Earlier this month, two struggling mid-tier mall owners declared bankruptcy after failing to clean up their balance sheets adequately outside of Chapter 11.

Many investors are wondering whether Washington Prime Group (WPG) is next. Like other mall owners, the REIT's financial metrics have deteriorated rapidly this year. Furthermore, high dividend payments and redevelopment expenditures over the past few years have caused its balance sheet to become overextended. As a result, Washington Prime stock has plunged 85% year to date and 95% over the past five years.

WPG Chart

Washington Prime data by YCharts.

However, management took a defiant tone in conjunction with the company's third-quarter earnings report last week, insisting that Washington Prime is in no danger of following its peers into bankruptcy. Let's take a look.

Another quarter of awful results

While most of Washington Prime's malls were open last quarter (unlike much of the second quarter), the REIT's financial results were still dismal. Comparable net operating income (NOI) plunged 32.6% year over year to $72.3 million. The main drivers of the NOI decline were tenant bankruptcies, rent relief measures, and doubts that Washington Prime will be able to collect unpaid rent from many of its struggling tenants.

Management noted that the Q3 NOI decline represented a sequential improvement over the second quarter, when comparable NOI fell 44.6% year over year. However, this is an empty victory: Both results are objectively terrible. (Furthermore, Washington Prime excludes its worst enclosed malls from its comparable NOI statistics. Including those "Tier Two" malls, NOI fell by nearly 36%.)

The sharp drop in NOI also caused Washington Prime's funds from operations (FFO) to plummet. Adjusted FFO per share fell 75% year over year to just $0.07 last quarter.

Fourth-quarter outlook comes with a big caveat

Looking ahead to the fourth quarter, Washington Prime's management said that it expects comparable NOI to decline 10% to 20% year over year. If the REIT can hit the midpoint (let alone the high end) of this forecast, it would mark an important step on the road back to health.

A corridor inside a mall

Image source: Getty Images.

However, the forecast "assumes that the Company's properties remain open throughout the fourth quarter and are not significantly impacted by any future government-mandated operating restrictions." As management tacitly admitted on the earnings call, that may not be a reasonable assumption. COVID-19 case numbers are rising rapidly in many parts of the U.S. In Ohio -- home to eight Washington Prime enclosed malls -- the number of new cases per day has quadrupled and the number of hospitalizations has tripled since the beginning of October. As a result, the governor is planning new measures to slow the pandemic's spread.

The fundamental problem for shareholders is that many of Washington Prime's malls were in trouble before the pandemic hit. The leased occupancy rate for its Tier One malls was already subpar at 90.4% a year ago and fell further to 87.5% as of the end of September. Another round of temporary mall closures could lead to additional vacancies, putting some malls at risk of falling into a downward spiral. (A high vacancy rate tends to dampen traffic, leading to additional store closures -- and further traffic declines.)

Deleveraging is the key to survival

Pretty much the only good news that Washington Prime investors got last week was that the company is making progress on efforts to fix up its balance sheet without going through bankruptcy. First, it has signed an agreement to sell the bulk of Westminster Mall in the Los Angeles suburbs for approximately $160 million. Washington Prime expects to net over $50 million when the deal closes -- likely in 2022 -- after paying off the mall's $75.7 million mortgage and other deal-related costs. Furthermore, it would retain parts of the property that are not slated for mixed-use redevelopment.

Second, management said it "is actively working on measures with existing debt investors that would result in deleveraging of its balance sheet if execution is successful." It did not provide any specifics, other than emphasizing that bankruptcy was not in the cards. One possibility is that some unsecured debt could be exchanged at a discount for new secured debt. (Washington Prime's publicly traded debt due in 2024 recently traded for 53 cents on the dollar, so it's possible that debt holders would be amenable to this kind of arrangement.)

Unless Washington Prime can claw back most of its 2020 NOI declines while also cleaning up the balance sheet, it is doomed in the long run. Unfortunately, there are still a lot of question marks about the long-term viability of many of its malls and its ability to deleverage in a meaningful way. Without a lot more clarity on those issues, investors should steer clear of this troubled company.