One of Warren Buffett's best-known aphorisms is: "Be fearful when others are greedy. Be greedy when others are fearful." This mindset has helped the Oracle of Omaha amass a roughly $79 billion fortune over more than half a century of investing.
Right now, there is rampant fear surrounding the future of U.S. malls -- and the companies that own them. As a result, investors have dumped shares of mall REITs like Pennsylvania Real Estate Investment Trust (NYSE: PEI). Indeed, PREIT stock has lost more than half of its value over the past year (even after factoring in dividends) and has fallen about 30% just in the three weeks since PREIT released its Q2 earnings report.
PREIT stock performance and total return. Data by YCharts.
Yet while U.S. malls are facing some major headwinds, investors are underestimating the ability of mall owners to retool their best properties to remain relevant. Moreover, some important company-specific earnings growth drivers are about to kick in for PREIT. That's why it's a great time to get greedy with this REIT stock.
Retailer bankruptcies and store closures have been dragging down landlords
Over the past few years, a number of high-profile retailers that had been struggling for a long time have finally been forced to file for bankruptcy. Many of those chains ultimately liquidated. Other retailers have reacted to changing shopper habits by closing lots of stores.
Most notably for mall owners like PREIT, department stores have been hit hard by the so-called "retail apocalypse." Sears Holdings has closed most of its stores over the past few years and barely survived bankruptcy. Regional department store operator Bon-Ton was less fortunate and liquidated last year. Macy's has closed approximately 120 full-line stores since the beginning of 2015. Lord & Taylor and Barneys New York are closing a substantial proportion of their stores, and both upscale retailers are at risk of going out of business entirely. Lastly, J.C. Penney (NYSE: JCP) has been losing money for years.
While department stores generally pay very little in rent, the in-line tenants that generate most of a mall's income often have "co-tenancy clauses" that reduce their rent when a mall experiences anchor vacancies. Additionally, with most department store chains shrinking, it's often necessary to split vacant department store buildings into smaller spaces in order to find new tenants. That takes time and money.
Over the past three years, about half of PREIT's malls have experienced at least one department store closure. The resulting co-tenancy impacts have contributed to sharp declines in PREIT's funds from operations (FFO). FFO has fallen from $1.89 in 2016 to an expected $1.16 to $1.27 in 2019. That's why PREIT stock has plunged from more than $20 three years ago to less than $5 today.
PREIT has had to replace a substantial number of anchor tenants in recent years. Image source: PREIT.
Is another shoe about to drop?
The most recent plunge in PREIT stock was triggered by the news that the U.S. would impose tariffs on an additional $300 billion of Chinese imports. Investors worried that this would add to the pressure on already-struggling retailers -- and J.C. Penney in particular.
It's true that J.C. Penney has struggled with weak sales and severe losses in recent years. The department store giant also gave investors a scare last month after Reuters reported that it was working with advisors to study a potential debt restructuring. And J.C. Penney has stores in 13 of PREIT's 18 core malls, so a near-term bankruptcy -- let alone a liquidation -- of the department store chain could be devastating for PREIT.
However, J.C. Penney significantly reduced its net loss last quarter, as management's efforts to boost gross margin started to pay off. J.C. Penney isn't out of the woods yet, but between its ample liquidity and its improving profitability, there's no immediate danger of bankruptcy.
PREIT's turnaround is about to begin
While about a dozen department stores have closed in PREIT's core malls over the past few years, the REIT has found new tenants for every single one. So why has FFO kept falling? Because many of those replacement tenants haven't opened yet.
That's about to change. By mid-2020, PREIT will complete six ongoing anchor replacement projects, leaving it with no department store vacancies. Many of the new tenants will open in the next few months. Additionally, the first phase of PREIT's premier redevelopment project -- Fashion District Philadelphia -- is set to open next month.
The additional rent from new tenants that will open their doors soon, along with the reversal of co-tenancy impacts, is likely to get FFO growing again starting in Q4. PREIT has also started to market land parcels at many of its malls in the Philadelphia and Washington, D.C., metro areas to multifamily developers. The REIT expects to generate $150 million to $300 million of land sale proceeds over the next few quarters, which it will use to shore up its balance sheet.
By this time next year, PREIT should have an improved balance sheet and higher FFO. That will put it in a strong position to handle a potential J.C. Penney bankruptcy or other department store closures that would necessitate a new round of redevelopment work. With PREIT stock now trading for less than four times FFO, the upside for investors if FFO returns to growth as expected far outweighs the risk that further setbacks undermine PREIT's turnaround.
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This article was originally published on Fool.com