Last fall, Pennsylvania Real Estate Investment Trust (PEI) filed for bankruptcy protection, brought down by too much debt and a sharp drop in revenue resulting from store closures and retail bankruptcies. However, PREIT emerged from bankruptcy within weeks without wiping out (or even diluting) shareholders' interests.

Yet while the retail REIT survived bankruptcy, that doesn't guarantee a happy ending for shareholders. Let's take a look at what PREIT needs to do to return to health.

Big challenges remain

Shareholders should be happy that PREIT didn't wipe them out. But the REIT also didn't eliminate any debt during the bankruptcy process. (In a more typical bankruptcy, some creditors would swap their debt for new shares in the company, while existing shareholders would be wiped out.) Moreover, PREIT is now paying higher interest rates for some of its debt than it did before the bankruptcy filing.

Adding to PREIT's troubles, the COVID-19 pandemic has caused many of its tenants to close stores, fall behind on rent, or file for bankruptcy. As a result, occupancy for its core malls fell to 90.3% at the end of 2020, down from 95.5% a year earlier. Furthermore, funds from operations (FFO) turned negative in 2020.

Thus, management faces two tough tasks going forward: fixing PREIT's balance sheet and rebuilding its earnings power.

A rendering of a redeveloped wing at Plymouth Meeting Mall

Image source: PREIT.

Interesting initiatives in the pipeline

Investors shouldn't underestimate the headwinds PREIT faces. But the REIT does have some attractive qualities relative to many mall owners.

First, in contrast to most mall REITs, PREIT doesn't have many anchor vacancies in its portfolio. Across its 18 core malls, there are about half a dozen vacant anchor spaces today. Moreover, two of those former department-store buildings will be torn down to make way for new mixed-use developments in the next few years. PREIT has signed leases for new tenants for two others.

Second, PREIT continues to bring new uses to its malls. A medical facility will replace a former Sears at one of its properties. At another mall, Aldi will open a store in part of a former Sears building. At a mall in the Washington, D.C. suburbs, PREIT has made room for a new self-storage facility in previously unused basement space. And at a mall in the Philadelphia suburbs, PREIT is seeking a strategic partner to convert most of the interior space to non-retail use, potentially for life science tenants.

While these factors are good for investors, they don't do enough to fix PREIT's underlying problems to make it a worthwhile investment. To get back to health, the REIT must ramp up asset sales and address small-shop vacancies in the years ahead.

Fixing the balance sheet

Asset sales are critical as the only realistic way for PREIT to fix its balance sheet. The company isn't likely to produce enough cash flow over the next few years to make a meaningful dent in its debt load.

PREIT currently has firm agreements to sell land parcels at five of its malls to multifamily developers for a total of $87.2 million. Those developers would build approximately 2,200 units. Another parcel is under contract for sale to a hotel developer for $2.5 million. Together, these deals could bring in $90 million over the next few years that PREIT can use to pay down debt -- without impacting its earnings power.

A mostly empty parking lot at Willow Grove Park Mall

PREIT is looking to sell excess parking lot space to hotel and multifamily developers. Image source: Author.

The key questions are whether these deals will close as planned and whether there will be more to come. PREIT's management has said there is room to add at least 5,000 multifamily units at its malls, which could ultimately more than double the potential land-sale opportunity, enabling additional debt reduction. But that depends on the REIT's ability to get zoning entitlements and (in some cases) gain necessary approvals from anchor tenants.

Can PREIT backfill vacant small-shop space?

Meanwhile, PREIT needs to line up new tenants to fill small-shop space that became vacant in 2019 and 2020. Importantly, it needs to do so without cutting rents too much.

Non-anchor occupancy at PREIT's core malls has fallen by about 5 percentage points over the past three years. The REIT's success at lining up large-format tenants is encouraging, but tenants occupying less than 10,000 square feet of space pay much higher rents and generate the bulk of a typical mall's revenue. Rebuilding non-anchor occupancy at favorable rents is the only way to get revenue back to at least pre-pandemic levels so that PREIT can support its debt load.

Recently, leasing demand has been very weak due to the pandemic's impact on the retail industry. PREIT signed leases for 103,000 square feet of small-shop space in 2020, down from 293,000 square feet a year earlier. Unless management turns that trend around soon, PREIT could find itself back in bankruptcy court before long.

PREIT certainly has some promising opportunities ahead of it. However, the REIT's crushing debt load and the lack of clarity about its ability to close asset sales in a timely fashion while backfilling small-shop vacancies make this an extremely speculative stock, suitable only for the most risk-tolerant of investors.