Before COVID-19 there was the so-called "retail apocalypse" that was destroying sales at brick and mortar stores. This has been a one-two punch for landlords who own retail properties, with enclosed malls taking a particularly big hit, and a number of mall-owning real estate investment trusts (REITs) have been forced to trim their dividends.
The most recent REIT slicing its dividend was Washington Prime Group (WPG). But there's a big difference between this mall owner and former parent Simon Property Group (SPG -0.06%), which suggests that Simon's dividend is still on solid ground. Digging into the numbers will help you understand why some REITs cut dividends and others do not.
A tale of two REITs
To address the elephant in the room right away, mall-focused real estate investment trust Simon Property Group did cut its dividend during the deep 2007-to-2009 recession. The company saw the downturn as an exogenous shock and chose to cut the dividend as a form of insurance against a worst-case scenario (which at the time included the fear of a complete collapse of the global economic system). Within a few years the dividend had been increased back to its previous levels, and at this point it is well more than double what it was before the temporary cut. It is entirely possible that Simon will view COVID-19 in a similar fashion.
However, Washington Prime didn't cut its dividend to inoculate itself against the risk posed by the coronavirus. Washington Prime chose to cut its dividend for two very important reasons. First, its portfolio of assets isn't all that great. Second, and perhaps more important, it needed to preserve cash in the face of adversity. A REIT can limp along with one or the other of these two problems for a long time, but put the two together, and the outcome is usually pretty bad for dividend investors.
Image source: Getty Images
Washington Prime's problems basically started from the day it was created as a spinoff from Simon Property Group. Simon took a bunch of the less desirable assets in its portfolio (accumulated via a series of opportunistic acquisitions) and created a new company. That's not to suggest that Washington Prime is a bad company, only that Simon kept the crown jewels.
The spinoff happened in 2014, before online sales started to really eat away at physical retail. With online retail taking off, the quality of a retail REIT's assets has become increasingly important. The retail apocalypse is a very real thing, even if the story is likely being overhyped. Simply put, it is the weakest properties that are getting hit hardest. Washington Prime effectively started life at a disadvantage on this score. Simon, with some of the best located malls in the country, is still seeing relatively strong performance from its portfolio. For example, despite the retail apocalypse, occupancy remained robust in 2019, rents were still growing, and sales per square foot at its malls increased.
The other half of the story
A good portfolio of properties, however, isn't enough. There are some mall REITs out there with great assets that are still facing big financial problems. Notably, Simon has opportunistically agreed to buy peer Taubman Centers (TCO) for $3.6 billion. Taubman is a much smaller REIT with a very impressive collection of high-end malls. It will be run as a separate entity within Simon, and be operated by the same management team that's currently in place, which will retain its 20% stake in the group. At the time the agreement was announced, it was emphasized that Taubman was gaining access to Simon's cash -- the implication being that Taubman didn't have the financial strength to keep investing in its portfolio while also continuing to support its shareholder dividends.
Washington Prime, with a lesser portfolio of assets, wasn't going to find a knight in shining armor to save it, so it had to resort to a dividend cut. But there are similarities between Taubman and Washington Prime that deserve attention. For example, Taubman's financial debt to equity ratio is around 2.1 times, and it covers its interest costs by 0.8 times. Washington Prime's balance sheet is in even worse shape, with a financial debt to equity ratio of nearly 3.1 times and interest coverage of 0.6 times. The gravity of these numbers becomes more clear when you compare them to Simon, where financial debt to equity is just 0.5 times and interest coverage is 4.1 times. Clearly, Simon stands out for its financial strength, while the other two were struggling to cope with bad situations.
SPG Financial Debt to Equity (Quarterly) data by YCharts
That's notable because malls require a lot of attention. A mall needs more than being located in a wealthy and densely populated region -- it also needs to be updated and maintained over time so it remains fresh and attractive for tenants and consumers. That means spending money. If a mall REIT doesn't have access to the cash it needs to do that, then its properties risk falling out of favor. That starts a downward spiral that is hard to pull out of -- which is why Simon's financial strength, coupled with its well-located portfolio, sets it apart from peers in the mall REIT sector.
Best in breed
To be fair, Simon could decide that COVID-19 is a large enough wild card that it needs to cut its dividend like it did during the Great Recession. But it won't be something forced on the REIT because of a weak portfolio or an overly stressed balance sheet, which are basically the reasons why Washington Prime was forced to trim its payout. In fact, even after buying competitor Taubman, Simon will remain one of the strongest companies in the mall REIT sector.
The big takeaway here is that dividend investors need to look past the business when researching a company. The balance sheet is at least equally important. A financially weak company with a good business can be forced to do things it doesn't really want to (like Taubman selling itself to Simon). But a financially weak company with a meh business is almost always a bigger risk than is worth taking -- like Washington Prime or CBL, a mall REIT that has now completely eliminated its dividend. When it comes to dividends, it pays to stick with the best -- and if you are looking to opportunistically invest in mall REITs today, that means Simon.
