Bankruptcies are extremely rare in the REIT sector. After all, REITs are required to keep the bulk of their assets in physical properties, or debt backed by real estate. Most real estate tends to appreciate over time, and as long as it holds its value, a REIT can sell properties to pay down debt in a pinch.
However, several mall REITs were already struggling entering 2020, because of the so-called retail apocalypse. Mall values have plunged because of falling rent and occupancy rates in many places. The COVID-19 pandemic exacerbated those problems. That culminated in bankruptcy filings from CBL & Associates (CBLQ) and Pennsylvania Real Estate Investment Trust (PEI) over the weekend.
These two bankruptcy filings have very different implications for investors, though. Let's take a look.
CBL finally files for bankruptcy protection
In August, CBL announced that it had reached a restructuring support agreement with a majority of its unsecured debtholders. The agreement called for it to declare bankruptcy to reduce its debt and preferred stock obligations by about $1.5 billion.
CBL was supposed to initiate the Chapter 11 process by Oct. 1, but it received multiple extensions to that deadline. The filing finally came on Sunday. CBL will continue to operate its properties normally during the bankruptcy process and has enough cash on hand to cover its needs for the foreseeable future.
The bankruptcy filing isn't expected to wipe out shareholders, but it will dilute the value of their holdings dramatically. Unsecured note holders are slated to receive 90% of the equity of a reorganized CBL, compensating them for exchanging their notes for new secured debt with a significantly lower face value. The remaining 10% will be shared between holders of CBL's common and preferred shares and the REIT's management.
In a recent presentation to creditors, CBL estimated that it will generate $217 million of adjusted funds from operations (FFO) in 2021, down from $271 million in 2019. Even after the pandemic ends, FFO could continue to decline as retailers rationalize their U.S. store footprints -- including closing stores in low-traffic malls (like many of CBL's properties). With lower FFO spread across a much larger share count and further FFO declines likely in the years ahead, CBL shares may be worth very little at the end of the bankruptcy process.
PREIT also lands in Chapter 11
A couple of weeks ago, it seemed like PREIT might be able to avoid bankruptcy by getting unanimous consent from its lenders for an out-of-court restructuring. Ultimately, it fell short of that goal, leading it to file for Chapter 11 protection on Sunday. However, it does have approval from 95% of its lenders for a prepackaged bankruptcy plan, which should speed up the Chapter 11 process and reduce administrative costs.
Unlike CBL, PREIT is not requiring any of its lenders to reduce the principal value of their claims. It simply intends to exchange its existing debt for an equivalent amount of new debt that provides some additional protections for lenders but gives PREIT greater near-term financial flexibility. It will also receive a $150 million capital infusion to help it complete ongoing investment projects in its properties. Under the plan, PREIT's common and preferred shares would remain intact with no dilution.
With all but one of its creditors having agreed to its Chapter 11 plan, PREIT hopes to complete the Chapter 11 process within about a month. The biggest risk is that distressed debt investment firm Strategic Value Partners -- the lone holdout from the prepackaged plan -- throws up obstacles in the hope of getting a better deal.
CBL and PREIT have gotten mixed news in recent weeks. On the positive side, a deal to rescue J.C. Penney's retail business is now close to being finalized. J.C. Penney is a key anchor tenant for both REITs, and a liquidation of the chain would have weakened the position of many mid-tier malls. On the other hand, a recent surge in U.S. COVID-19 case numbers could hurt retail traffic or drive some states to impose new restrictions on malls.
Given the uncertainty associated with the pandemic, it's quite possible that neither of these bankruptcy filings will lead to a happy ending for shareholders. However, PREIT is far more likely than CBL to provide a meaningful recovery to patient investors. First, it owns higher-quality properties than CBL, with a focus on big-city suburbs where land is scarce, enhancing long-term redevelopment potential. Second, PREIT has invested far more aggressively in its properties than CBL. Those investments could drive a quicker recovery in financial performance when the pandemic ends.
Nevertheless, the bankruptcy process involves significant risks. Only the most risk-tolerant investors should consider putting any money into PREIT or CBL shares.