Pennsylvania Real Estate Investment Trust: An Undervalued Mall REIT.

Summary

• PEI is a landowner of prestigious and important malls.
• A consistent part of the decrease in revenues has been due to a strategic reduction and transformation of the own properties.
• PEI's operating income continues to be too modest to support the outflows used in financial activities.
• According to valuation models, PEI's stock price these days appears undervalued.

PEI's real estates

Pennsylvania Real Estate Investment Trust (PEI) is one of the oldest equity REITs in the USA primarily focused on retail shopping malls located in the Mid-Atlantic region.

PEI own interests in 26 retail properties, whose 21 are shopping malls, located around 9 States in the USA. Remarkably, PEI owns and manages A-class malls for which tenants pay an average rent of $49/sq.ft. The choice to operate with the highest class mall allows PEI to have a competitive advantage with her peers, not only for the possibility to gain a higher rent but also to enhance value through a better strategic positioning on the market. I think for instance of the advantages of managing a property located around an area subjected to densification (population forecasted growing), also an area inhabited by high-income people with more whims to satisfy than others ones living in rural areas. Strong of these real estate features, PEI has had an average of the 95% of occupancy rate across the last few years.

More importantly, during the past years of retail crisis due to the shift of consumer habits, PEI has shifted the 24% of traditional mall tenants toward those offering services such as dining and entertainment, health and wellness, off-price retail, and fast fashion. An example of these redevelopments is the Fashion District Philadelphia, a shopping mall, renewed in partnership with Macerich (MAC) for which has expected a more complete tenants occupancy within the first half of 2021. These improvements and redevelopments have been extremely important to prevent the firm from a deep deterioration of its business due to the advent of e-commerce and its related consequences. Complementary that, another important strategic view improvement has been the progressive reduction of the department stores tenants category as management rightly reacted to the impacts of the named "retail apocalypse" crisis.  

Since most of PEI's revenue comes from rents collected from its tenants, PEI has developed lease agreements under which tenants pay a minimum rent which can be:   

• a fixed amount eventually increased 2 or 4 times during the lease term;
• a percentage of their sales revenues that exceed certain levels specified in their lease agreements;
• a percentage of their total sales revenue.

Almost every lease provides that the tenants will reimburse PEI for certain expenses relating to the property, like common area maintenance costs, real estate taxes, utilities, etc...

Revenues reduction catalysts

Looking at the total revenues of PEI from 2015 to 2020 we can see a progressive reduction on those because of three factors:

1. The effects of the "apocalypse retail" crisis that has struck department stores in primis and, indirectly shopping malls that rent to them;
2. Strategical reductions in real estate assets planned in the past by management of PEI. 
3. COVID-19 pandemic, that from the first quarter of 2020 has locked-down people to home setting-up a new crisis. 

Data by YCharts

In 2012, one of the most important decisions of the PEI management to face front the retail sector crisis was divesting an important slice of the asset portfolio so that the proceeds from divestitures were gradually utilized to focus on upgrading the best properties. 

Data by YCharts

 This was confirmed from cash flow data, where flight-to-quality strategy caused important outflows of the net cash provided from operating activities and conversely a recursive revolving borrowing in order to finance investing activities, especially in 2015, 2017, and 2019. Financial data and occupancy rates showed that the decrease in revenues was primarily due to a strategic business transformation more than the effects of retail apocalypses. This information can be easily found in the last 10-K.

Data by YCharts

Worth to say that till now PEI agrees with her lenders to find every possible solution to manage at the best the burdensome debt situation; one of the many covenants imposed to restructure debt was the dividends distribution zeroing to common shareholders, a tough decision but necessary. Others of them are better described by Adam Levine-Weinberg CFA in his article PREIT: Covenant Modifications Solve One Big Problem, But COVID-19 Remains A Concern and by R. Paul Drake in his article The Artificial Bankruptcy Of Pennsylvania REIT 

Valuation

This section attempts to value the most probable value of the common stocks of PEI. I use two approaches:

1. Fundamental valuation based on the FCFF (free cash flows of firm);
2. A contingent claims valuation very close to the Black&Scholes options valuation.

In Method 1. I use 12-trailing months' accounting variables useful to assess the cash flows. They can be found in the last 2019 10-K and 3Q20 10-Q SEC files. In the next step, I ran the model assuming very conservative forward cash flows, growth rate, and a cost of capital substantially stable in the long run. Moreover, I think that transformational investments in the asset should bring the EBIT/Revenues ratio closer to 50% in the next several years; a ratio not too far from those seen in the past when PEI was performing better than now. 

Furthermore, I also supposed a 20% chance of failure for PEI within the next 10 years and asset proceeds of 50% of fair value.  

I found a value per share for the entire firm (debts included) of $8.46. 

In Method 2. I use a contingent claim valuation is due to bypass the negative equity value per share. Actually, readjusting the Black&Scholes model used for option valuation is possible to appraise certain firms in trouble and heavily indebted like PEI now. So, the idea behind this approach considers, like the underlying price of a stock option, the liquidation value of the current operating asset value netted by depreciation and related mortgage debt; correspondingly to the strike price of an option, I use the entire PEI's book value of debt. 

It comes out a value of the equity per share of $ 6.82.

Investment thesis

Considering that all above and valuing the most probable fair value of the equity per share in a very conservative view, I see stock price fair value per share within a range of $6.82 - $8.46; hence given the market price today (below $2 per share) I am bullish on it.