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The Mall REIT Conundrum

Most every day, on my way to work, I drive by my area mall, and it’s a constant reminder that ‘Darwinism’ is alive and well. Charles Darwin wrote in 1882, "This preservation, during the battle for life, of varieties which possess any advantage in structure, constitution, or instinct, I have called Natural Selection.”

Survival of the fittest is an expression that originated from Darwin as a way of describing the mechanism of natural selection. In Darwinian terms the saying is best understood as "Survival of the form that will leave the most copies of itself in successive generations."

We are all witnessing firsthand the evolution in which certain malls have become extinct, and others are experiencing a “retail renaissance”. This “battle for life” has taken many forms in the mall sector, ranging from redevelopment, ground-up development, to natural death.

This picture (above) of course provides a dire example of a mall that has not survived, and while many have suggested that the “retail apocalypse” is no myth, there are hundreds of examples of thriving malls, like the one below, owned by Simon Property Group (SPG).

In a Bloomberg article last year, “These Malls Didn’t Get the Memo They’re Dying,” the author cites “Class A malls” that are able to attract premier tenants, and have performed well from both a fundamentals and valuation perspective.

According to Green Street Advisors, “this disparity is captured by the analysis below, which calculates that the roughly 270 malls rated Class A (by Green Street Advisors) represent 72% of total mall value. By contrast, the balance of more than 700 Class B/C malls represents only 28% of total mall value.

The most commonly utilized method for determining a malls classification (as A, B, C, or D) is the sales-per-square-foot of their in-line tenants. The chart below (prepared by Korpacz) illustrates that sales per square foot greater than $500 generally falls into the ‘A’ category.

The traditional mall consists of three to four department store anchors that generate traffic, that in turn drives foot traffic to the interior of the mall. According to Bloomberg, JC Penney, Sears, and Macy’s rank near the bottom of major anchor tenants in sales per square foot, unsurprising given their declining earnings and sales.

Recognizing that Sears is in the midst of a death spiral, JC Penney (JCP) is also struggling to maintain a foothold. CNBC said that Penney’s “plans to close three stores by the spring as part of an ongoing evaluation of its performance”. Earlier in 2018 the department store chain said it was cutting 130 jobs (at the corporate office) in an effort to save around $25 million annually.

Macy’s is also struggling as last week Bank of America downgraded shares in the retailer from “neutral” to “underperform” after weak holiday sales. According to CNBC, Macy’s expects “a declining earnings trend in the coming years absent a sharp increase in comps”.

Follow The Money

As readers and followers know, I have been pounding the alarm bells for the B/C mall REITs for quite some time. As I mentioned above, I drive by my area mall daily (owned by CBL) and it’s a constant reminder that death is inevitable, when there is no competitive advantage.

There are hardly any malls being constructed in the U.S., and this means that the only way for the REITs to grow is to either (1) grow organically, (2) redevelop, (3) invest internationally, or (4) acquire other malls or mall REITs. And without adequate cost of capital, options 2, 3, and 4 are almost impossible. So now I’ll highlight another use of the A,B,C, and D concept…

As referenced above, analysts and investors use the sales per square foot approach to evaluate the quality rating of a mall. Another way to utilize this concept is to examine the overall quality of the balance sheet, in an effort to determine how the company is able to manage its growth.

I consider Simon Property (SPG) and Unibail-Rodamco-Westfield(OTCPK:UNBLF) to be the only class A Mall REITs and that’s because the company enjoys a similar ‘A’ rating with S&P and Moody’s and Fitch. While I have not written on Unibail yet, I consider this mall REIT a big-time consolidator in the years to come.

Around a year ago Unibail-Rodamco, Europe's largest commercial landlord, acquired Australia’s Westfield Corp. for about A$21 billion ($15.8 billion) in the biggest property acquisition since 2013. The consolidated entity has the highest quality mall portfolio in the world, as viewed below:

Although not rated, I consider Taubman Centers (TCO) a high-quality mall REIT based on both sales per square foot and cost of capital. Taubman has the highest sales per square foot in the mall sector at $845 PSF.

Macerich (MAC) has high-quality sales per square foot metrics (was $688 in Q3-18) with a portfolio of many quality retailers including Zara, lululemon, Victoria’s Secret, Tesla, Sephora and Apple. Macerich’s balance sheet is also strong, with 47.3% debt/market cap, 3.30x interest coverage, and 5.6 year weighted average maturity.

According to Green Street Advisors, “Macerich is the most ‘urban’ of the mall owners they measure, as calculated by population densities within a 10-mile trade area”.

Don’t forget the newly formed Brookfield Property REIT (BPR) that was formed by Brookfield Real Estate Partners (BPY) to merge General Growth Properties (formerly GGP). BPY is an LP structure and BPR is a simpler 1099 structure that pays non-qualified dividends like any REIT.

The GGP deal creates larger public float for BPY and the transaction is immediately FFO/share accretive. The transaction provides direct access to enhance GGP’s irreplaceable class A retail portfolio, and with a REIT that is certain to expand over time. I consider BPY/BPR to be a consolidator in the years’ ahead.

PREIT (PEI) is a solid pick, but I have become increasingly concerned with the company’s exposure to JC Penney. Although PREIT has sales per square foot in excess of $500 ($510 as of Q3-18), the 14 JC Penney stores concern me, and if there’s enhanced development in 2019, I’m concerned that the divided could be cut. As a result, we recently downgraded PREIT to a SPEC BUY.

Rounding out the Mall REITs: Washington Prime (WPG) and CBL Properties(CBL) - both Strong Sells. I have frequently referred to the B & C Malls as “ugly duckling” because that is precisely what they have become.

No matter how you slice it or dice it, these two REITs are lost in time, and they are likely going to fall into the “retail apocalypse” category. Remember that it’s not just the department stores that are struggling, but also the in-line tenants that will put further pressure on redevelopment efforts.

Without scale (growth) or cost of capital, it’s going to be extremely difficult for these REITs to generate growth, and maintain their current dividend. For that reason, I believe these REITs should consider a move to convert back to C-Corp status, from REIT status, to eliminate continued pressure on the dividend payout.

I prepared the chart below using the "A-B-C-D" definition for both sales per square foot and cost of capital. Also, although I haven’t really touched on the definition of a “D” mall, I consider “D” to stand for “dog worth demolishing”.

One more harbinger as we commence 2019: Although Sears is almost finished, I expect to see more store closures ahead, especially in the department store sector. This means that the B/C mall REITs are going to have their work cut out for them as they attempt to patch, fix, and even demolish dark department stores.

As I drive by my local mall, I always peer out the window and try to imagine what the closed Sears store will become. And to be honest, I cannot come up with a logical highest and best use. Given the fact that the mall is around 85% occupied, redevelopment for this asset is going to be quite tricky.

Simply put, it boils down to “survival of the fittest” and that’s precisely why I have maintained a more tactical approach in the retail sector, choosing to select only the “best in class” names.

As I ponder the future of the mall sector, I cannot help to believe that there will be a continued wave of consolidation, and I am predicting that the top “A” mall REITs (as rated by Rhino) will be the consolidators and I consider the most logical M&A deal (today) to be Macerich (the seller) and Unibail-Rodemco-Westfield (the buyer).

PREIT is not a needle-mover for any of the “A” mall REITs, and this means that private equity could be the ticket out (for PREIT). Always remember, it comes down to scale and cost of capital as the two most important competitive advantages and if you are going to place hard earned capital on any REIT, make sure it’s a SWAN. As my mother always told me, "the cream eventually rises to the top".

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