- Simon Property Group's enterprise value has fallen more than those of other mall REITs over the past few months.
- Simon is now valued at a 10%-11% cap rate, which seems like an excessive discount, even factoring in the short-term headwinds it faces.
- I still prefer Macerich stock, due to the higher quality and densification potential of its properties, the optionality inherent in its debt structure, and its position as a buyout candidate.
In recent years, investors interested in the U.S. mall REIT sector have had to choose between paying a premium for sector leader Simon Property Group (NYSE:SPG) or seeking a higher yield from riskier peers: either mid-tier mall owners or REITs with top-tier mall portfolios but higher leverage like Macerich (MAC) and Taubman Centers (TCO).
The whole landscape has been upended in 2020, though. In February, Simon agreed to purchase all of Taubman's common stock for $52.50 per share. (The Taubman family will continue to own a 20% minority stake in the business.) And in March, the rapid spread of COVID-19 led most states to impose stay-at-home orders, forcing malls to close.
This caused mall REIT stocks (which had already been struggling in recent years) to plunge. Not surprisingly, shares of highly-levered Macerich have fallen more than Simon Property Group stock. That said, Simon's enterprise value has actually fallen further than that of Macerich, because equity makes up a much larger proportion of the former's capital structure.
As a result, Simon Property Group's valuation now implies a double-digit cap rate based on 2019 NOI. Simon also trades at a slight discount to Macerich on that basis. At such a bargain price, Simon Property Group is definitely worth a look for long-term investors with moderate-to-high risk tolerance, notwithstanding the extreme short-term pressure it faces from COVID-19. Nevertheless, I continue to see Macerich stock as more attractive.
An uncertain near-term outlook
The COVID-19 pandemic has created two major short-term problems for mall REITs. The most immediate problem comes from tenants skipping rent. Mall owners have been quite concerned about this risk. In late March, Taubman Centers sent a letter to tenants emphasizing that "All Tenants will be expected to meet their Lease obligations" notwithstanding the temporary closure of the REIT's malls. Taubman reasoned that it was still on the hook for utility, insurance, and mortgage payments and so it wasn't reasonable for tenants to expect a rent holiday.
However, most mall tenants are facing massive working capital pressure as various bills come due while inventory is trapped in stores, so they simply aren't in a position to pay. This problem is not isolated to lower-quality malls or "weak" tenants. Last week, Nate Forbes said that his company (upscale mall owner The Forbes Company) had collected just 19% of April rents. Clearly, mall REITs' cash flow could be extraordinarily weak for at least the second quarter.
The second issue is that even when malls reopen (a process that has already begun for Simon Property Group), things won't go back to normal quickly. Many retailers will have to file for bankruptcy due to the massive losses they are incurring this year. Some will go out of business; others may survive but will negotiate rent reductions in bankruptcy court. Additionally, since lower traffic appears inevitable until there is a widely-available vaccine against COVID-19, even retailers that aren't in danger of bankruptcy may try to renegotiate their leases.
Thus, beyond the headwind from unpaid rent, mall REITs (even those with top-tier properties like Simon and Macerich) are likely to suffer meaningful NOI declines over the next several quarters from a combination of higher vacancies and lower average rents.
Simon Property Group shares are still cheap
The likelihood of significant near-term NOI declines makes any valuation analysis somewhat unreliable. That said, while COVID-19 could be a fatal blow for some lower-tier malls, the A malls and outlet centers that account for the bulk of Simon Property Group's value are likely to make a full recovery after the pandemic is beaten back.
To put it a different way, shopping centers that were already falling out of favor may be doomed, but those that have remained vibrant retail centers up until now should have long-term staying power. As a result, I expect Simon Property Group and similarly-situated mall owners to gradually replace failed tenants and get average rents back to 2019 levels over the next 3-5 years. (The pace of recovery will depend first and foremost on how quickly a vaccine becomes available.)
This makes 2019 NOI levels a decent baseline from which to measure. Of course, higher-than-normal cap rates are warranted now due to the short-term interruption in rents and the capital costs necessary to replace certain tenants. But even accounting for the short-term headwinds, Simon appears undervalued.
Last year, Simon Property Group's NOI (including its share of JVs) totaled $5.8 billion. Meanwhile, it ended the year with $31.2 billion of debt, including its share of JV debt. Based on the recent share price of $63, Simon's equity value is approximately $22.3 billion. It also ended 2019 with $1 billion of cash. That puts its enterprise value (adjusted for JVs) at about $52.5 billion, representing a cap rate of 11% on Simon's 2019 NOI.
The Taubman acquisition adds a wrinkle to this valuation analysis. Simon Property Group agreed to acquire an 80% stake in its smaller competitor at a 6.2% cap rate on underwritten NOI. So far, Simon appears to be moving forward with the deal despite the pandemic's massive impact on malls. (Simon does not have any clear right to back out unless Taubman breaches any of its obligations; pandemics are specifically excluded in the Material Adverse Effect clause.) On a pro-forma basis including the acquisition, Simon Property Group is valued at a cap rate of just over 10%.
Considering the mall operator's solid balance sheet and track record of operational excellence, this seems too harsh. Near-term results will certainly be very weak, but Simon should be able to nurture most of its properties back to health over the next several years. Given the low interest rate environment, an appropriate cap rate for a fully-healthy Simon Property Group would be no more than 7%, and quite possibly closer to 6%.
Macerich still looks like a better bet
Simon Property Group stock has rallied nearly 50% since bottoming out in early April, but I see plenty of additional upside for patient investors as the recovery from COVID-19 progresses. That has earned Simon a spot on my watch list.
Nevertheless, I continue to prefer shares of Macerich, despite its significantly weaker balance sheet and slightly pricier valuation. (Macerich's cap rate has hovered between 9% and 10% in recent weeks.) Macerich stock offers four major advantages over Simon Property Group shares in the current environment.
First, Macerich owns higher-quality properties, on average. This shows in its 2019 portfolio sales per square foot of $801, compared to $693 for Simon's U.S. malls and premium outlets. To be fair, Macerich's sales per square foot statistics have been inflated by ridiculously high sales at a handful of Tesla (TSLA) stores in its portfolio. However, the same is undoubtedly true of Simon to some extent.
Put simply, while Simon owns a lot of excellent malls, it also owns a meaningful number of mediocre properties that could suffer if the pandemic leads to the closure of many U.S. department stores and other retailers. By contrast, while Macerich has a handful of B malls and a small number of C and D malls left in its portfolio, it represents more of a pure play on high-quality A malls.
Second, virtually all of Macerich's debt consists of non-recourse mortgages. Macerich's enterprise value may exceed $9 billion, but excluding non-recourse debt, its enterprise value is closer to $2 billion. That gives it massive optionality. It stands to reason that COVID-19 will have an uneven impact on various properties depending on geographic location, tenant roster, physical setup, and other idiosyncratic factors. Macerich can walk away from properties that suffer permanent value impairment from the pandemic, while keeping those that bounce back quickly.
Conversely, Simon uses much less non-recourse secured debt in its operations. It had over $17 billion of unsecured debt as of year-end, representing more than half of its total debt. That figure will rise to nearly $22 billion after the Taubman acquisition is completed.
Third, Macerich's portfolio is uniquely concentrated in densely-populated markets. Some investors might see that as a disadvantage in an era of social distancing. However, I am highly skeptical of the theory that COVID-19 will drive a big shift in populations from cities to far-out suburbs and rural areas. And in the long run, Macerich's urban real estate holds massive potential for additional development: primarily the addition of multifamily residential buildings.
(Source: Taubman Centers July 2019 Investor Presentation, slide 11)
Fourth, Macerich's rock-bottom market cap could make it a buyout target, with Brookfield Property Partners (BPY) representing the most logical buyer. Even at its current, beaten-down share price, Simon Property Group is too large to be a realistic acquisition candidate. (In any case, it's extremely doubtful that the Simon family would be interested in selling.)
In short, Simon Property Group stock appears oversold and represents an attractive bargain despite the short-term headwinds mall owners face. However, Macerich still looks like a better bet, with the quality and location of its malls, the optionality inherent in its debt structure, and its potential to be a buyout target more than offsetting its balance sheet risk.
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