Shopping Center REITs: Big Box Boom

Summary

• Big Box Is Back: The COVID pandemic has radically transformed consumer spending habits - perhaps permanently - shifting spending towards goods over services and towards larger-format retailers over smaller shops.
• While enclosed regional malls face a long and uncertain road to recovery, the outlook for open-air Shopping Center REITs has brightened considerably this year. Recent earnings results have been impressive.
• Rent collection has fully normalized and trends in occupancy rates and leasing have been encouraging. 9 REITs raised guidance in Q2 and a full earnings recovery appears likely by late-2022.
• It took a few years, but Big Box retailers have learned to compete effectively in the e-commerce era. Shopping centers are becoming hybrid distribution centers in a decentralized last-mile delivery network.
• We've seen the "animal spirits" come alive with several mergers, an IPO, and signs that external growth will be reignited. Valuations again appear attractive as the share price rally has cooled while fundamentals have heated up.
• This idea was discussed in more depth with members of my private investing community, Hoya Capital Income Builder. Learn More »

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REIT Rankings: Shopping Centers

(Hoya Capital Real Estate, Co-Produced with Colorado WMF)

Shopping Center REIT Sector Overview

Big Box Is Back: The COVID pandemic has radically transformed consumer spending habits - perhaps permanently - shifting spending towards goods over services and towards larger-format retailers over smaller shops. While enclosed regional malls face a long and uncertain road to recovery, the outlook for open-air Shopping Center REITs has brightened considerably this year. In the Hoya Capital Shopping Center REIT Index, we track the 17 largest open-air shopping center REITs, which account for roughly $65 billion in market value.

Shopping Center REITs have continued their post-vaccine resurgence through mid-2021, rallying another 48% this year and pushing many of the higher-quality REITs above their pre-pandemic highs. Unlike other more troubled REIT sectors riding the "reopening rotation," however, this rally has been built on more than "hope" and optimism alone. As discussed in our REIT Earnings Recap, recent earnings results have been impressive - even by pre-pandemic standards - as shopping center REITs reported a complete normalization of rent collection in Q2, powering an impressive 22% surge in same-store Net Operating Income ("NOI") growth, the highest in the REIT sector.

Shopping center REITs - which were not hit nearly as hard as their enclosed mall peers - reported an average FFO/share decline of 19% in 2020, but recent trends indicate that a full earnings recovery appears likely by mid-2022. All nine of the shopping center REITs that provide guidance raised their full-year outlook - many by a significant margin - with an average upward revision of 640 basis points ("bps"). Positive standouts included Federal Realty (FRT) which reported a nearly 40% surge in its same-store NOI and raised its FFO outlook by 980 bps, along with Regency Centers (REG) which reported a 31% surge in NOI and now expects FFO to return to pre-pandemic levels this year - likely the first shopping center REIT to fully recover.

Unlike malls, the majority of shopping center tenants - particularly grocery stores and "big box" retailers - remained operational as "essential businesses" even during the peak of the lockdowns. While mall REITs have continued to report some level of difficulty in collecting rents, shopping center rent collection rates essentially fully normalized by the end of Q2, up from an average of around 75% in Q2 of last year. Recent trends in occupancy rates and leasing spreads have been equally encouraging as shopping center REITs have been able to negotiate non-monetary concessions in exchange for rent deferrals that we believe should bear fruit over time including waiving co-tenancy clauses, lifting use restrictions, and extending lease terms.

Strong leasing activity has been the positive highlight of the past several quarters and unlike their mall REIT peers, leasing volumes picked up considerably in the first half of 2021. Encouragingly, leasing spreads remained firmly positive last year - rising by roughly 5% for full-year 2020 and have risen by a similar amount so far in 2021 - which is roughly in-line with the average spread over the past three years. Occupancy rates increased 60 basis points from Q1, on average, with each of the sixteen REITs reporting a sequential improvement, confirming our call last quarter that the "bottom" for occupancy rates and leasing spreads was likely seen in early 2021.

We've also seen the "animal spirits" come alive across the shopping center REIT sector with several mergers, an IPO, and signs that external growth will be reignited after a half-decade of relative stagnation. Kimco Realty (NYSE:KIM) and Weingarten Realty (NYSE:WRI) closed last month on their merger to form the largest shopping center REIT with an enterprise value of nearly $20B. In mid-July, Kite Realty (KRG) and Retail Properties of America (RPAI) followed suit in a merger that will result in a combined enterprise value of roughly $8B upon closing later this year. KRG will be the surviving entity in the transition and each RPAI common share will be converted into 0.6230 newly issued KRG common shares.

Elsewhere, formerly non-traded REIT Phillips Edison & Company (PECO) went public in July, raising $476 million through an offering of 17M shares. PECO is an internally-managed REIT and one of the nation's largest owners and operators of grocery-anchored shopping centers with a portfolio comprised of 278 wholly-owned shopping centers across 31 states. Grocery-anchored centers have historically commanded premium valuations relative to power centers and REITs with a heavier balance of grocery-anchored centers have generally delivered steadier operating performance throughout the pandemic.

Shopping Center REIT Performance

After plunging more than 50% early in the pandemic, shopping center REITs began to stabilize by late summer of last year and have been the best-performing property sector since last November. While the rally has paused over the past quarter amid the "fourth wave" of the COVID pandemic, shopping center REITs are still the third-best performing property sector this year, remaining higher by 47.6% so far in 2021 compared to the 29.9% gains from the Vanguard Real Estate ETF (VNQ) and the 20.8% gain from the SPDR S&P 500 ETF (SPY). We believe that valuations again appear attractive as the share price rally has cooled while fundamentals have heated-up.

This year's rebound comes after five straight years of underperformance relative to the broad-based FTSE Nareit All Equity REITs Index including the -28% total returns last year, far below the -8% returns from the broad-based Index. Despite the rally this year, retail landlords have significantly underperformed the performance of their tenants as the SPDR S&P Retail ETF (XRT) has returned more than 110% since the start of 2020, and the Amplify Online Retail ETF (IBUY) has surged more than 200% compared to the roughly flat cumulative returns by these REITs over this time.

Diving deeper into the company-level performance, each of the sixteen shopping center REITs - excluding PECO, which went public this year - are higher by at least 25% so far this year, led to the upside by many of the hardest-hit REITs from last year including Retail Value (RVI), Cedar Realty (CDR), and Acadia Realty (AKR), each of which have gained more than 50% this year. Nine of sixteen shopping center REITs have now produced positive total returns since the start of 2020, led to the upside by SITE Centers (SITC), Brixmor Property (BRX), and Regency Centers.

Performance trends during the pandemic closely mirrored balance sheet quality more than any other factor as the nine REITs with investment-grade S&P credit ratings delivered double-digit outperformance relative to their non-investment-grade peers last year. Balance sheet metrics - particularly the critical Debt/EV Ratio metric - have improved considerably as share prices have rebounded as all but four REITs are now trading with Debt Ratios below 60%, down from 14 at the end of 2020, per data tracked by NAREIT.

Deeper Dive: Analyzing The 'Big Box Boom'

Helping to power this reopening rally, retail sales in the U.S. have continued to set record-highs throughout 2021, powered by WWII levels of fiscal stimulus. Regaining all of the lost ground during the pandemic by early 2021, the strength in retail sales has cooled a bit in recent months but we've noted ongoing strength in many of the "big box" categories including home improvement, general merchandise, grocery, sporting goods, electronics/appliances, and home furnishings stores. Amazingly, the non-store retail category - which includes Amazon (AMZN) - was higher by less than 6% year-over-year in the most recent July report, which was the second-weakest annual growth rate in a month for e-commerce sales since 2015.

It took a few years, but Big Box retailers have learned to compete effectively in the e-commerce era. Underscoring this "Big Box Boom," the ten largest brick-and-mortar retailers have posted average returns of roughly 50% since the start of 2020. Recent earnings reports from Home Depot (HD) and Lowe's (LOW) have been historically strong, as have earnings results from many of the largest "big-box" general merchandise retailers including Walmart (WMT), Costco (COST), and Target (TGT). The large publicly traded grocers have also seen renewed strength driven by the pandemic including Albertsons (ACI) - which has surged more than 100% since the start of 2020, and Kroger (KR) - which has gained nearly 50%.

Data by YCharts

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 centers have increasingly become hybrid distribution centers in a decentralized third-party delivery network powering "same-hour" delivery to challenge Amazon's dominance in ultra-fast delivery. The pandemic significantly accelerated retailers' investment in their in-store order fulfillment platforms which has evolved from a pure "click and collect" model into a multi-channel "last-mile" delivery network supplemented by delivery platforms like Uber (UBER), Postmates (POSTM), and DoorDash (DASH) as the food delivery model is becoming more ubiquitous across all retail categories.

Not all shopping centers are equally well-suited for this evolution, however, and many retail locations lack the logistical infrastructure - location, parking, ease of pickup - to serve as hybrid fulfillment hubs. The pace of store closings increased substantially in 2020 but has moderated in 2021 with CoStar (CSGP) estimating that we'll see the least amount of retail stores closing up shop in more than a decade. Store openings have outpaced closures in several months this year as retailers - predominately "big-box" and dollar stores located in open-air shopping centers - expanded their footprint. We believe that the longer-term outlook for most open-air strip centers remains far more promising than their regional mall REIT peers due precisely to their physical layout and strategic importance in the retail fulfillment network.

After a development boom during the 1990s and early 2000s, only a limited amount of 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 REIT Indexes.

Shopping Center REIT Dividend Yields

Helped by the thirteen dividend increases across the sector this year, shopping center REITs currently pay an average dividend yield of 3.3%, which is well above the market-cap-weighted REIT sector average of 2.6%. Shopping center REITs pay out only about half of their FFO, however, leaving some upside potential for dividend growth. Over time, we believe that shopping center REITs will likely again become one of the highest-yielding REIT sectors.

Diving deeper into the sector, we note that dividend yields range from a sector-high of 4.8% from small-caps Urstadt Biddle (UBA) and Saul Centers (BFS) to a sector-low of 1.5% from Cedar Realty (CDR). As we've discussed since the start of the pandemic, for investors looking purely for dividend safety and the highest potential for dividend growth, Regency Centers and Federal Realty would be the most conservative bets given their low payout ratio, sector-leading balance sheets, and history of dividend growth. By the end of the year, we expect Regency, Retail Value, and Cedar Realty to join the rest of the sector in hiking their dividend payouts.

For investors interested in the "preferred route" to invest in these REITs, seven of the seventeen REITs also offer preferred securities including one issue from Federal Realty (FRT.PC), two from Kimco (KIM.PL) (KIM.PM), one from SITE Centers (SITC.PA), two from Saul Centers (BFS.PD) (BFS.PE), two from Urstadt Biddle (UBP.PK) (UBP.PH), two from Cedar Realty (CDR.PB, CDR.PC) and one from RPT Realty (RPT.PD). All of these issues are standard cumulative redeemable preferred securities that currently trade with an average yield of roughly 5.7% and trade at modest premiums to par value.

Shopping Center REIT Valuations

As noted above, we believe that valuations again appear attractive as the share price rally has cooled while fundamentals have caught up. Trading at an average 17.0x Price-to-FFO (Funds from Operations) multiple based on consensus 2022 FFO, shopping center REITs are trading at healthy discounts to the REIT sector average. While shopping center REITs have produced below-average FFO growth over the past half-decade, we believe that the headwinds of the "retail apocalypse" may be beginning to shift favorably into mild tailwinds for the open-air shopping center REIT sector.

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. Shopping center REITs disposed of $1.5 billion in assets in 2020, but the recent share price recovery has brightened the outlook for external growth, as shopping center REITs now trade at premiums to their private-market implied net asset value ("NAV"). 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 discounts this large make it nearly impossible to accretively acquire properties.

Takeaway: Valuations Again Appear Attractive

For landlords, it's far easier to pay dividends when you're collecting the rent. After fourteen of the seventeen shopping center REITs reduced or suspended their dividend last year amid the pandemic, we've seen thirteen shopping center REITs either resume or raise their dividends so far in 2021 with more likely to come in the months ahead. We turned bullish on shopping center REITs in mid-2020, dubbing them an "essential bargain," but urged caution last quarter as valuations appeared stretched. We believe that valuations again appear attractive as the share price rally has cooled in recent months while organic fundamentals and external growth opportunities have heated up.

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Disclosure: I/we have a beneficial long position in the shares of HOMZ, HD, LOW, REG, ROIC, WMT, COST, TGT, WBA, AMZN either through stock ownership, options, or other derivatives. 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.