Mall REITs: Surviving The Apocalypse, For Now

Summary

• Mall REITs are longing for the days when the 'retail apocalypse' was their biggest concern. Despite a 100% rally from their lows, malls remain the worst-performing property sector in 2020.
• Malls reported collection of less than 25% of rents in April and May as retail landlords struggled to collect rent from "non-essential" tenants. Most mall REITs have eliminated their dividends.
• Glimmers of hope have emerged, however, amid the economic reopening as several key mall-based tenants have reported a faster-than-expected demand recovery, prompting a substantial share price rebound.
• While mall REITs may be off life-support for now, the pandemic likely further amplified the significant secular headwinds facing the enclosed mall format and accelerated store closing decisions.
• Absent a miracle, mall REITs are likely to underperform the REIT average for the fifth straight year in 2020. Excluding the relatively steady Simon Property, the sector should be avoided for non-speculative investors.
• This idea was discussed in more depth with members of my private investing community, iREIT on Alpha. Get started today »

REIT Rankings: Mall REITs

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

Mall REIT Sector Overview

Having once represented as much as 15% of the "Core" REIT ETFs, mall REITs now comprise just 3-5% of the broad-based real estate indexes. Within the Hoya Capital Mall REIT Index, we track the eight mall REITs, which account for roughly $35 billion in market value: Simon Property (SPG), Brookfield Properties (BPR), Macerich (MAC), Taubman (TCO), Tanger Outlets (SKT), Washington Prime (WPG), Pennsylvania REIT (PEI), and CBL & Associates (CBL). Mall REITs are typically classified into several "quality" tiers based on tenant sales productivity and there has been a widening bifurcation in fundamentals between these tiers over the last half-decade.

As we'll expand on throughout this report, we remain bearish on the mall REIT sector as the coronavirus pandemic likely further amplified the significant secular headwinds facing the enclosed mall format and accelerated store closing decisions. Below, we present a framework for analyzing each property sector based on their direct exposure to the anticipated COVID-19 effects as well as their general sensitivity to a potential recession. We note that mall REITs fall into the "High" category in both the direct COVID-19 sensitivity as well as the general economic sensitivity. For mall REITs, however, even solid economic growth and relatively strong growth in retail sales in prior years weren't enough to avoid a fourth straight year of underperformance in 2019.

Mall REITs are longing for the days when the 'retail apocalypse' was their biggest concern. While we are expecting a solid recovery in May given recent high-frequency data, significant damage has already been done to many already-struggling mall-based retailers. Retail Sales data for April showed a record plunge as the pandemic-related shutdowns wreaked havoc on the sector. Sales plunged 16.4% in April - worse than the 12.3% predicted - and followed March's 5.7% decline which was previously the worst month on record. The plunge in sales was especially staggering in certain categories including a 79% drop in clothing sales and a 61% dip in electronics sales.

The pace of store closings is expected to increase substantially in 2020 during the coronavirus fallout, adding to what was already a record year of store closings in 2019. We've already seen bankruptcy filings this year from JCPenney, J. Crew, Neiman Marcus, and Modell's, among others, and there are likely more to come as the retail landscape continues to change and punish those who were slow to adapt. While nearly 90% of total retail sales are still completed through the traditional brick and mortar channels, e-commerce sales account for roughly a quarter of "at-risk" retail categories. Following a similar pattern as 2019, the market share loss and pace of store closings will likely hit the traditionally mall-based retail categories especially hard in 2020.

Malls reported collection of less than 25% of rents in April and May - by far the lowest in the real estate sector - as retail landlords struggled to collect rent from "non-essential" tenants. By comparison, housing, industrial, and technology REITs, along with self-storage and office REITs, all reported collection of more than 90% of rents. Unlike their open-air brethren which we discussed in Shopping Center REITs: It Pays to Be Essential, the enclosed mall format generally houses far fewer "essential" tenants, and with limited ability to offer "curbside pickup" or other "socially-distant" shopping alternatives the majority of mall properties were entirely closed for much of March and April with most properties beginning to reopen by mid-May.

Mall REITs were a favorite of yield-hungry investors for much of the past half-decade, but it's tough to pay dividends if you don't collect the rent. All of the mall REITs besides Simon Property, Taubman Centers, and Brookfield Property have eliminated or reduced their dividend since the start of 2020 and if rent collection doesn't improve significantly in June, cuts are likely unavoidable for the rest. Economic shutdowns ravaged the economically-sensitive property sectors and punished highly-levered REITs and we've tracked 54 equity REITs - primarily retail and lodging REITs - out of our universe of 165 equity REITs that have now announced a cut or suspension of their common dividends.

As if the retail apocalypse and coronavirus pandemic weren't big enough concerns for the enclosed mall format, these headwinds have been magnified by the sky-high leverage levels of many of these mall REITs. As of the end of April, four mall REITs currently operate at Debt Ratios above 85% according to NAREIT while all three lower-productivity mall REITs operate at levels over 95%, prompting CBL to state that its ability to continue to operate as a "going concern" for the next year is in "substantial doubt." As we've highlighted in various other reports including, REITs: This Time Is Different, while most commercial equity REITs entered the COVID-19 crisis on solid footing following a decade of conservative decision-making and prudent balance sheet management, mall REITs were generally the exception to the rule.

Before diving deeper into the analysis, we should note that six of the eight mall REITs do offer preferred securities, tracked in our new iREIT Preferred REIT & Bond Tracker. These include one issue from Simon Property (SPG.PJ), two from Taubman Centers (TCO.PJ, TCO.PK), two from Washington Prime (WPG.PH, WPG.PI), three from Pennsylvania REIT (PEI.PB, PEI.PC, PEI.PD), and two from CBL & Associates (CBL.PD, CBL.PE) and one from Brookfield Property (BPYUP). Among these six mall REITs, their preferred securities have underperformed their comparable common stock by an average of 7% so far in 2020 as the preferred dividends from CBL have been suspended while those from PEI and WPG remain significantly in doubt.

Mall REIT Investors On A Roller-Coaster Ride in 2020

Mall REITs were slammed harder than any other property sector - including hotel REITs - amid the depths of the coronavirus pandemic, plunging by as much as 60% at the lows in late March with the lower-productivity mall REITs essentially pricing in expectations of imminent bankruptcy. Glimmers of hope have emerged, however, amid the economic reopening as several key mall-based tenants have reported a faster-than-expected demand recovery, prompting a substantial share price rebound in recent weeks. Despite a roughly 100% rally from their lows, malls remain the worst-performing property sector in 2020 with declines of 31.1%.

The recent "reopening recovery" comes after encouraging reports on rebounding demand from several mall-based tenants including American Eagle (AEO), Abercrombie & Fitch (ANF), and Cheesecake Factory (CAKE), which last week reported that it has already recaptured 75% of sales. During last week's virtual REITweek conference, commentary from these mall REITs was similarly encouraging with Tanger Outlets noting a sharp rebound in demand at several of their open-air outlet centers that were among the first to reopen. The surprisingly strong nonfarm payrolls report last week and data showing a record surge in personal incomes in April amid unprecedented levels of fiscal stimulus have also certainly helped to ease concerns regarding a potential depression-like pullback in retail spending.

Reopening optimism has helped Pennsylvania REIT and Washington Prime Group to surge by more than 100% in the last month alone, but each remains lower by more than 50% this year. Taubman Centers remains the lone mall REIT in positive territory this year after Simon Property announced plans to acquire the fellow high-productivity mall REIT in a pending merger that is expected to close this summer, though some analysts have cast doubts that there won't be attempts to renegotiate the terms of the deal which was announced just weeks before the coronavirus outbreak in the United States.

Mall REIT Fundamentals Go From Bad To Worse

As the lone sector to record a full-year of negative same-store NOI growth at any point within the last decade, mall REIT fundamentals were the weakest in the real estate sector heading into 2020 before the outset of the pandemic. While the higher-productivity mall REITs generally managed to keep their heads above water amid the retail apocalypse, the water is clearly getting increasingly more dangerous. The three high-productivity mall REITs - SPG, TCO, MAC - reported an average 0.5% decline in same-store NOI growth in 1Q20. The lower-productivity mall REITs - PEI, WPG, CBL - reported a -7.3% average decline in same-store NOI growth. Tanger, the lone outlet center REIT, reported a decline in same-store NOI growth of -7.3%.

All eight mall REITs withdrew full-year guidance amid the pandemic, which had initially forecast an average same-store NOI increase of 0.8%. Occupancy declined roughly 170 basis points year-over-year for high-tier mall REITs and dipped another 140 basis points for the lower-tier malls and we think we'll likely see sector-wide occupancy dip below 90% by the end of 2020 given the expected jump in store closures in the back-half off 2020. However, these REITs did all report positive tenant sales performance, averaging 2.5% on a cap-weighted basis, though the survivorship bias effects do significantly skew the tenant productivity data as ultra-high-productivity retailers like Tesla (TSLA) and Apple (AAPL) assume more weight as other stores close.

Leasing spreads, perhaps the best leading indicator of NOI growth, continue to point to declining growth in the years ahead, though these metrics didn't completely fall off the cliff in Q1 quite yet. Leasing spreads averaged -5.2% for the low-tier malls, down from the 4.3% rate last quarter and the worst since 4Q18. The high-productivity REITs reported an average 0.5% climb in leasing spreads, the lowest in more than a half-decade. We're watching leasing spreads in Q2 especially closely, expecting a sharp decline for the balance of 2020 and likely well into 2021 as market rents trend lower amid an anticipated jump in store closings and expect to see double-digit declines in spreads for low-productivity mall REITs by the end of the year.

A potential saving-grace for a retail sector, following a development boom during the 1990s and early 2000s, very little new retail space has been created since the recession. Despite that, the US still has more retail square footage than any other country in the world. Elevated levels of store closings in recent years, spurred by the rise of e-commerce and likely amplified by the coronavirus pandemic and related economic shutdowns, have created ample "shadow supply" of recently vacated space which has negatively impacted retail REIT fundamentals. Just as the "network effects" of having a thriving ecosystem of diverse retailers was a key selling point of the enclosed mall format for tenants and shoppers alike during the rapid rise of the mall format from 1970 through 2000, investors and analysts are increasingly worried about the "death spiral" effect in struggling mall properties whereby occupancy and foot traffic falls below a level to keep the property viable.

Anemic internal growth and limited external growth resulted in the first year of negative FFO growth in 2019 - on a weighted average basis - since the financial crisis due to the relatively strong performance from sector stalwart Simon Property, which accounts for roughly 80% of the sector weight. Based on a simple average, however, FFO growth has been negative since 2017 and will likely be sharply negative in 2020. Low-productivity mall REITs saw a nearly 30% decline in FFO growth in 1Q20 while high-productivity mall REITs saw a -4.3% decline. We expect FFO growth to decline between 15% and 30% in 2020 on a simple-average basis, down from initial guidance of -12.9%.

Last quarter, we introduced the "4 C's of Brick & Mortar Competition." We believe that outside of the high-productivity malls and outlet centers that have the critical mass and "network effects" to offer a value-add retail experience that cannot be replicated online or otherwise, retailers in lower-productivity enclosed malls will find it difficult to compete on any of these four axes due to the inherent challenges of the format. As discussed in our Shopping Center REIT report, by embracing the "bricks and clicks" model including in-store pickup and honing the cost and convenience advantages of the strip center format, non-enclosed shopping centers have proven to be more adaptable to the rapidly changing retail distribution chain.

Mall REIT Valuations

Mall REITs trade at some of the lowest valuations across the REIT sector, particularly the three lower-productivity mall REITs which trade at an average FFO multiple of roughly 2x. While value and yield-seeking investors may be attracted to these REITs, we caution that the "deep value" strategy hasn't been particularly rewarding to REIT investors over the past decade. In our recent report, "The REIT Paradox: Cheap REITs Stay Cheap," we discussed our study that showed that lower-yielding REITs in faster-growing property sectors with lower leverage profiles have historically produced better total returns, on average, than their higher-yielding counterparts. Mall REITs continue to trade at a wide NAV discount, estimated at 35-45% based on consensus estimates.

For the handful of larger REITs that have continued to pay their dividend, mall REITs have become one of the highest-yielding REIT sector, but not necessarily for the right reasons. While dividend growth has been almost as anemic as FFO growth over the past half-decade, weak share price performance has boosted dividend yields well above the REIT average. Mall REITs pay an average dividend yield of 8.6% compared to the 3.3% REIT sector average.

As noted above, three mall REITs - SKT, WPG, and CBL - have completely eliminated their dividend in recent months while two more - MAC and PEI - have reduced their dividend. Even so, MAC is the highest-yielding mall REIT at 15.3%, followed by Brookfield Property and Simon Property at 9.4% and 5.9%, respectively. Within the sector, more than other REIT sectors, investors need to be cautious not to fall into common "value traps" by assuming that high dividend yields can offset declining price returns, or that dividends are any more "certain" than share price appreciation.

Key Takeaways: Sticking With 'Essential Sectors'

Mall REITs are longing for the days when the 'retail apocalypse' was their biggest concern. Despite a 100% rally from their lows, malls remain the worst-performing property sector in 2020. Mall REITs reported collection of less than 25% of rents in April and May as retail landlords struggled to collect rent from "non-essential" tenants while other "essential" property sectors including housing, industrial, and technology REITs, along with self-storage and office REITs, which all reported collection of more than 90% of rents.

Glimmers of hope have emerged, however, amid the economic reopening as several key mall-based tenants have reported a faster-than-expected demand recovery, prompting a substantial share price rebound. While mall REITs may be off life-support for now, the pandemic likely further amplified the significant secular headwinds facing the enclosed mall format and accelerated store closing decisions. Excluding the relatively steady Simon Property, the sector should be avoided for non-speculative investors and continue to see better opportunities elsewhere in the REIT sector.

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Analyst’s Disclosure: I am/we are long SPG. 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.

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