When a stock's yield climbs above 10%, it's usually a sign that investors think the company's dividend is unsustainable. However, occasionally, an ultra-high dividend yield highlights that the market severely misunderstands a company.
Pennsylvania Real Estate Investment Trust (NYSE:PEI) looks like a prime example of the latter phenomenon. The stock has lost half of its value since last spring -- and three-quarters of its value since the fall of 2016 -- but investors are misinterpreting a plunge in the REIT's funds from operations (FFO). With FFO likely to return to growth in 2020, PREIT stock could regain much of the ground it has lost.
FFO has declined -- but mostly by design
At the beginning of 2014, PREIT owned about three dozen enclosed malls, ranging from ultra-successful to deeply troubled. Sales per square foot was roughly stagnant at $380.
Since then, PREIT has steadily sold off underperforming properties, while returning others to mortgage lenders. All but one of the 14 worst malls it owned at the end of 2013, as measured by sales per square foot, have exited PREIT's portfolio. This process is not quite over. PREIT classifies three of its malls as non-core properties today; two are likely to be handed over to lenders within the next year or so and one is being sold in pieces.
This activity has dramatically improved the quality of PREIT's portfolio. (The move to quality has proved especially prescient recently, as many of the malls that PREIT dumped were anchored by Sears and/or Bon-Ton, two department store operators that went bankrupt last year.) In 2018, PREIT's core malls grew sales per square foot 3.4% year over year to $510. Furthermore, lease renewals had an average rent 6.9% higher than the expiring leases, indicating that tenants are eager to stay in PREIT's remaining malls, which are vibrant shopping destinations.
However, the other side of the coin is that while PREIT's lower-quality properties were in decline, they were still contributing a substantial amount of revenue and net operating income (NOI). Removing them from the portfolio has caused PREIT's NOI and FFO to decline steadily in recent years. Efforts to proactively replace struggling department stores like Sears with better tenants who can pay higher rents have also negatively affected FFO in the short run.
Indeed, FFO has fallen from $1.96 in 2014 to $1.54 last year. For 2019, PREIT expects FFO to plunge to a range of $1.20 to $1.34, driven by NOI declines for its non-core malls, lower termination fee revenue (which is good in the long run), and a non-cash accounting change.
The tide is about to turn
FFO is one of the most widely followed metrics for REITs, but it excludes key expenses such as routine maintenance capex and tenant improvement allowances. Funds available for distribution (FAD) is an alternative metric that includes these costs. A big reason PREIT stock has plunged over the past year is that FAD probably won't fully cover the REIT's $0.84 dividend in 2019.
However, FFO and FAD are set to rebound beginning next year. First, PREIT's high-potential Fashion District Philadelphia development is scheduled to open this September. Management expects PREIT's 50% share of this property to produce about $15 million of incremental NOI annually, with most of that amount showing up in 2020.
Second, PREIT is nearing the end of its multiyear anchor replacement program. It expects the new tenants to generate more than $12 million of incremental annual NOI, with more than half of that amount coming on line in the fourth quarter of 2019 and the first quarter of 2020.
As a result, the REIT expects FFO and FAD to improve dramatically next year, such that the $0.84 dividend will represent less than 90% of its FAD. Furthermore, some of PREIT's current redevelopment projects won't be fully stabilized until 2021, creating further upside for that year.
Meanwhile, PREIT hopes to reduce its debt by selling outparcels, parking lot space suitable for multifamily developments or hotels, and two undeveloped land parcels. Collectively, these efforts could raise $70 million in the first half of 2019 and $200 million to $300 million in total over the next couple of years, while having little or no impact on PREIT's NOI. This debt reduction would improve PREIT's balance sheet and boost FFO and FAD by reducing interest expense.
Investors have overlooked the opportunity
PREIT stock currently trades for less than five times the company's projected 2019 FFO, while the REIT's dividend yield has inflated to nearly 15%.
Low multiples like this are typically associated with troubled companies with declining earnings. At first glance, PREIT seems to fit right into that bucket. However, by the end of this year, PREIT will have removed most of its lower-quality properties from its portfolio. By and large, what's left are regionally dominant malls with strong foot traffic and rising sales per square foot. That's a platform for future NOI and FFO growth.
To be sure, PREIT does face risks. A near-term economic downturn could cause the recent wave of retail bankruptcies to accelerate and make it harder to find replacement tenants. (So far, this hasn't been a problem; 93% of the space occupied by tenants that went bankrupt in 2017 and 2018 was either retained or released already.) A downturn could also dampen interest in the land parcels that the REIT hopes to sell in 2019 and 2020.
PREIT's rock-bottom valuation more than compensates for these risks. And if FFO does return to growth next year, investors could suddenly see the company in a whole new light, driving the stock price back into double-digit territory. In the meantime, PREIT's 14.6% dividend yield is a great incentive for shareholders to be patient.