Like many of its fellow mid-tier mall owners, Washington Prime Group (WPG) has been hit hard by falling mall traffic and anchor store closures in recent years. However, management has been extremely vocal about its plans to get funds from operations (FFO) growing again.

Last week, Washington Prime reported unimpressive fourth-quarter and full-year 2018 results and offered a gloomy forecast for 2019. And while the REIT provided a bullish outlook for 2020, investors should wait for clear confirmation that its strategy is working before risking any money on Washington Prime -- notwithstanding its 17% dividend yield.

More of the same

Washington Prime's adjusted FFO peaked in 2015 at $1.91 per share, before dropping to $1.78 in 2016 and $1.63 in 2017. The company's recent earnings report revealed that adjusted FFO fell to $0.38 in the fourth quarter of 2018, compared to $0.44 in the year-ago period. That put full-year adjusted FFO at $1.51.

Several factors drove the decline in FFO last year. First, Washington Prime has been slowly shedding lower-performing malls in recent years, following the example set by Pennsylvania REIT (PEI) and others. Second, interest expense increased year over year. Third, the company sold joint venture interests in several properties to O'Connor Capital Partners in mid-2017, giving up a 49% share of the income from those assets. Fourth, the liquidation of Bon-Ton and a huge number of Sears store closures depressed revenue.

Turning to other metrics, sales per square foot for Washington Prime's "Tier One" malls -- which account for the bulk of its earnings -- inched up 1.5% to $399 last year. The occupancy rate also rose modestly to 93.9%, up from 93.5% at the end of 2017. But, unfortunately, the REIT has had to reduce rents to keep its malls full. On average, leases signed last year called for rent 8.8% lower than in the leases they replaced.

An aerial view of Polaris Fashion Place in Columbus, Ohio

Image source: Washington Prime Group.

As a result, it's not surprising that Washington Prime has a gloomy 2019 forecast. Management expects net operating income (NOI) to fall 1% to 3%, due to lost rent from closed anchor stores and "cotenancy" clauses that often give other mall tenants a rent break when an anchor space sits empty.

Moreover, FFO is on track to plunge about 20%, to a range of $1.16 to $1.24. Aside from the factors pressuring NOI, a recent credit rating downgrade will add to interest expense. New accounting rules will depress FFO this year, too, similar to what PREIT recently projected.

Predicting a turnaround

In recent years, Washington Prime's management has laid out a sensible strategy of replacing department stores with non-retail uses such as dining, fitness, and entertainment. At some malls, mixed-use components like apartments, offices, and hotels could be added, too.

Several months ago, the REIT highlighted 28 current and former department store locations that it plans to redevelop over the next three to five years, at a total cost of $300 million to $350 million. Twenty-one of those stores will be vacant by the end of the first quarter, but Washington Prime has lined up new tenants or larger mixed-use projects for seven of them already.

That gave management the confidence to predict that comparable NOI for Washington Prime's tier one malls and open-air properties will rise 2% to 3% year over year in 2020. With the stock trading for just five times FFO, a return to growth could drive huge gains for shareholders -- at least if it's sustainable.

Check out the latest Washington Prime earnings call transcript.

Investors can't count on Washington Prime

The good news for shareholders is that Washington Prime gets 42% of its core NOI from outlet malls and open-air centers that do not have any department store anchors. These properties are likely to deliver relatively steady growth in the coming years.

Unfortunately, the other 58% of NOI comes from a fairly mediocre collection of malls. Even the tier one malls have average sales per square foot of $399, compared to $510 for PREIT's core portfolio. Lower store productivity makes it harder for tenants to justify the high rents that malls charge. It also indicates lower mall traffic, an issue that tends to be self-reinforcing. PREIT's sales per square foot grew more than twice as fast as Washington Prime's last year.

Additionally, Washington Prime is several years from fully addressing the recent Sears and Bon-Ton store closures in its portfolio. That doesn't leave it much flexibility to deal with the risk of a wave of store closures from the likes of J.C. Penney in the next few years. By contrast, PREIT has signed leases to replace all of the currently vacant department store locations in its portfolio by mid-2020. And with a better collection of malls, PREIT will have an easier time replacing both department stores and in-line tenants in the future, relative to Washington Prime.

If all the major department store chains stay in business and there's no recession in the next few years, Washington Prime could deliver excellent returns for investors. However, in a downside scenario, the REIT could see NOI tumble, making it difficult or impossible to refinance maturing debt. As a result, investors should probably steer clear of this risky high-yield REIT.