How to Invest in Mall REITs

Scads of big-name retailers have gone out of business in the last few years. Don't let that speak for the industry as a whole. In this week's episode of Industry Focus: Consumer Goods, host Dylan Lewis and Motley Fool contributor Luis Sanchez dive into mall REITs. Tune in to learn how the mall REIT business model works, and why it's lower-risk than buying retailers themselves; what the different classes of malls are and why that matters; how the most successful malls are warding off the apocalypse; the most important risks and metrics to keep an eye on; some best-in-class stocks for your watch list; and more.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. A full transcript follows the video.

This video was recorded on Sept. 10, 2019.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today's Tuesday, September 10th. We're talking about a unique take on shopping malls and the retail apocalypse. I'm your host, Dylan Lewis, and I'm joined by Motley Fool contributor Luis Sanchez via Skype. Luis, how's it going, man? 

Luis Sanchez: Hey, Dylan! I'm doing good! I'm enjoying the weather up here in New York. It's starting to cool down. I think people who heard my podcast last week on Zillow probably heard that I'm still in this process of moving. That's been occupying a lot of my free time. 

Lewis: Unfortunately, it takes up way too much time for everybody. There's no easy way to do it.

Sanchez: Yeah, especially in New York City. It's a real nightmare sometimes. But, there's a light at the end of the tunnel. We're getting there.

Lewis: What have you been up to vis à vis stocks? I know you're someone who is always watching the market, writing for us regularly. What's been on your mind lately?

Sanchez: I'm very eagerly watching what's going on in stocks right now. There's a really interesting rotation this week actually where growth and momentum names are selling off while value stocks are gaining. It's actually relevant to what we're going to talk about today. Malls and REITs and the whole retail sector are mostly value stocks. We've actually seen a nice pop this week in the malls and the shopping centers. I'm excited to talk about this. Hopefully our discussion today can shine a light on a really interesting area of the market that could be on the cusp of making a comeback. 

Lewis: Yeah, I was excited when you pitched me this idea. We have spent a lot of time on the show talking about shopping malls and the retail apocalypse. Traditionally, that's been something that we've talked about with the various stores, the various chains, going under. You have a particularly unique look at that space. 

Why don't we talk a little bit first about what's been going on there? Then we'll dive into the mall REIT specific sector. 

Sanchez: Dylan, I'm not sure if you've seen a movie called The Perfect Storm. What basically happens in that movie is that a group of fishermen go out to sea for a commercial fishing trip as a tropical storm is developing. Of course, the fishermen ignore the warnings from the storm when it's small. And then the storm eventually develops into this massive hurricane. And then another massive storm joins forces with the first storm, and together they create this perfect storm which wreaks havoc on the sailors. The obvious analogy that I'm making here is that brick and mortar retailers are the sailors on that ship. There's a couple of mega trends that have joined forces to create this perfect storm against them.

The first mega trend is the rise in e-commerce. E-commerce is the slow-moving train that we've all seen coming now. Back in the year 2000, online retail was just about 1% of the total retail pie. In 2010, that figure was closer to 7%. Here we are in 2019, and now, online retail is about 15% of total retail spending in the U.S. Now, 15% penetration might not sound like too big of a deal; but on the margin, it's really crushing growth rates of physical stores. And, keep in mind that the jump from 7% to 15% happened over the last nine years, which really makes me wonder where we'll be in 10 years. The trend is pretty clear here, although I don't know exactly what the penetration is going to look like out that far. 

The other big mega trend is this overabundance in retail stores in the United States vs. pretty much everywhere else in the world. If you add up all the retail square feet in the United States and divide it by the population, our retail store space per capita is the highest in the world. And it's the highest by a long shot. The U.S. has roughly 24 square feet of retail store space per person. No. 2 is Canada with about 17 square feet. Then there's Australia with about 11 square feet. Outside of those three, the rest of the developed world in Europe and Asia are at less than five square feet per capita, which is one-fifth of ours. I'm not exactly sure how this happened, but it seems like it's a pretty clear sign that the brick and mortar store footprint in America is probably over developed. 

The last important piece of the puzzle here is that many of the retailers and malls have taken out a bunch of debt and were over-levered going into this period of decline. What typically happens, where companies have too much debt, and they have these over-levered balance sheets, during a period where they're seeing revenue and earnings decline, is that the pain they're experiencing is maximized. In this case, it's resulted in quite a few national retail brands going into bankruptcy. 

Lewis: Yeah, one of the big issues that you'll see companies run into is, you have these very large interest payments that you have to maintain in order to stay in good standing with your creditors, but you don't have top line growth to point to, and you have all these other expenses that are associated with your physical locations. That starts to create that death spiral a little bit. I think that the idea of a retail apocalypse maybe hyperbolic, but it's hard not to consider something pretty serious going on here when you look at all of the big-name brands that have started to go that way.

Sanchez: The retail apocalypse has been brought up a few times. At the same time, it's my favorite and least favorite term. It's a pretty entertaining idea, but it's exaggerated. I don't think physical retail is going to zero. And not all these companies are going to go bankrupt. There's actually a couple of encouraging trends that have been developing. The number of retail store bankruptcies each year is on the downtrend. In 2017, we saw more than 20 retailers go bankrupt. In 2018, that number was closer to 17. In 2019, we're about halfway through the year, there's about a dozen notable bankruptcies. 

What has happened is that the weaker retail brands will be first because they were either just poor concepts or had bad balance sheets. A large subset of those companies that went bankrupt were private equity buyouts and just went private with too much debt. Some of those companies are going to come out of bankruptcy as stronger companies. The market's going to adjust. Retailers will probably learn a lesson, and are going to operate more conservatively. Will there be more bankruptcies? Yeah, sure. But, I expect that to moderate in the coming years. I think we're already seeing signs of that starting to happen.

Lewis: We can bring it around now to the shopping malls and the shopping mall REITs in particular. Very often, these chains that we're talking about do not own their physical storefront. They are very often renting. That's where a lot of these shopping mall REITs come in. Before we get specifically in the shopping mall part of REITs, why don't we just give a quick refresher on how REITs work, Luis?

Sanchez: A REIT is a real estate investment trust. There's a quirk in the U.S. tax code where a REIT can pass along its earnings directly to shareholders. That's important because there's this concept in U.S. tax law, something called double taxation, where profits are taxed at the corporate level, and then they're taxed again at the shareholder level when shareholders receive dividends and sell their stock for a gain. But if a company wants to qualify as a REIT, all it needs to do is own enough real estate to derive three-quarters of its earnings from real estate and pass along 90% of its income and dividends. The byproduct of that is, REITs pay really attractive dividends. The dividend yields in the shopping center industry are looking even more attractive today because their stock prices have fallen.

Going more specifically toward what a shopping center mall does. The business model of a shopping center is to buy real estate, develop a mall, and then rent out stores to tenants, which are primarily retailers. Typically what they do is, they will sign multi-year leases with their tenants. Those can be as long as five to 10 years, or even longer in some cases. What the leases do is, they provide a contractual guaranteed payment of rent with annual rent increases usually negotiated around 2%. On top of that, mall REITs will typically collect a small portion of sales. That ends up usually being a smaller portion of overall revenue for a mall. Most of their earnings come from the rent they collect. 

In theory, a shopping center actually should be a pretty good business. They have contractually guaranteed revenue for years out and with growth locked in. They also have some pretty nice tax advantages. 

Lewis: I'm reminded a little bit, though, of the Mike Tyson quote, "Everyone has a plan until they get punched in the face." The business that we're looking at with these mall center REITs, wonderful long-term contracts with predictable cash flows coming in, assuming everything goes well. We talked about the perfect storm coming for retail, though, and the fact that a lot of these renters may not be in a position to honor some of those long-term contracts. Obviously, there are some quirks and some downsides to this business model. 

Why don't we talk a little bit about some of the different renters that come into the mall REIT space and how they're classified? 

Sanchez: There's definitely a hierarchy when it comes to malls. At a high level, it's kind of a rule of three. There's class A malls, class B malls, class C malls, and then there's everything else. Within those rigid groups, there's still a spectrum of quality. For example, there's class A malls, but there's also class A++ malls. 

Just to start at the top, class A malls are considered to be the best; the highest quality, at least. They're also known as luxury malls. These malls are defined by having more upscale brands and locating in affluent neighborhoods. Within a five or 10 mile radius of a class A mall, you'll typically see an average household income approaching $90,000 or higher. That affluence is directly reflected in really high sales per square foot at these luxury malls. To classify as a class A mall, you typically need to have sales per square foot of around $500 or more. Malls that can achieve those really high sales productivity metrics are going to be able to charge higher rents to retailers. The counter to that is, they probably paid more to acquire and develop their malls because the real estate's more valuable.

Some of the companies that have a lot of exposure to class A malls would include companies like Taubman Centers, Macerich, Brookfield Property REIT, and, to a lesser extent, Simon Property Group. I'd say that about Simon because it also has exposure to outlet malls, which are a bit of a different animal. 

Lewis: The TLDR on the class A malls, Luis, is this idea that you have luxury brands in there, they are at the most desirable locations, they have really supportive income demographics around them. You're looking at something that is truly just best in class.

Sanchez: Right. They're going to have luxury brands. They're going to have really high sales per square foot. They're probably going to have nicer fixtures. They might even have nicer restaurant options. They tend to be more of a retail destination than just a place purely to go and do your shopping. 

Lewis: What about the class B malls?

Sanchez: Class B malls are probably middle of the pack. If you live in a mid-sized city, these might be the No. 2 mall or No. 3 mall in town. If you live in a smaller city, they might just be the only mall in town. They probably won't have a Louis Vuitton store or a Porsche gallery like a luxury mall, but they're going to have all the other typical trappings of a mall, including department stores like Macy's and retail stores like Foot Locker. A class B mall will typically generate between $300 and $500 in sales per square foot. Pennsylvania REIT is a good example of a Class B mall operator. 

Lewis: Listeners might be ready to expect our class C and class D discussion. We're going in alphabetical order here. I feel like the Sesame Street model. What's the deal with them?

Sanchez: Class C mall, we really start getting into lower-quality territory. They're often lumped in with an even lower class called class D, which, as you could expect, is even less attractive. Typically, what you see here is, these are the malls that are located on the side of town with less favorable demographics, or malls that are found in rural areas, where population density and household income are going to be lower. Class C malls will actually look a lot like a class B mall in that they have a lot of the same tenants. The difference is that they tend to be smaller, or they'll just have a lot more vacancies. What we're looking for in terms of sales per square foot is in a range below $300. Some companies that are associated with managing lower-quality malls would be CBL and Associates and Washington Prime Group. Keep in mind, these companies have a broader portfolio. They own class A malls, they also own class B malls. But they also own a lot of class C malls. And when you look at an average of where their portfolio sits, it's going to be in that class C or lower class B territory. 

Lewis: So, when you look at what's going on with some of the shifts we're seeing in retail, who has been bitten by those changes? Is it something that's felt a little bit more in the luxury side? Or is it something that's further down with class B, C, D?

Sanchez: At the end of the day, a mall is really only going to be as healthy as its tenants, which are retailers. The retailers are only going to be as healthy as their shoppers. What we've seen is that, given that framework, the class C malls and class D malls have been hit the hardest. They just have inferior demographics, which translates into less productive stores, measured by sales per square foot. You have to think about yourself as a retailer. If you need to close stores to reduce your overhead, you're probably going to start with your least productive stores. But when stores start closing, this actually creates a negative feedback loop at those lower-quality malls. Once a mall starts getting some vacancies, less people start visiting the mall because there's less options. And once there's less people at the mall, and less people spending money, the malls become less productive, which causes even more stores to close. You could see this playing out at some of those class C mall stocks I mentioned. CBL Associates and Washington Prime Group, they've seen their vacancy rates go up, and they've seen their sales per retail square foot start to trend lower. That's also reflected in their stocks getting hit a lot harder than the rest of the group. 

Lewis: It would stand to reason that a lot of the class B malls are probably also struggling a little bit.

Sanchez: Class B malls are doing better, but they're not doing great. The reason they're not doing great is because they basically share the same struggling tenants as the class C malls. The upside to the class B malls, though, is that they've had an easier time replacing the vacancies than the class C malls. But the really big issue with both class C and class B malls has been department stores closing. We've all heard of stores like Sears and Bon-Ton going bankrupt, and other stores like Macy's and J.C. Penney closing stores. But the problem for a mall is that when a department store closes at its location, these aren't normal stores; these are what's called anchor stores, and they occupy a much larger part of real estate that are usually customized for the store. Mall operators know that department stores aren't coming back anytime soon. There's just not really a lot of department stores opening stores right now. So, what they've had to do is just be a little bit more creative. They've had to redevelop those spaces into something else. Maybe a movie theater, or something for smaller stores. That redevelopment costs money, obviously. 

Lewis: Yeah, there's an upfront cost there. I am a believer in the idea that bringing things that are not strictly retail to malls could lead to a little bit of a revival. The stuff that we tend to see going into those spaces -- you mentioned movie theaters, but I think gyms also fall into that category; we see fitness centers there as well. The job of an anchor is to bring people to the mall. The idea is, once they're there, they'll go maybe get a couple of other things in addition to the one or two items that they need from Macy's. Maybe they'll get a snack, maybe they'll wind up going and getting some goods somewhere else. Well, I think about what those types of places might be able to do -- the movie centers and the fitness centers. Those are the kinds of places that people will often come to several times a month, or several times a week in the case of a gym or fitness center. So, there is the possibility that after a lot of these malls have gone through and upgraded so that they have something there that is a little bit more attractive to consumers, it could lead to some really great tack-on benefits for the other residents there. The problem is, you have to take care of that spend upfront to make it happen, Luis. 

Sanchez: Yeah. Hopefully, people are going to their gyms weekly, or multiple times a month.

Lewis: [laughs] In the case of class A malls, it seems to me like they have not felt the pinch nearly as much as the B, C, and D malls. 

Sanchez: Yeah. Class A malls have done a lot better than the rest of the bunch. A lot of that is because they simply don't have exposure to the same degree to a Sears or a J. C. Penney in the way that a class B mall would. They still have anchors, but they tend to be higher-end anchors. And sometimes those anchors have issues, too. 

The other thing is that, because Class A malls are so much more productive and have better foot traffic, if you're a retailer, a class A mall location is probably going to be a lot lower on the priority list of the stores you want to close. There's also this whole other separate class of brands that pretty much exclusively operate stores at class A malls. Obviously that's going to be your luxury brands like Louis Vuitton and Hermès. They wouldn't be caught dead in a class C mall, and it wouldn't really make sense for the type of customers that go into those malls, either. 

But then, there's this whole other subset of digitally native brands. This is a newer trend. This newer generation of consumer brands that maybe started as online-only are now just starting to open a select number of stores, they're pretty much exclusively opening stores at class A malls to build their brand. A few examples of these brands could include Warby Parker, or Bonobos, and even somewhat ironically, Amazon has been opening stores. 

Lewis: Yeah, it's funny, you go through the disruption model; you say, "We're going to cut out the middlemen. We're going to avoid all of these real estate costs. We're going to be able to give you lower prices." That was certainly the promise that we got with Warby Parker. Very similar promise with some of the others, Dollar Shave Club and Harry's and things like that. And then they realize, it's actually kind of helpful to have a retail presence, because when you have that, you essentially have a showroom or a billboard for your products. People can come in, put their hands on them, and check them out. And those consumer touch points can prove quite valuable. 

Sanchez: Absolutely.

Lewis: OK, we touched on the idea of retail space being repurposed. That's happening in different ways for different levels of malls. We mentioned the movie theaters for some of the class B and C malls. But then you also have this other redevelopment that's happening primarily more in urban neighborhoods.

Sanchez: There's a lot of interesting things going on as far as mall redevelopment goes. As it relates to the class B malls, they're really still going to be more focused around redeveloping anchor store space, as we just mentioned. They've actually been turning a lot of former anchors into a variety of things, including theaters, gyms, and sometimes subdividing anchor space into smaller stores. If you think about it, a fitness center, a grocery store, and a restaurant are good bets because those things aren't going to be disrupted by online retail anytime soon. But at the higher end, there's this other trend of redevelopment called densification. Densification is essentially turning a mall into more than just retail, making them mixed use real estate with hotels, offices, and even multifamily residential developments. This is occurring mostly at the A malls primarily because their locations are in dense, urban environments where there might be more demand for other types of real estate. And what some of these mall operators are discovering is that the highest-value use of their real estate might not be retail, it might be another kind of real estate. Some examples that I've noticed from different densification projects would be, Simon Property recently partnered with Marriott to build an eight-story hotel at its Sawgrass Mills mall in Miami. Macerich has actually turned a Los Angeles mall into a Google corporate campus, and they've retained a small portion of the mall to continue being a retail store outlet. And Macerich has also been adding co-working spaces to a lot of its malls across the country. 

It's still pretty early days for densification projects, so it's tough to really judge how much value is going to accrue to the mall operators. But at a high level, I think these are probably a good idea. A mall operator can diversify their revenue. They can be more than just a retail operator. And as we know, retail hasn't been the most stable category lately. And then, there's also this idea that putting an office or residential development at a mall or right next to a mall, it's probably going to increase foot traffic at the mall. It might actually improve the value of the retail space there. 

Lewis: So there's kind of a virtuous cycle playing out, it seems, there. I like the idea of these real estate trusts, these real estate developers, deciding to be a little bit more nimble and opportunistic when they see the way that the winds seem to be blowing with retail. I will say, if you are a shareholder of any of these companies, and you see that you don't have primarily retail tenants, you have either co-working or more residential tenants coming in, then the metrics you're going to be interested in seeing on those tenants are going to be a little different. Just make sure that you keep that in mind. 

With that, Luis, taking a look at everything we've talked about today, I'm generally someone who stays away from retail stocks. We're focusing on mall REITs here. Is there anything that you see as particularly interesting from an investing perspective? 

Sanchez: Going back to that earlier point, not all these malls are created equal. I think there's going to be some winners here. There's also going to be losers. The bigger picture point is that the whole sector has significantly sold off in unison from the highs it achieved three or four years ago. Even the luxury large-cap malls like Simon are trading significantly off. Considering that, it's probably a good time to be a buyer, because there's all these negative headlines, and a lot of people are just staying away from the entire group. If you believe in that whole idea of being greedy when others are fearful, this is a good example of that. 

However, I would probably still stay away from the lower-quality class C and D malls, and probably also the class B malls. If you look at the CBL and Associates or the Washington Prime stocks, you'll see these eye-popping 20%-plus dividend yields. I wouldn't trust those super high dividends. Those companies are still struggling. They're probably going to cut their dividends. They might not even be around in five years in the same way that we know them now. 

Where I'm really interested and where I'm looking is really at that luxury mall operator segment. Those stocks have sold off quite a bit, too. They're showing dividend yields as high as 7% to 9%, so, still pretty attractive from a dividend perspective. I strongly believe that all the luxury players are probably going to survive this retail apocalypse. They might actually come out the other end a bit stronger. If you think about weaker malls closing, there's less retail space to go around. Supply and demand. They might have more pricing power against their tenants. The reality really is that luxury malls have held up really well. They've continued to maintain high occupancy. They've actually continued to raise their tenant rents through this whole period. And most of these guys have continued to raise their dividends as well, and have pretty decent balance sheets. But really important is just the idea that their real estate is really valuable, even if they convert parts of their malls into other things like offices or hotels. The way I think about it is that these luxury mall operators have a lot of optionality to what they can do with their real estate. 

The stocks that I'm really focused on that meet this description would be Simon Property Group, Mesa Macerich, Taubman Centers, and Brookfield Property REIT.

Lewis: That sounds like a solid watch list for people that are interested in the space. I think it's worth bolding and underlining the thought here that high dividend yields are not necessarily here to stay. Whether you're talking about a REIT, an MLP, or just your standard stock, a yield may look good, but that's a backwards-looking metric. That's based on what they've been paying over the last 12 months and the current share price. It is not necessarily indicative of what they're going to be paying going forward. The best way to get a sense of that is to understand the cash flows that are coming into the business and their ability to sustain that dividend. Always, always, always make sure that you are paying attention to that. 

Luis, it sounds like the wrap-up here is, if you're interested in the mall REITs, stick to the quality names in this beat-up sector. They're going to be the most resilient. They're the ones with the most valuable real estate. Is there anything else that you're interested in adding before we wrap up today's show?

Sanchez: Something that I've been thinking about is, just within this whole retail sector, you have the retailers on one side, and then you have the malls on the other side. And I think the retailers tend to get the most attention because they have really good brand names, and you always hear about them. But the malls are actually a really great way to get exposure to the sector, but maybe to do it in a less risky way. If you think about it, investing in a mall, you're getting this really diversified exposure to dozens of different retailers that are paying rent to the mall. But you do have some protections in that you have that recurring revenue, and you have that optionality of the real estate, but there's also that really nice tax loophole for dividends, which can be really lucrative to investors over time. 

Lewis: Yeah. I think anyone that's held some high-yield dividend stocks in an account that wasn't tax advantaged knows the bite where, not only is the company being taxed, you're being taxed. It's just rough all around. To only go through one layer of taxation is far favorable. 

I think we'll wrap things up there, Luis. Thanks for hopping on today!

Sanchez: Great! Thank you, Dylan! It's my pleasure!

Lewis: Alright, listeners. If you notice anything interesting happening at your local mall, if you see any cool concepts hopping in outside of the fitness and theater space, we'd love to hear about them. It's always cool to hear from people on the ground and what they're seeing out there. It's super relevant to what we're talking about on today's show. You can shoot us an email over at [email protected], or you can tweet us @MFIndustryFocus with that info. Of course, you can catch us on YouTube as well for some more content. We have podcast videos over there. We have additional video content over there. If you don't subscribe to the podcast already, check us out over on Spotify or Apple podcasts, wherever you get your podcasts. Make sure you subscribe. 

As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for all his work behind the glass! For Luis Sanchez, I'm Dylan Lewis. Thanks for listening and Fool on!