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Can “Densification” Help Save Mall REITs?

By Reuben Gregg Brewer - Aug 21, 2019 at 7:45PM

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A changing retail landscape calls for new strategies to help real estate investment trusts maintain growth.

The internet has contributed to the closing of department stores operated by Sears, Kmart, and Bon-Ton. It has ripped apart niche retailers like Charlotte Russe and Payless ShoeSource. And the damage from the so-called retail apocalypse isn't over, with companies like Gap and Ascena Group closing stores and even entire brand concepts. This is a huge problem for mall real estate investment trusts (REITs) like Simon Property Group (SPG -3.00%).

But Simon and its peers have a plan: densification. What is this? And will it help?

The pain is real

The notion of the retail apocalypse is being overhyped by the media because it is a compelling story. That, however, doesn't mean it isn't a real issue. Store closures are a clear problem for retail landlords. It's one of the main reasons the entire enclosed-mall REIT sector is suffering today, with even industry giant Simon -- generally considered to be one of the best-run mall REITs around -- down by around a third from its 2016 highs.

Hands holding blocks that spell the words risk and reward

Image source: Getty Images.

A big piece of the problem for these landlords, though, is timing. They are working to fill empty space, but that doesn't happen overnight. They have to get the old tenant out, find a new tenant, and fix up the space so the new retailer can move in. That sounds easy enough, but getting it all done is a slow process. That's doubly true today, since online shopping is shifting consumer buying habits, and a lot of retailers are moving cautiously.

That hasn't stopped mall owners, it has just forced them to think outside the old box. That's why the term "densification" has been getting tossed around a lot. It's a fancy word for adding nonretail tenants to the mix. Today that includes old favorites like fitness centers and restaurants, which have an experiential business. But it's increasingly including things like office space, apartments, and even medical service providers. Those last three are not the normal clients that a mall REIT would be turning to as a means to fill vacant space.

Interesting, but not enough

Densification is a positive trend for mall REITs, there's no question about it. They are adjusting to a changing market and keeping their assets relevant. However, there's an old mantra in real estate that is still applicable today: location, location, location.

No amount of densification of a mall will save it if it's in a poor location. In fact, densification may not even be possible if the property is poorly located. That basically means a mall in a secondary or tertiary market with a weak or shrinking population and relatively low average income levels. At one point, malls were put up in these markets, but with online shopping gaining ground, these areas often can't support a large enclosed mall anymore.

Mall REITs aren't ignorant of this fact, with companies like Simon, Taubman (TCO), and Macerich (MAC -3.82%) spinning off or selling weaker assets. These companies are in a stronger position to fill malls with new tenants as older ones fall away. But not all mall REITs are created equal, and companies like Washington Prime Group (WPG) and CBL (CBL) are saddled with lower-quality assets. These companies will have a much more difficult time attracting new tenants. Note that Washington Prime's dividend has been stuck in neutral since 2015, and CBL recently eliminated its dividend (a material statement, given that REITs are designed to pass income through to shareholders). Simon, Taubman, and Macerich have each increased their dividend over that same span.

SPG Dividend Per Share (Quarterly) Chart

SPG Dividend Per Share (Quarterly) data by YCharts.

One factor to look at that will help you figure out how well-positioned a mall REIT is (or isn't) is sales per square foot. Washington Prime and CBL have sales per square foot in the high $300 space compared to the mid-$600 level for Simon, nearly $750 for Macerich, and around $900 for Taubman. It's simple logic: Retailers want to be in malls that generate greater sales, ones that are well situated, and ones that attract shoppers.

Densification is great, and it's a fun buzzword, but it doesn't change the big picture for mall REITs: A good location is vital. And only so many malls can be in good locations, with some industry watchers estimating that only around 30% of the roughly 1,000 malls in the United States fall into the top-quality "A" category. The rest of the malls in the country are likely to have a notably harder time filling vacant space. Those in the bottom "C" and "D" tiers (about 35% of the group) could be at serious risk of closing their doors forever.

Stick with the best

If you are attracted to contrarian plays, then mall REITs are probably right up your alley at the moment. But there are real issues facing the sector. While every company tends to focus on its best talking points, don't get lured into a mall REIT saddled with weak malls in bad locations. Look past buzzwords like densification and take a deep dive into the strength of the underlying property portfolio. In this case, it pays to be picky and to stick with the industry's best-positioned players, like Simon.

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Stocks Mentioned

Simon Property Group, Inc. Stock Quote
Simon Property Group, Inc.
SPG
$110.26 (-3.00%) $-3.41
The Macerich Company Stock Quote
The Macerich Company
MAC
$11.82 (-3.82%) $0.47
Taubman Centers, Inc. Stock Quote
Taubman Centers, Inc.
TCO
CBL & Associates Properties, Inc Stock Quote
CBL & Associates Properties, Inc
CBL
Washington Prime Group Inc. Stock Quote
Washington Prime Group Inc.
WPG

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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