REIT Rankings: Shopping Centers
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Shopping Center REIT Sector Overview
One of the four major real estate sectors, the retail real estate sector can be divided into three subsectors: enclosed malls, open-air shopping centers, and free-standing. In the Hoya Capital Shopping Center REIT Index, we track the fourteen largest open-air shopping center REITs, which account for roughly $60 billion in market value: Regency Centers (REG), Federal Realty (FRT), Kimco (KIM), Brixmor (BRX), Weingarten (WRI), American Assets (AAT), SITE Centers (SITC), Retail Properties of America (RPAI), Acadia Realty (AKR), Urban Edge (UE), Retail Opportunity Investments (ROIC), Kite Realty (KRG), RPT Realty (RPT), and Urstadt Biddle (UBA).
Together with malls and free-standing net lease properties, retail REITs comprise roughly 12-15% of the broad-based real estate ETFs (VNQ and IYR). The retail real estate sector is tracked by the Benchmark Retail Real Estate ETF (RTL). Open-air shopping center REITs have characteristics that are generally viewed as less exposed to the retail-related headwinds compared to their mall REIT cousins with a tenant base that has exhibited a higher degree of resilience and adaptability to the continued pressures on the brick and mortar retail sector. The bifurcation between high and low-quality retail centers, however, continues to widen with grocery, discount, and hardline-anchored (hardware, home improvement) locations viewed as more valuable than shopping centers anchored by softline, hobby/specialty, and electronics retailers.
Shopping Center lease terms typically average 10-15 years at signing and have CPI-based or fixed contractual rent bumps along with additional “percentage rent” based on retailer sales. Unlike the mall sector where private market sales are few-and-far-between, the transaction market is significantly more active with shopping center REIT having transaction volumes that are 8 times higher than mall REITs over the last twelve months.
Also unlike the mall sector, shopping center REITs own a small share (5-10%) of total open-air shopping center properties, leaving open the possibility of external growth via acquisitions, though a poor cost of capital over the last half-decade has forced these REITs to be net sellers of assets. The margin profile is similar between malls and shopping centers with cap-ex burdens each well above the REIT sector averages at roughly 20% of annual NOI.
After a development boom during the 1990s and early 2000s, very little new retail space has been created since the recession. Despite that, the US still has more retail square footage than any other country in the world. Elevated levels of store closings in recent years, spurred by the rise of e-commerce, have created ample “shadow supply” of recently vacated space which has negatively impacted retail REIT fundamentals. While nearly 90% of total retail sales are still completed through the traditional brick and mortar channels, e-commerce sales account for roughly a fifth of “at-risk” retail categories, which exclude food, auto, and gasoline sales and brick and mortar retailers have been losing share at a rate of roughly 1% per year. The market share loss has been most significant for the traditionally mall-based retail categories including department stores, clothing, sporting goods/books, and electronics retailers.
Store closings have unexpectedly surged in 2019 as the combination of higher minimum wages, tariff-related cost pressures, and heavy discounting have pressured margins at softline and specialty retailers. Coresight Research has tracked more than 7,500 closings so far this year, already outpacing the full-year count for 2018, and estimates that up to 12,000 could announce closings by year-end. As we’ll discuss in greater detail below, shopping center REITs have generally avoided the wave of store closings in 2019, which have been primarily concentrated in the enclosed mall-based category after the sector was hit particularly hard in 2017 and 2018 with the unexpected closures of big-box giants Toys “R” Us and Sports Authority.
Shopping Center REITs have seen recent success in “de-boxing” the larger vacated store footprints into several smaller store layouts that can command higher total NOI than the single big-box tenant. By nature of the heavy fixed cost structure, brick and mortar stores operate with a high degree of operating leverage, so relatively small changes in sales can have significant impacts on an individual location’s viability. Invariably, brick and mortar stores are one of many retail distribution channels and, at scale, are relatively efficient compared with online retail. According to AlixPartners, for apparel retailers, in-store profit margins are actually higher than online sales due primarily to high (and rising) last-mile shipping costs.
Retailers including Home Depot (HD), Walmart (WMT), and Target (TGT) are perhaps the most prominent examples of traditional brick and mortar retailers – primarily open-air shopping center-based – finding significant success with a “bricks-and-clicks” strategy by combining the best features of in-store shopping while using technology to remove key pain points. Additionally, as rental rates of industrial distribution center real estate space continue to rise high-single digits (as discussed in our Industrial REIT report), we see more retailers seeking to utilize stores as distribution hubs. According to TechCrunch, “Target says as it’s shifted away from upstream distribution centers for order fulfillment to its stores, costs went down by more than 40%. And costs related to same-day services went down by 90%.”
Shopping Center REIT Fundamental Performance
Shopping Center REITs have delivered a relatively strong year despite the re-acceleration in store closings and fears of a ‘retail apocalypse 2.0’. “Beat and raise” has been a phrase not been heard often over the last half-decade in the context of retail REITs, but 2Q19 saw just that. Seven of the thirteen REITs that we track raised full-year same-store NOI guidance with zero REITs lowering guidance. Overall occupancy ticked down a modest 30 basis points year-over-year while small-shop occupancy actually ticked higher by roughly 20 basis points. Cash leasing spreads remain healthy at 7.9% with all thirteen REITs reporting positive cash spreads, compared to the mall sector that saw three REITs report negative spreads.
After underperforming the REIT averages for the last decade, shopping center REITs delivered same-store NOI growth that was only fractionally below the broader REIT average in 2Q19. According to NAREIT’s T-Tracker, over the last twelve months, shopping center REITs grew same-store NOI by 2.5%, the best rate since early 2015 and essentially in-line with the broader REIT average of 2.6%. Mall REITs, meanwhile, saw same-store NOI growth of just 0.9%. For now, it appears that much of the pain from big-box store closings may be in the rear-view for the sector as leasing spreads have accelerated modestly over the last several quarters. That said, we recall a similar sense of stability-turning-to-growth in 2016 before the unexpected Sports Authority bankruptcy and again in 2018 before the Toys “R” Us closing.
On that point, according to data from Coresight Research, the shopping center sector has so far dodged the worst of the store closing bullets so far this year. While the store closing count is significantly higher than last year, the four largest contributors to store closings have been in the mall category in 2019. By comparison, four of the top five contributors to store closings in 2018 were primarily open-air shopping center-based retailers. Forever 21’s just-announced bankruptcy, a retailer that we actually saw as one of the stronger-performing mall-based retailers, will add several hundred more store closings.
The retail real estate sector has seen generally declining same-store occupancy since peaking in 2015 at above 96.5%. While still at a relatively healthy-looking 94.9%, the decline in occupancy is likely understated, however, as retail REITs have actively “recycled” underperforming properties and held low-occupancy properties for sale, outside of the same-store basket. Longer term, we think that open-air shopping centers have proven to be more adaptable to the rapidly changing retail distribution chain than the enclosed mall sector and see this sector as more capable of maintaining same-store occupancy levels in the mid-90s.
As we discussed in our recent commentary, we’ve become more bearish on the retail sector – particularly the enclosed mall sector- over the last year and a half given the disappointing fundamental performance amid an otherwise ideal macroeconomic backdrop that we’ll analyze below. While 2Q19 earnings for the shopping center sector do raise our hopes that the worst is indeed behind us, we’ve seen our share of false starts and recent experience has taught us that big-box bankruptcies can often emerge quickly and unexpectedly and can have a lingering impact on this sector. While we remain underweight on retail real estate as a whole, we see pockets of value in low-leverage and well-capitalized REITs that focus on the higher-quality grocery and hardline-anchored locations – Regency, Retail Opportunity and Federal Realty.
Shopping Center REIT Stock Performance
Shopping center and mall REITs have each underperformed the broader REIT average in each of the past three years. Interestingly, shopping centers were the single worst-performing REIT sector in both 2017 and 2018, the only “repeat-loser” in the REIT sector in the past decade. From 2016 through the end of 3Q19, the shopping center has accumulated roughly 33% in underperformance relative to the NAREIT All Equity REIT Index while malls have underperformed by a cumulative total of 59% during this time.
While mall REITs are destined to push their underperformance to four straight years, shopping center REITs have a fighting chance to outperform the REIT sector average for the first time since 2015. Shopping center REITs have climbed by 24% so far this year, just shy of the 25% returns on the broader REIT average. By comparison, the SPDR S&P Retail ETF (XRT), which includes only retailers and not real estate owners, is up by just 3% this year.
Shopping Center REIT Valuations
As they have for most of the past half a decade, retail REITs screen as inexpensive across most traditional REIT metrics, but have produced FFO growth that has lagged the broader REIT averages during this time. For the past five years in the REIT sector, “growth” has been an outperforming factor while “value” has significantly lagged. Powered by the iREIT Terminal, we note that shopping center trade at 17x AFFO, which is below the REIT average of 20x AFFO. As noted, shopping center REITs now trade at a modest NAV discount.
Capital Markets And Property Development
REITs are at their best when they’re utilizing their superior access to equity capital to fuel external growth via accretive acquisitions. While REITs have become more active builders over the last decade, the majority of FFO growth over the last twenty years has resulted from acquisitions, and it’s tough to grow FFO when relying exclusively on organic growth. A sharp disconnect has persisted between private market valuations of retail real estate assets and the REIT-implied valuation, forcing retail REITs to be net sellers of assets for nearly a half-decade. However, with gains of nearly 25% so far this year, shopping Center REITs now trade at a more modest 0-10% discount to NAV, which should slow or even reverse the selling activity. Shopping Center REITs sold a net $3.8 billion in assets over the last year, amounting to a very significant 6% of aggregate market value.
The saving grace of the retail REIT sector over the past half a decade has been record-low new development. Significant amounts of “shadow supply” from recent and future store closings persist across the sector, however. New supply growth has averaged less than 0.5% of existing stock per year since the recession, helping the industry absorb this ample “shadow supply” from vacated stores. For several high-productivity retail REITs, redevelopment remains a substantial source of untapped long-term value. Top-tier retail assets are ideal for the “live-work-play” mixed-use residential expansion and there are a handful of highly successful redevelopments from these three higher-productivity REITs.
Macro Retail Sales Trends And Outlook
After reaching the fastest rate of growth since 2012 in the middle of last year, retail sales growth has generally moderated over the past several months, but data has been relatively strong this summer despite the volatility seen in the financial markets. Continuing a similar trend seen throughout this summer, total retail sales beat estimates last month, but many “brick and mortar” continue to see significant weakness. E-commerce (non-store retail) sales were again the stand-outs last month with the category seeing the largest year-over-year increase in sales in nearly twenty years.
For retailers, the more significant issue over the last two years has not been on the demand side, but rather on the expense side. Before even considering the margin hit from tariffs and excess inventory, labor costs have risen considerably over the last two years as eighteen states raised their minimum wage in 2018 and many cities (largely in already high-cost markets) have raised minimum wages over the last two years, oftentimes far above market rate, which has begun to result in retail job cuts and store closures. Hourly earnings surged to 5% in early 2019, outpacing the roughly 3% growth in retail sales, while retail job growth has been negative on a year-over-year basis for all of 2019.
While the majority of the store closings (on a square footage basis) over the last five years were concentrated in the anchor and big-box space, more than half of the store closings so far in 2019 have been in the specialty categories, indicating that smaller businesses have been hit especially hard by minimum wage pressures. While hardline and food retailers tend to be somewhat immune from e-commerce related disruption, softline and specialty retail categories are generally more at risk. During the so-called “retail apocalypse” of 2016-2017, these categories were particularly weak but recovered nicely in 2018 before turning lower again over the last two quarters.
Shopping Center REIT Dividend Yield
Shopping center REITs pay an average dividend yield of 4.3%, which ranks towards the top of the REIT sector. (Note that our REIT Average is skewed lower by our cap-weighted indexes and coverage universe which generally excludes externally-managed and small-cap REITs under $1B in market capitalization.) Mall REITs, meanwhile, pay an average dividend yield of 6.0%, the highest in the REIT sector. Both retail REIT sub-sectors, however, have payout ratios above the REIT sector average.
Within the sector, more than other REIT sectors, investors need to be cautious not to fall into common “value traps” by assuming that high dividend yields can offset declining price returns. As we’ve pointed out for the past several years, despite paying double-digit dividend yields, mall REITs like CBL, PEI, and WPG face strong headwinds and there’s certainly no “free lunch” in equity investing. Similar themes apply to the shopping center, where we note quite a bit of divergence in dividend yield, which is typically inversely related to the quality of the underlying portfolio. Kite Realty pays the highest yield at 7.8% while American Assets pays the lowest yield at 2.4%. Several REITs are paying dividend yields near their projected 2019 free cash flows, so investors should expect more modest dividend growth from these REITs in future years.
Bull And Bear Thesis For Retail REITs
While retail REITs get more than their fair share of negative headlines, there are a handful of reasons to be bullish on the long-term prospects for the retail REIT sector. Recognizing the challenges of the pure-play online retail strategy, more retailers have embraced the “brick and clicks” omnichannel retail strategy, including e-commerce giant Amazon (AMZN). There’s been very limited new construction of retail real estate space over the last decade and high-productivity retail REITs continue to find accretive yields in redeveloping vacated store space into higher-value mixed uses, including multifamily and experience-based retailers. Below we outline five reasons to be bullish on shopping center REITs.
While the “retail apocalypse” may have been exaggerated, retail REITs continue to be challenged by broader secular headwinds, pressures that have intensified in 2019. Store closures have surged this year as retailers deal with a myriad of pressures including tariff concerns, rising minimum wages, and excess inventory. Downsizing retailers have focused their investment on higher-performing stores and have continued to close weaker-performing stores in lower-tier malls and retail centers. As we often discuss, valuations can be self-reinforcing in the REIT sector and cheap REITs tend to stay cheap as low equity valuations make it more challenging to raise the capital needed for redevelopment and external growth. Below we outline five reasons to be bearish on shopping center REITs.
Bottom Line: Shopping Center REITs Are Dodging Bullets
Embracing the “bricks and clicks” model such as in-store pickup, open-air shopping centers have proven to be more adaptable to the rapidly changing retail distribution chain. After underperforming the REIT averages for the last decade, shopping center REITs delivered same-store NOI growth that was only fractionally below the broader REIT average in 2Q19.
We’re not malls, we promise! Open-air Shopping Center REITs have delivered a relatively strong year despite the re-acceleration in store closings and fears of a ‘retail apocalypse 2.0’. Dodging bullets: shopping center REITs have generally avoided the wave of store closings in 2019, which have been primarily concentrated in the enclosed mall-based category. While 2Q19 earnings for the shopping center sector do raise our hopes that the worst is indeed behind us, we’ve seen our share of false starts and recent experience has taught us that big-box bankruptcies can often emerge quickly and unexpectedly and can have a lingering impact on this sector.
The bifurcation between high and low-quality retail centers continues to widen. We continue to see well-located grocery and hardline-anchored centers as the few engines of growth in the retail sector. While we remain underweight on retail real estate as a whole, we see pockets of value in low-leverage and well-capitalized REITs that focus on the higher-quality grocery and hardline-anchored locations – Regency, Retail Opportunity and Federal Realty.
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Disclosure: I am/we are long REG, VNQ, HD, WMT, TGT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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