Mall owner Pennsylvania Real Estate Investment Trust (NYSE:PEI) released its fourth-quarter earnings report on Wednesday afternoon. At first glance, the report may look like a disaster. Same-store net operating income (NOI) decreased 4.3% year over year last quarter. As a result, PREIT's full-year adjusted funds from operations (FFO) came in at $1.54 per share, near the bottom of management's $1.53-to-$1.58 guidance range.

Even worse, PREIT's 2019 forecast calls for adjusted FFO per share to plunge as much as 22% to a range of $1.20 to $1.34.

However, digging beneath the surface, PREIT's outlook is much better than it appears. And with multiple redevelopment projects on track to wrap up in late 2019 and early 2020, the REIT has a good chance of returning to FFO growth next year.

Check out the latest PREIT earnings call transcript.

The downtrend continues

In recent years, PREIT has been aggressive about improving its portfolio of malls. That has mainly entailed selling low-quality Class B and Class C malls -- properties with sales per square foot below $400 -- to get ahead of falling mall traffic that has disproportionately impacted the worst malls. PREIT has also proactively recaptured space from struggling department stores in order to bring in stronger tenants that would pay more rent and drive higher foot traffic.

A rendering of a redeveloped mall wing.

PREIT is steadily diversifying away from department store anchors. Image source: PREIT.

This strategy has caused steady declines in FFO over the past five years because PREIT now has fewer income-producing properties and it always has some malls undergoing redevelopment work. Indeed, PREIT's annual FFO per share was $1.96 as recently as 2014. The midpoint of its 2019 adjusted FFO guidance is 35% below that level.

Breaking down the causes of falling FFO

While PREIT's same-store NOI decreased last quarter, it increased slightly for 2018 as a whole. Nevertheless, adjusted FFO declined from $1.67 to $1.54. Virtually all of the decline was driven by lost income from properties that PREIT sold between the beginning of 2017 and the end of 2018, as well as lower income from malls that it plans to get rid of.

In 2019, it expects same-store NOI to grow again. However, PREIT is projecting a $7.5 million decline in NOI from three properties -- Wyoming Valley Mall, Valley View Mall, and Exton Square Mall -- that are on the chopping block (and thus excluded from the same-store NOI calculation). That alone would reduce FFO by $0.10 per share.

Management also forecast a roughly $6.2 million year-over-year decline in lease termination revenue for 2019. That would negatively impact FFO by $0.08 per share. That said, lower lease termination revenue also implies that there may be fewer vacant storefronts to fill in 2020.

Finally, a change in accounting rules for leasing costs will hit FFO by about $5.3 million ($0.07 per share) this year. Together, these three items account for virtually all of PREIT's projected FFO decline for 2019. All three are nonrecurring headwinds.

The underlying business is still healthy

On the bright side, sales per square foot at PREIT's core malls rose to $510 from $475 a year earlier. Organic comp sales growth accounted for about half of the increase, while removing lower-performing malls from the portfolio drove the rest of the gains.

This stands in contrast to what lower-tier mall operators like CBL & Associates (NYSE:CBL) have been experiencing. CBL's sales per square foot inched up to $377 in 2018 from $372 a year earlier (and $375 on a same-center basis).

PREIT's strong sales per square foot enabled it to achieve renewal spreads -- the difference in the average rent for renewed leases going forward compared with what those tenants paid last year -- of 6.3% for the fourth quarter and 6.9% for the full year. On average, tenants are willing to shoulder higher rent going forward to stay in malls with strong and rising sales per square foot.

A rendering of a movie theater and parking lot attached to a mall.

Image source: PREIT.

Meanwhile, CBL's average rent spreads were down by double digits last year. Because it has weaker properties, CBL has been forced to offer rent concessions to keep tenants from leaving.

Still expecting a rebound in 2020

Looking ahead to 2020, the outlook for PREIT is far better. First, it is scheduled to complete the redevelopment of anchor stores at two malls in the fourth quarter of 2019, with two more anchor redevelopments finishing up in the first half of 2020. This will drive an immediate revenue bump as the new tenants begin paying rent while also driving longer-term benefits by revitalizing these malls.

Second, PREIT's Fashion District Philadelphia mall in Center City Philadelphia is scheduled to open in September. The rent contribution from this promising property will be quite small in 2019 but should be sizable in 2020, with further growth likely in 2021.

PREIT still has more work ahead of it as it tries to get on a better footing and drive sustainable FFO growth. But at least it has a solid foundation to build upon. PREIT's top 11 malls -- which account for about two-thirds of its NOI -- achieved 5% comp sales growth in 2018 and averaged sales per square foot of more than $550. These properties are likely to produce growing cash flow in the coming years, powering a turnaround for this underappreciated mall REIT.