How to Invest in Mall REITs

Many investors are scared to put their money into any retail-related stocks, and who could blame them? Thanks to Amazon and other e-commerce retailers, there has been a highly publicized wave of retail bankruptcies, store closures, and general carnage in the brick-and-mortar retail space.

While some areas of the retail industry are certainly hurting, it's important to realize that all types of retail aren't in the same boat. Discount-oriented retail is thriving, to name one example. If you've been in a Costco or Five Below recently, you know exactly what I mean. Retail businesses that have an experiential component are also doing quite well in most cases -- places like megaplex cinemas and golf entertainment complexes.

There are mall-focused real estate investment trusts, or REITs, that allow you to invest in the right kinds of retail. Here's a rundown of what you need to know before you invest in any mall REITs and three that are worth a closer look.

Image source: Getty Images.

What is a REIT?

A REIT (pronounced "reet"), or real estate investment trust, is a specialized type of investment vehicle. The simple way to describe a REIT is like a mutual fund or ETF, but for real estate assets. Just as a mutual fund or ETF pools investor money to buy a collection of stocks, bonds, or other investments, a REIT pools money from many investors for the purpose of owning a portfolio of real estate assets.

REITs were created to give individual investors access to real estate investment opportunities that would otherwise be unaffordable or impractical. Using this article's focus as an example, there aren't too many people reading this who could afford to purchase a top-quality shopping mall. However, there are REITs that can allow you to put your money to work in that way.

In order to qualify as a REIT, an investment company must have at least 75% of its assets invested in real estate or related assets and also must get 75% or more of its income from rent or other real estate sources. And a REIT must commit to pay at least 90% of its taxable income as dividends -- which is why most REITs have above-average yields.

There are two main varieties of REITs -- equity REITs and mortgage REITs. Equity REITs primarily own, operate, develop, and/or manage physical investment properties, while mortgage REITs invest in mortgages, mortgage-backed securities, and other such finance-related assets. For the rest of this discussion, if I use the term REIT, you can assume I'm referring to equity REITs.

Some REITs, like the three I'm going to discuss in this article, are publicly traded on major stock exchanges. Others are available for public investment but aren't exchange listed, and still others are private.

Who should invest in mall REITs?

Mall REITs make great investments for people looking for strong total returns from their investments. These stocks often pay above-average dividend yields yet also offer the potential for excellent growth as the retail industry evolves.

However, like any evolution, the transition from the old retail environment to one that works in an e-commerce-driven world isn't going to happen overnight. Consider mall REITs like those I'm about to discuss here strictly as long-term investments. Unless you have a long time horizon to let your investment grow -- a minimum of five years or so -- I wouldn't suggest mall REITs for your portfolio.

Key metrics for REIT investors

Many metrics that apply to general stock investing translate well to REIT investing, but there are some exceptions.

The most significant is net income, which is often used interchangeably with the term "earnings" when discussing stocks. However, net income is a poor indicator of how much money a REIT is making. I won't get too deep into an accounting discussion, but the main reason is that companies are allowed to depreciate business assets, including real estate, as a deduction against their profits for tax purposes. For most businesses, whose real estate holdings might include a factory or warehouse, this doesn't tend to be too big a distortion. For REITs, whose assets are almost entirely real estate, it's a completely different story. The depreciation "expense" tends to make REIT earnings look far lower than they actually are.

That's where funds from operations, or FFO, comes in. FFO adds back in the depreciation expense and makes a few other smaller adjustments to give investors a clearer picture of how much money a REIT is actually making. Think of FFO as the "earnings" of the REIT world, and use it accordingly -- for example, when doing price-to-earnings analysis.

Going further, many REITs also use company-specific FFO metrics. You may see these listed as core FFO, normalized FFO, or adjusted FFO. The general idea is that these adjust for certain one-time items or take other factors into account in order to give the clearest possible picture of earnings. As a general rule, if a company issues one of these metrics along with its FFO, it's a good idea to use it when making assessments about the REIT's value as an investment.

One other important metric for REIT investors to know is capitalization rate, or "cap rate." This is a property's annual income as a percentage of its acquisition cost (or current market value). It can be used to show how profitable a newly acquired property is or can be used to show how much value a REIT got for a property it sold. As an example, if a REIT acquired a property for $10 million at a 7% cap rate, this means that the property is expected to generate operating income of $700,000 per year.

Advantages of REIT investing

In exchange for agreeing to the requirements for REIT classification, these companies enjoy a pretty big tax advantage. Specifically, REITs are not taxed on the corporate level regardless of how much profit they make.

When you buy most dividend stocks, the profits the company earns are effectively taxed twice -- once at the corporate level when profits are earned and again at the individual level as profits are paid to shareholders as dividends. REIT profits, on the other hand, are only taxed after they are paid out to shareholders. And if investors hold their REIT shares in tax-advantaged retirement accounts like IRAs, they won't even have to pay taxes on their dividends at the individual level, which makes REITs fantastic IRA investments.

There are a few other advantages to adding REITs to your portfolio. Diversification is a big one -- although publicly traded REITs are technically stocks, most experts put real estate in a different asset category. Plus, REITs are excellent total-return investments, meaning that they're designed to produce a high level of income, as well as long-term share price appreciation, as the underlying portfolio of properties grows in value.

Why invest in mall real estate?

There are a few good reasons that malls make solid investments. Among others:

• Malls tend to be very tenant diverse. If one mall has 100 different stores, it isn't too dependent on any one tenant for income.
• Malls also tend to lease their space on a long-term basis to tenants, with gradual rent increases (known as escalators) built right in.
• Because of the current headwinds affecting the retail sector, mall REITs are trading at low valuations.

We discussed cap rates earlier; as of the latest available information, the average mall property is valued at an 8.2% cap rate. Compare this to 5.3% or 6.4% for average apartment and industrial properties, respectively. In other words, retail properties are valued significantly lower than many other types of commercial real estate, relative to their income potential.

Also, it's worth clarifying that most commercial real estate, malls included, is generally divided into A, B, or C. (There are Class D properties, but you don't want to invest in them. These are typically distressed properties located in declining or undesirable areas.) While no official criteria need to be met for a mall to be included in a certain "class," Class A refers to top-notch malls with modern amenities that are located in desirable areas, and Class B and Class C malls refer to lower-quality properties.

The right kinds of malls to invest in

In a nutshell, I'd suggest narrowing your search to malls that are likely to adapt well to the changing retail environment. For example, Class A malls with lots of dining options, mixed-use spaces, and modern amenities have an experiential component that can't be replicated online. Outlet malls offer bargains that aren't generally available online, and this deep-discounted nature makes them recession resistant in addition to being e-commerce resistant.

On the other hand, older malls and those strictly reliant on the old-style mall model of a few big anchor stores and a bunch of full-retail stores aren't likely to weather the changes in retail as well. We've already seen some losses and dividend cuts in REITs that specialize in Class B and C mall properties, and the pain is likely to get worse in many cases.

To be clear, REITs generally won't explicitly state that they hold, say, Class C properties. However, you can read each REIT's latest annual report to get a better feel for the type of malls it owns.

Risks of investing in mall REITs

Aside from the risk of e-commerce competition and potential tenant bankruptcies that it can cause -- which can be somewhat mitigated by offering top-notch amenities, modern dining options, and other such features -- there are a few other risks investors should be aware of.

• Interest rates: Generally speaking, rising interest rate environments are bad for REITs. As risk-free interest rates rise (the 10-year Treasury is a good REIT indicator), investors expect more of a risk premium from income-based investments like REITs. Since yield and price move in opposite directions, this puts downward pressure on REIT stock prices.
• Costly borrowing: Most REITs rely on borrowed money to grow, and rising interest rates mean higher borrowing costs.
• Execution risk: When malls invest considerable resources to adapt to changing consumer trends, they face greater pressure to get those changes right. For example, one mall REIT I'm about to discuss plans to renovate and repurpose the space previously occupied by struggling anchor stores like Sears and JC Penney. If the transformation succeeds in attracting new tenants and higher rental income, it'll be great. Just keep in mind that sentence started with "if."

3 top mall REITs

Now that we've discussed REIT investing in general and the right kind of mall real estate to invest in, let's take a look at some examples. Here are three mall REITs that are well positioned to thrive in the evolving retail landscape, all of which implement somewhat unique strategies.

Source: Company dividend records. Dividend growth rates as of 2018.

Simon Property Group

As you can see in the chart above, Simon Property Group is a massive REIT. In fact, it's one of the largest REITs of any kind in the world.

Simon owns a big portfolio of Class-A shopping malls and outlet centers. Its "The Mills" brand is well known for its quality and modern shopping malls, and its "Premium Outlets" brand has the leading market share in outlet retail.

To be clear, Simon hasn't been immune to retail headaches. In fact, Sears is a major tenant, and several other struggling retailers have a presence in Simon's malls. However, Simon's strategy is to create shopping destinations that people want to physically go to. It aims to achieve this by offering top-notch amenities, tons of retail and entertainment options, and other nonretail features.

In fact, Simon views its vacant Sears properties as some of its biggest opportunities. The company has been using the vacated space to incorporate nonretail elements such as hotels, apartments, and offices into its malls, which creates a natural source of foot traffic for its retail tenants.

The numbers show how effective Simon's strategy has been so far. Simon's FFO per share continues to increase as an impressive rate, and its portfolio occupancy has been steadily high, with a five-year average of 96.3% as of 2018. Simon's retail tenants had a reason to smile, too -- retailer sales have steadily risen on a per-square-foot basis in recent years. And as Simon continues to redevelop its properties into world-class shopping destinations, there's no reason to believe this trend can't continue.

Tanger Factory Outlet Centers

I mentioned that Simon has a dominant lead in the outlet center market. Tanger Factory Outlet Centers is the No. 2 player, but it's a pure play on outlet shopping. Not only is outlet shopping likely to emerge from the e-commerce transition in good shape, but as of early 2019, the stock had been trading extremely cheaply (at less than 10 times FFO -- roughly half of the industry average) for some time, so it's definitely got an attractive risk-reward profile.

As of the end of 2018, Tanger owned 44 outlet centers located throughout the U.S. and Canada, with 15.3 million rentable square feet of space. As I mentioned earlier, outlets not only have an experiential component to the shopping experience but also tend to hold up well during tough times. As CEO Steven Tanger says, "In good times, people love a bargain, and in tough times, people need a bargain."

In fact, thanks to the recession-resistant nature of the business model, Tanger's occupancy has never fallen below 95% in the past 25 years, even in the depths of the Great Recession.

Finally, Tanger has lots of room to grow once the dust settles in the retail space. The vast majority of Tanger's outlet centers are in the Eastern U.S., and the outlet industry is a pretty small part of retail overall. Tanger has understandably pumped the brakes on growth in recent years, but I wouldn't be surprised if that changes in the future.

Taubman Centers

Taubman Centers owns a portfolio of 26 retail properties, with a mix of higher-end malls and outlet properties (starting to notice a theme here?). With and a history of having the highest sales per square foot among leading mall REITs, Taubman boasts the most productive retail properties in the industry -- for comparison, in 2018, Taubman's malls generated 31% more sales per square foot than Simon's and more than double that of Tanger's, and the company achieved similar performance in previous years as well.

As such, Taubman's portfolio also commands the highest rent in the industry, but it's still a relative bargain for tenants. Taubman's average retail tenant pays higher-than-average rent but actually pays less than at competing mall REITs relative to the sales the space generates. And with consistently high occupancy, there's no shortage of demand for space in its properties.

Taubman's strategy is simple: to own the best retail assets in the best locations and fill them with the best tenants. Period. Over time, as lesser-quality retail properties are shaken out of the market, Taubman's properties are likely to steadily capture more sales traffic and therefore become even better rental income generators.

Taubman also embraces the appeal of omnichannel retail and welcomes tenants who mostly operate online. Amazon rents retail space from Taubman, as do brands like Casper, Untuckit, and Peloton, just to name a few. Furthermore, Taubman has hardly any exposure to troubled department stores, relying more heavily on financially solid anchors like Macy's and Nordstrom instead.

The wrong kinds of malls to invest in

Remember that not all mall REITs are good investments in the current retail environment. Specifically, it's important for mall REIT investors not to get lured in by dividend yield traps -- REITs with a portfolio of low-quality malls that pay a high and unsustainable dividend.

In several cases, thanks to awful performance and the subsequent plunge in stock prices, certain low-quality mall REITs have had dividend yields well into double digits. However, these dividends aren't likely to be sustainable. Many lower-quality malls rent space to distressed tenants like Sears or J.C. Penney and don't have the resources to redevelop all of their properties effectively.

In short, stick with Class A and outlet-based malls. They have the best risk-reward profile as the retail industry adapts to growing e-commerce adoption.