If you extend the hyperbole of the so-called retail apocalypse to its logical conclusion, every physical store in the world will eventually be shut down. Does that sound reasonable? Probably not, given that humans are inherently social animals. That's why investors need to step back and question the story here. What's really going on with the American mall is a little deeper than what the histrionics around online shopping suggest.
It's a real phenomenon
The first thing to accept in the retail space is that the consumer shift toward online shopping is a very real trend. It has been particularly hard for enclosed malls and the stores that occupy these often massive facilities because apparel sales have been especially susceptible to the shift toward online buying. The smaller specialty retailers and anchor tenants that fill enclosed malls lean heavily toward apparel. It's not surprising that these retailers have been hit hard, with some once-iconic names facing material headwinds or even falling into bankruptcy.
That's bad news for the real estate investment trusts (REITs) that own enclosed malls, including Simon Property Group (NYSE:SPG), Taubman Centers (NYSE:TCO), Macerich (NYSE:MAC), Pennsylvania REIT, Washington Prime, and CBL Properties (NYSE:CBL). However, there are two important facts that separate the good from the bad here.
The first is the quality of the malls each of these companies own. Malls fall along a spectrum, with the highest-quality malls located in wealthy and densely populated regions. Lower-quality malls tend to be located in more remote areas with less wealth. It doesn't take a rocket scientist to figure out that you'd rather own a mall around a lot of rich people. On that score, Simon, Taubman, and Macerich stand above the pack, with some of the best-located malls in the country.
The malls these REITs own are well-positioned to weather the retail apocalypse because retailers, increasingly including once-online-only sellers, will want to be in the malls with the best locations. So unless you believe that inherently social human beings are going to stop being social, then location, location, location is still the name of the game for mall REITs. But that's not the only thing that's important.
A "balanced" approach
Even well-located malls need to keep their facilities modern and clean. That requires spending money. But to spend money you need to have money (or at least adequate access to it). And that's where the real problems start to show up in the mall REIT space.
It's important to note that the balance sheet issue is hitting the REITs with lower-quality assets first. For example, CBL properties has a relatively low-quality portfolio, with sales per square foot near the bottom of its peer group. It wouldn't have much financial wiggle room even if times were good, however, because its leverage has long been toward the high end in the mall REIT space. When you put lesser malls together with too much leverage, you end up with a struggling company that can't afford to properly maintain its assets. CBL has eliminated its dividend at this point so it can free up cash to spend on its facilities in an attempt to turn its business around. Washington Prime Group recently cut its dividend too, noting that it is also highly leveraged relative to peers. The 35% dividend yield at Penn REIT, meanwhile, suggests investors are expecting a cut at this REIT as well.
But here's the interesting thing: Macerich has one of the best mall portfolios, but its 14% yield suggests that investors are worried about its ability to weather the changing retail landscape while maintaining its dividend. The problem is, again, leverage. While nowhere near as high as at peers like CBL and Penn REIT, Macerich's financial debt to equity ratio is still kind of high at around 1.3 times. Compare that to Simon, which has a ratio of just 0.5 times. With notably less leverage, Simon has much more leeway to keep spending on its properties.
In fact, Simon's recent agreement to acquire Taubman Centers highlights this problem. The all-cash deal will result in the Taubman insiders (largely the Taubman family) continuing to own 20% of what will be a separately managed mall portfolio. The big talking point when the deal was announced was that Taubman would now have access to the capital it needed to keep its malls fresh. The Taubman family basically figured out a way to maintain its economic interest in the mall portfolio it had built while getting access to the Simon checkbook. To be fair, Taubman's stock roughly doubled in February driven by the Simon deal, so shareholders aren't exactly getting a raw deal. But this highlights a very big issue in the mall REIT space today: You have to spend money to make money. And, of course, access to capital is a key differentiator.
On that score, Simon is the standout winner. Even after the Taubman deal, it will still have a strong balance sheet and liquidity of around $3.5 billion. After Simon would come Tanger Factory Outlet Center (NYSE:SKT), which doesn't own enclosed malls, but still gets lumped in with these REITs because there's no other place to put it. The factory outlet center owner, and much smaller REIT, has the next best balance sheet in the industry, with a largely unused $600 million line of credit available. If you are a contrarian investor looking to pick up retail REITs on the cheap, Simon and Tanger are good places to start your search.
There will be more pain
There's no way to predict what will happen in the future, all you can do is make educated guesses. Here are a few attempts at that.
First, based on human history, it is unlikely that malls will go away. Poorly located malls are the ones that face extinction. Second, the mall owners most likely to survive this difficult time are those with the strongest financial condition going into it. On that score, Simon and Tanger are the leading names. This retail transition is far from over, of course, but if you're looking to buy a mall owner today, you would be better off sticking to financially strong names with good assets -- noting that it is debt levels that are causing the real problems in the industry.