At the end of 2018's first quarter, once-thriving retailer Sears (SHLD +0.00%) was operating 381 fewer stores than it was a year ago. And the company's footprint is continuing to shrink. Sears announced more closures recently, and it looks like a total of 275 Sears and Kmart stores could close during 2018.
As a result, many malls across the U.S. are about to be left with massive amounts of vacant square footage, and as a result, many mall operators are getting hammered.
This is particularly true when it comes to lower-end ("Class B" and "Class C") mall operators like CBL & Associates (CBL +0.00%), just to name one example. CBL operates Class B and C malls in mid-sized markets, and a staggering 60% of its properties have a Sears or J.C. Penney (which isn't in much better shape) occupying an anchor location.
Because this is going to lead to lots of empty square footage, it will also likely lead to rent concessions made to remaining tenants to entice them to stay. And many analysts believe rent concessions may not be enough -- store closures throughout CBL's malls could become widespread.
However, massive mall REIT Simon Property Group (SPG +0.81%) is excited to get those blank canvases back to add value to its properties.
Image source: Getty Images.
This mall REIT sees an opportunity
The difference between mall REITs like CBL and Class-A mall operators like Simon is the financial flexibility the company has. Simon's excellent credit rating, strong balance sheet, and high borrowing capacity allow it to do something about the closures.
As one of the largest REITs in the market, Simon Property Group has invested lots of money in developing the most desirable shopping destinations. In fact, five of the 10 most valuable REIT-owned malls are in Simon's portfolio.
Over the past several years, Simon has been gradually transitioning its properties away from the traditional mall setup (almost exclusively retail and quick-service dining) and into mixed-use properties. Many of Simon's mall properties now have other types of real estate such as hotels, offices, apartments, entertainment properties, and dining options that traditionally wouldn't have been found in malls. And the strategy appears to be widely successful so far.
Because of this new direction, Simon is looking at Sears' store closures as an opportunity. For example, Sears on May 31 announced that it would close another 63 stores "in the near future." This is in addition to previous guidance that 166 of the company's stores would close in 2018.
Well, on the same day as Sears' announcement, Simon issued a press release to calm investors' nerves, saying that the "team is fully engaged in capitalizing on this opportunity and continues to pursue plans to replace Sears stores with new and compelling ways to live, work, play, stay, and shop at these Simon destinations nationwide," according to COO Michael McCarty.
McCarty says the company has big plans for former Sears spaces. "A combination of innovative retail, restaurant, and entertainment concepts are in play for each center. Mixed-use elements such as hotel, residential, office, and fitness are also being incorporated," added McCarty.
Simon has already redeveloped several Sears locations
I mentioned briefly that Simon's strategy has been successful so far. Keep in mind that Sears has been closing stores for some time, so Simon has already had quite a bit of practice in this area.
For example, Simon announced in April plans to redevelop five former Sears locations. One will simply turn the Sears into new shops and restaurants. Another will incorporate a 120,000-square-foot athletic facility, as well as residential and restaurant spaces. And another is turning the space into two new restaurants and expanding the space of an existing department store.
Furthermore, it's important to mention that Simon has relationships with several non-retail companies that it could use to its advantage when redeveloping former Sears locations. For example, the company recently expanded its relationship with Marriott. There are more than 15 Marriott-branded hotels at Simon's properties already, and at least five more are in the works.
Is mixed-use the future of malls?
One thing is looking more and more certain: The old mall business model of three or four department stores as anchors, a cookie-cutter food court, and the same collection of stores just doesn't work in the new retail landscape. Shoppers can get most of the same items online -- and often for cheaper prices. And with their savings, they can eat somewhere a bit nicer than the pizza stand in the food court.
While it's still early in the transition, the first signs are pointing toward the success of mixed-use mall properties. Entertainment-oriented tenants like movie theaters, family amusement centers, and more are inherently immune to online competition. A variety of modern dining options gives people more reasons to come to the mall. And hotels, apartments, and offices create a natural source of foot traffic.
With excellent credit ratings and virtually unlimited borrowing capability, Simon is well-positioned to transition its mall properties to adapt to the changing retail environment, and it could turn out to be a bargain at its current valuation of less than 14 times its 2018 expected funds from operations, or FFO.
