A Terrible Time To Own Retail

Summary

• Shopping center REITs roared higher in 2021. The impressive rally has made prices less attractive compared to other REITs.
• Few analysts are willing to take a simple bearish view on a subsector. It isn’t popular with readers. It goes against their incentives.
• While retail isn’t dead, it is becoming less relevant. Ordering online with in-person pickup helps, but there are other challenges coming.
• Valuations don’t leave much margin for safety. Pressure from rising wages has the potential to severely impact traditional retail tenants, which could weaken leasing spreads over the next several years.
• Rising wages are driving a material shift in our expectations for inflation. Beware of jumping to conclusions about Treasuries or REIT values though.
• This idea was discussed in more depth with members of my private investing community, The REIT Forum. Learn More »

monsitj/iStock via Getty Images

Shopping center REITs have enjoyed a resurgence in 2021. Many analysts appear to be forecasting the great revival of shopping centers. I'm going to take a less sanguine view. However, I want to begin by acknowledging the optimistic case. Shopping centers have benefitted from adjustments within their parking lots to enable rapid pickup. The ability for consumers to order online and pick up at the store shortly thereafter has been important to the tenant's ability to maintain profitability (or reduce losses). Shopping centers are involved in this because they need to make it possible, yet putting up a few "Online Only" signs for spaces next to handicap parking is a pretty simple task.

Bulls Hate This View

When I write about how the sector is becoming more fully valued, it isn't good for customer retention. Even a spectacular article on the topic has a clear negative impact. Many investors think "well, this sector is fully valued so I'll buy a different sector where the analysts are very bullish". Think about that for a bit. We're not going to simply argue that shopping center REITs are near a fully valued level, we're seeing that for the overall market. There are still small pockets of value, but perpetually bullish analysts are just prioritizing revenue over taking care of their customers.

I premise the rest of the article with that commentary because it provides context. It speaks to our conviction about the long-term fundamentals and our motivation (protecting investors) in highlighting these issues.

Is Retail Dead?

Absolutely not. It isn't healthy either. We may see stronger performance in the near term since companies on the verge of bankruptcy had a great opportunity to file already. Further, REITs that adjusted their lease accounting for potential defaults that don't occur may report stronger values (artificially strong, as 2020 was artificially weak). This can be a tricky situation since it requires quite a bit of digging into the accounting. Since relatively few investors are looking for opportunities to short, this type of digging is most useful when we think we might uncover a buying opportunity.

Two Challenges

There are two issues facing retail today, in my view:

1. Retail is becoming less relevant.
2. Valuations are high.

Relevance

Because consumers can order so many things online and have it shipped to their door, physical retail is becoming less relevant. This is one of the reasons I've tended to prefer net lease REITs which own restaurants and industrial properties over the more generic retail property. While restaurants were hammered during the pandemic, hot food isn't coming from an Amazon warehouse. The consumer may decide to order through DoorDash, but the order still needs to be routed to a local restaurant. That keeps restaurant real estate relevant. However, big-box retail is becoming far less relevant and that means an abundance of space. When a big box store shuts down, the landlord often needs to split up the box and lease it out to several smaller retailers. Consequently, investors can't simply look at the number of closures relative to openings in a year. On average, the new locations which are opening will tend to be smaller.

Based on a long-term view, we're expecting retail rents to grow at slower rates than most other property types. In some areas, they may decline. However, slow growth could still put them below the rate of inflation. This produces a long-term challenge. If prices are low enough, investors could be compensated for taking on lower risk. Are prices low enough? No.

Valuations

It usually comes back to valuation. While there are REITs that I wouldn't buy at any price, these aren't them. These are REITs with good management teams (some great), some have strong balance sheets, and the "flaw" is just weaker revenue growth. Again, we need to remind investors that looking at year-over-year metrics following the pandemic can be misleading. We won't emphasize artificially low values for 2020 as proof the sector is struggling or artificially high values for 2021 as proof it overcame the long-term structural challenges.

We will start by using "Price-to-NAV". The NAV (Net Asset Value) used in these calculations comes from the consensus analyst estimate. If we believe the consensus estimate is absurd, we would disclose that. We don't have any reason to believe the consensus NAV estimates for these shopping center REITs are significantly flawed.

Source: Author's chart, data from TIKR.com

You may notice that in each case the current price-to-NAV is higher than the 5-year average. It is true that price-to-NAV ratios were absurdly low during the pandemic, but the last few months have been dragging the averages higher. Seeing the higher-than-normal price-to-NAV ratios, investors could start asking themselves, "do I believe the future performance of this real estate will be substantially superior to prior levels"? Remember, this period covers far more than just the pandemic. We can enhance this analysis by also comparing current values with the historical levels for AFFO multiples:

Source: Author's chart, data from TIKR.com

The only case where the AFFO multiple is lower than average is Regency Centers (REG). In that case, it is only slightly lower. In some cases it is quite materially higher. The most notable cases are Retail Properties of America (RPAI) and Brixmor Property Group (BRX). Despite our overall pessimistic view for the property type, we think BRX deserves to trade at or above the historical average AFFO multiple because a population shift is favoring their real estate. On the other hand, shopping centers in higher cost areas may struggle more to maintain rent levels as tenants grapple with consumers migrating away from those areas.

First Conclusion

Valuations across the shopping center REITs recovered dramatically. The current valuations leave far less margin for weakness in leasing results over the next several years. That feels like a pretty high bar given some of the long-term macroeconomic headwinds. Despite solid management teams and a resurgence in retail real estate, tenants are still facing several issues. The lingering difficulty of competing with e-commerce may be compounded by other factors such as the requirement for higher wages to attract employees. Staffing retail locations may become materially more expensive. The additional cost reduces the attractiveness of opening new retail locations. A reduction in new store openings would drive difficulties in leasing spreads or occupancy over the next several years. Current valuations imply continued solid growth in AFFO per share year-over-year. If that growth stalls out, then existing multiples and price-to-NAV ratios would provide room for a material decline. That doesn't fit our risk/reward profile.

Ratings:

• None

For subscribers who stumbled across the public article first, please see the expanded version.

The charts in this section will still be updated for each new article, but the rest of the text for the public version will be mostly repeated from piece to piece. We structure the article this way because the repeated sections are extremely important to understanding REIT investing, yet we find people rarely click links to access additional information. Therefore, it needs to be in the body of the article so any reader can easily refer to it.

Cheap Stays Cheap

When Hoya Capital Real Estate wrote Cheap REITs Stay Cheap, he said:

"While the allure of high yield REITs can be tempting, we've stressed in our research that while there are no shortcuts in REIT investing, that one can indeed "tilt the playing field" in one's favor by having the discipline to focus on high-quality names and long-term dividend growth rather than "juicy" yields that can be cut at any moment. High yield REIT investors had a rough 2020 as REITs in the highest quadrant of dividend yields entering 2020 plunged more than 30% and saw the vast majority of dividend cuts while REITs in the lowest dividend yield quadrant produced positive total returns."

He hammered the point home with this chart:

Strategy

Our goal is to maximize total returns. We achieve those most effectively by including "trading" strategies. We regularly trade positions in the mortgage REIT common shares and BDCs because:

1. Prices are inefficient.
2. Long term, share prices generally revolve around book value.
3. Short term, price-to-book ratios can deviate materially.
4. Book value isn't the only step in analysis, but is the cornerstone.

We also allocate to preferred shares and equity REITs. We encourage buy-and-hold investors to consider using more preferred shares and equity REITs.

Performance

We compare our performance against 4 ETFs that investors might use for exposure to our sectors:

Source: The REIT Forum

The 4 ETFs we use for comparison are:

Ticker	Exposure
MORT	One of the largest mortgage REIT ETFs
PFF	One of the largest preferred share ETFs
VNQ	Largest equity REIT ETF
KBWY	The high-yield equity REIT ETF. Yes, it has been dreadful.

We focus more on high-quality equity REITs than high-yield equity REITs, but we find many potential investors are more excited about KBWY because they see a high yield and assume it means high returns. Clearly, it doesn't (read our articles and you'll get exposed to that lesson frequently). However, it is one of the main alternative options many investors may consider. You may have noticed that KBWY delivered weaker returns over the last 5 years than the index ETFs for preferred shares, mortgage REITs, or equity REITs. That's a testament to the poor performance that comes from picking based on dividend yield.

Misconceptions

There are a few common misconceptions. Sadly, these are so prevalent that I need to address them on a regular basis.

1. Several investors who have begun to learn about NAV believe that buying at a large discount to NAV is always a good idea. While a discount can be attractive, it shouldn't be used in isolation. REITs that persistently trade at a large discount to NAV simply do not outperform.
2. Many investors believe that by "demanding" a higher return in the form of dividend yield they can achieve higher returns. This doesn't work. It has never worked. It regularly results in worse returns.
3. Many investors believe FFO can be used in isolation to determine if a REIT's dividend is safe. This is categorically false. We're providing charts using "Analyst AFFO", which subtracts for recurring capitalized expenditures such as replacing roofs and repaving parking lots. If you owned a physical building, could you spend rent money on replacing a roof and then spend the same dollars on paying for a cruise? No. If you stick to using FFO instead of AFFO, you will fail dramatically at valuation.
4. Some investors think payout ratios in a single year are enough to tell them everything they need to know. That isn't true either. Sometimes there are non-recurring factors that can still impact "Analyst AFFO". Despite attempts to standardize definitions, there are some unusual factors that can still have significant short-term impacts. That doesn't mean you can shrug off a high payout ratio, it means you need to dig deeper.
5. Many investors fall into one of two extremist camps. The first camp thinks no one can beat the market regularly, therefore they are only interested in index funds. Ironically, these investors still choose several different index funds instead of just using one target-date fund, which automatically diversifies their holdings. The second camp assumes that beating the market is simple and becomes overly confident. These investors may often be heard disclosing trades months later, but never in real-time. You can guess why.

Demonstration

Since someone always wants to argue about those points, I need to keep reminding investors: A persistent discount to NAV is not a positive sign.

I'm going to use several charts built using TIKR.com to demonstrate. Each chart is HUGE so we could maintain resolution. Consequently, I didn't want to post them all inside the article and waste your bandwidth. Below you'll see them split by category and listed with both the ticker and the sector:

Frequent Discount to NAV & Declining Price	Mixed Discount / Premium & Rising Price	Frequent Premium to NAV & Rising Price
APTS: Apartments	MAA: Apartments	SUI: MH Parks
BRG: Apartments	ESS: Apartments	ELS: MH Parks
ILPT: Industrial	DRE: Industrial	REXR: Industrial
WPG: Mall & Shopping Center		O: Net Lease
CIO: Office		DLR: Data Centers

If you find this layout confusing, let me know. So far it seems like the most efficient way to convey the information.

What about big discounts with a long-term trend higher in share prices and NAV? Why don't we have that as a category? Go try to find two examples. I'll be here waiting.

When someone tells you that all of their REITs trade at large discounts to NAV, that should be a red flag. It's great catching a premium REIT during a rare discount, but a persistent discount is a bad sign. If you're a buy-and-hold investor, your #1 focus should be on quality.

It is shockingly rare to see a combination of a long-term rising share price and a frequent discount to NAV. If the discounts to NAV are frequent, it doesn't bode well.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.