The majority of earnings season for mall REITs got crushed into a single afternoon this quarter. The sector has been hit particularly hard by the COVID-19 pandemic, and mall owners apparently decided to get all their bad news out at once.

While every single mall owner reported dreadful results, the numbers were particularly bad for mid-tier mall REITs like Pennsylvania Real Estate Investment Trust (PEI) and Washington Prime (WPG). Let's take a look.

Wipeouts for key metrics

Two of the most important financial metrics for REITs are net operating income (NOI) and funds from operations (FFO). NOI measures the income generated by a property or set of properties after deducting property-level operating costs from revenue. FFO is a proxy for a REIT's operating cash flow. Unlike NOI, it includes corporate overhead and interest costs. However, it excludes non-cash items like depreciation and amortization that are presented on traditional income statements.

PREIT and Washington Prime both reported massive declines in NOI and FFO for the second quarter. PREIT said that same-store NOI (excluding lease termination revenue) plunged 36.6% year over year last quarter. Total NOI fell 39.1% to $33.2 million. Meanwhile, adjusted FFO turned negative, falling to negative-$0.06 per share from $0.22 per share in the year-ago period.

A rendering of a redeveloped section of PREIT's Plymouth Meeting Mall

Image source: PREIT.

Washington Prime's results were arguably even worse. Comparable NOI plummeted 44.6% year over year in the second quarter, falling to just $59 million. Moreover, that figure understates the actual level of NOI erosion, as Washington Prime excludes 13 lower-quality malls that it considers tier-two or non-core properties from its comparable NOI calculations. Adjusted FFO per share fell to just $0.01, compared with $0.27 a year ago.

Looking beneath the surface

While the earnings metrics reported by PREIT and Washington Prime were shocking at first glance, they don't necessarily reflect the REITs' longer-term prospects. Most enclosed malls were forced to close for a substantial proportion of the second quarter. In fact, when PREIT reported its Q1 results on May 21, just three of its 21 malls had reopened. The majority of its malls reopened in the second half of June, meaning that they were closed for virtually the entire quarter.

Due to the mall closures, many tenants stopped paying rent and/or sought to restructure their leases. Indeed, PREIT and Washington Prime both collected a little over half of the rent they were owed for the period from April to July.

The impact of the pandemic also led to a big jump in retail bankruptcies. When a retailer files for bankruptcy protection, landlords generally have to write off any unpaid past-due rent. Bad debt expense and rent abatements related to bankruptcies and mall closures drove the vast majority of the NOI declines reported by PREIT and Washington Prime.

One additional wrinkle is that landlords can continue booking revenue from tenants that withhold rent, as long as they are confident that they will eventually be able to collect it. Different mall REITs are taking different approaches here. PREIT has been pushing hard to collect past-due rent over time through deferral agreements. By contrast, Washington Prime said it was writing off 26% of contractual rent for the second quarter, which may reflect its greater exposure to small businesses with limited financial resources.

Looking ahead

Cash rent collections have improved steadily for mall REITs in recent months. This makes sense, given that most malls have been able to reopen, enabling tenants to start generating cash again.

On the other hand, the surge in tenant bankruptcies will have a lingering impact on financial results for mall owners like PREIT and Washington Prime. And with the COVID-19 pandemic far from over, it's safe to assume that there will be more retail bankruptcies over the next year or so. In addition, as mall vacancy rates rise, even tenants that aren't in financial distress will gain bargaining power, potentially allowing them to negotiate lower rents.

PREIT and Washington Prime were already struggling before the pandemic hit, so recovering from this big of a setback will be challenging. While shares of both mall REITs have lost more than three-quarters of their value in 2020, they are unsuitable for all but the most risk-tolerant investors at this point.