come by for the shopping center and mall REIT sectors during this time. Shopping center REITs now trade at a 40-60% estimated discount to net asset value, which the widest discount ever recorded. Even before the recent leg-lower in valuations, shopping center REITs disposed of $1.8 billion in assets, on net, in full-year 2019.

Shopping Center REIT Dividend Yield

Despite the four dividend suspensions, shopping center REITs currently pay an average dividend yield of 7.7%, which ranks towards the top of the REIT sector. This can and likely will change in a hurry over the next week, however, with a half-dozen or more additional shopping center REITs likely to "pause" or cut their dividends by the end of earnings season. The cuts from the four REITs do help to bring down the FFO payout ratio to below 70%, which is roughly in line with the sector average of around 70-75%.

Seven shopping center REITs currently display dividend yields above 10%, but these seven are, in our view, also the most likely to suspend/cut their dividends over the next month. Investors looking purely for dividend safety, Regency Centers and Federal Realty would be the "safest bet" to maintain their dividend amid the pandemic based on their low payout ratio and sector-leading balance sheet. Among small-cap under-the-radar names, Saul Centers (BFS) and Urstadt Biddle (UBA) are in the quality tier immediately below the aforementioned sector stalwarts.

Bull And Bear Thesis For Retail REITs

While retail REITs can't seem to catch a break over the last half-decade, there are a handful of reasons to be bullish on the long-term prospects for the retail REIT sector. Recognizing the challenges of the pure-play online retail strategy, more retailers have embraced the "brick and clicks" omnichannel retail strategy, including e-commerce giant Amazon (AMZN) while big-box giants like Walmart, Costco (COST), and Target have certainly honed the omnichannel model to significant success. Additionally, there's been very limited new construction of retail real estate space over the last decade and high-productivity retail REITs continue to find accretive yields in redeveloping vacated store space into higher-value mixed uses, including multifamily and experience-based retailers.

While the "retail apocalypse" may have been exaggerated, retail REITs continue to be challenged by broader secular headwinds, pressures that have intensified further amid the coronavirus pandemic. Store closures surged last year as retailers deal with a myriad of pressures including tariff concerns, rising minimum wages, and excess inventory. Downsizing retailers have focused their investment on higher-performing stores and have continued to close weaker-performing stores in lower-tier malls and retail centers. As we often discuss, valuations can be self-reinforcing in the REIT sector and cheap REITs tend to stay cheap as low equity valuations make it more challenging to raise the capital needed for redevelopment and external growth.

The "bears" have certainly had their voices heard over the past half-decade. At the real estate sector-level, three themes dominated the 2010s: 1) The Housing Shortage, 2) The Retail Apocalypse, and 3) The Internet Revolution. The two worst-performing real estate sectors from 2010-2019 were malls and shopping centers as the so-called "retail apocalypse" continues to take its toll on landlords. Shopping centers and mall REITs have both lagged the Equity REIT Index in each of the past four years, and absent a miracle, these retail REIT sectors are likely to continue that underperformance in 2020.

Key Takeaways: We'll Find Out Who's Essential

Who's "essential" and who's not? Retail REITs have been slammed by the unprecedented coronavirus-related economic shutdowns, adding further pain to a sector already dealing with the ongoing retail apocalypse. Unlike malls, the majority of shopping centers remain operational as "essential businesses." However, these REITs are more dependent on now-struggling small business retailers and independent franchises to fill small shops. Shopping center REIT fundamentals were actually pretty solid heading into the pandemic. Same-store NOI growth outpaced the REIT average in 2019 for the first time in nearly a decade.

The majority (11 of 17) of shopping center REITs report earnings this week. Among REITs to already report, 53% of April rent was collected while 54% of tenants were operational. Grocery-anchored and high-quality power center REITs will be able to weather than near-term pain, but signs of stress - and dividend cuts - are likely to emerge among smaller names. We continue to see well-located grocery and hardline-anchored centers as the few engines of growth in the retail sector. We'll have full coverage of shopping center earnings season on iREIT on Alpha and in our Real Estate Daily Recap reports.

For an in-depth analysis of all real estate sectors, be sure to check out all of our quarterly reports: Apartments, Homebuilders, Manufactured Housing, Student Housing, Single-Family Rentals, Cell Towers, Healthcare, Industrial, Data Center, Malls, Net Lease, Shopping Centers, Hotels, Billboards, Office, Storage, Timber, Prisons, and Real Estate Crowdfunding.

Analyst’s Disclosure: I am/we are long REG, ROIC. 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.

It is not possible to invest directly in an index. Index performance cited in this commentary does not reflect the performance of any fund or other account managed or serviced by Hoya Capital Real Estate. All commentary published by Hoya Capital Real Estate is available free of charge and is for informational purposes only and is not intended as investment advice. Data quoted represents past performance, which is no guarantee of future results. Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy. Hoya Capital Real Estate advises an ETF. In addition to the long positions listed above, Hoya Capital is long all components in the Hoya Capital Housing 100 Index. Real Estate and Housing Index definitions and holdings are available at HoyaCapital.com.