Shares of Taubman Centers (TCO) doubled in February, after top mall REIT Simon Property Group (SPG -2.00%) agreed to buy all of Taubman's publicly traded stock at a big premium. Taubman shares traded for around $26 at the end of January, but Simon offered to pay $52.50 per share for an 80% stake in the upscale mall owner. (The founding Taubman family would retain the other 20%.)

Unfortunately, the COVID-19 pandemic upended the retail industry soon thereafter. Top-tier malls have been particularly hard hit, as successful malls typically attract big crowds, making social distancing impractical.

As a result, Simon Property Group now wants to back out of its deal to buy Taubman. On Wednesday, the REIT announced that it was terminating the agreement and requesting a court declaration that Taubman had suffered a material adverse event that would permit such a termination. As a result, Taubman stock plunged as much as 41% on Wednesday -- bottoming out at $26.70 -- before recovering to end the day down 20% at $36.17.

TCO Chart

Data source: YCharts.

Let's see what this development means for investors in these two mall REITs.

The deal price doesn't make sense anymore

It's not very surprising that Simon wants to back out of its agreement to acquire Taubman. When the two companies announced the buyout deal on Feb. 10, they said that it reflected a 6.2% cap rate based on projections for Taubman's net operating income.

At the time, a 6.2% cap rate might have seemed reasonable to both sides. Taubman owns some of the most productive malls in the U.S.: sales per square foot reached $972 for its domestic properties last year. Just a few years ago, top-tier malls were often valued at cap rates of 4% or 5%. (Lower cap rates imply higher valuations.) More recently, investors have demanded higher cap rates to compensate for the risk posed by a rising tide of retail bankruptcies. As of February, a 6.2% cap rate was cheap enough -- given the quality of Taubman's portfolio -- to be attractive to Simon, while still representing a substantial premium over Taubman's share price.

However, the COVID-19 pandemic forced most malls to close in March. While many have reopened, traffic is likely to remain weak for quite some time. Many mall tenants are playing hardball with landlords like Simon and Taubman, arguing for rent reductions in light of the abrupt drop in mall traffic. Others simply failed to pay their rent in April and May. Some will go bankrupt due to the impact of the pandemic. The likely result is falling occupancy and a decline in average rents: even for high-quality malls.

That means the baseline for net operating income has declined. Thus, Simon Property Group's offer price effectively values Taubman at an even lower (i.e. more generous) cap rate. Yet Taubman's properties could require substantial investment to get back to their pre-pandemic level of performance, which implies that the appropriate cap rate is actually higher than it was a few months ago. Simon itself currently trades at an implied cap rate of about 9.5% based on 2019 NOI.

The interior of Taubman's The Mall at Millenia

Image source: Taubman Centers.

Bring in the lawyers

The potential problem for Simon is that it doesn't necessarily have the right to terminate the Taubman deal. The language defining a "material adverse effect" in the acquisition documents specifically excludes pandemics (and their consequences) from giving Simon the right to terminate the agreement. There are only limited exceptions to this broad exclusion.

In its Wednesday press release, Simon indicated that two of those exceptions may apply. First, it said that the pandemic "has had a uniquely material and disproportionate effect on Taubman compared with other participants in the retail real estate industry." That would constitute grounds for terminating the deal. Second, Simon argues that Taubman breached its obligations by failing to operate its business effectively, "including by not making essential cuts in operating expenses and capital expenditures."

I'm not a lawyer, but these arguments sound tenuous at best. While Taubman has been hit harder than the average company in the "retail real estate industry", it's no worse off than the average mall REIT. If Taubman's industry is defined as mall real estate rather than retail real estate more broadly, this justification falls apart. (The acquisition agreement does not specify what industry Taubman participates in.)

As for the second claim, Taubman may argue that maintaining capex is necessary to preserve the value of its properties. Operating expense reductions (or the lack thereof) wouldn't have been all that significant, and it would always be possible to implement cost cuts going forward. It's far from clear that Taubman's failure to aggressively cut costs represents a material breach of its responsibilities.

Is it all a negotiating stance?

Not surprisingly, Taubman Centers put out a press release on Wednesday stating that it "intends to hold Simon to its obligations under the Merger Agreement and the agreed transaction, and to vigorously contest Simon's purported termination and legal claims." In the short term, litigation seems inevitable.

However, some analysts have suggested that the termination notice is really just a negotiating tactic. Taubman's portfolio continues to have substantial long-term value, and Simon has the financial wherewithal to go through with the acquisition. The mall giant may just be holding out for a better price.

Taubman probably has a better legal case than Simon, but litigation is expensive, time-consuming, and the results are never certain. Furthermore, Taubman has more to lose. It wouldn't be that terrible for Simon if it were forced to go through with the acquisition. By contrast, Taubman doesn't have a great plan B. Considering the impact of the pandemic, there's no way it is worth anywhere close to $52.50 per share on a stand-alone basis.

Thus, I expect this litigation to be settled. The acquisition price could be negotiated down or Simon may pay a breakup fee to compensate Taubman for its trouble and avoid the risk of losing in court. Either outcome would be better for Simon than going through with the deal at $52.50 per share. Until the legal issues are resolved one way or the other, Taubman Centers stock is likely to remain quite volatile.