The retail apocalypse of the past few years has upended the business models of retail-focused real estate investment trusts -- especially those that mainly invest in malls. Recent interest-rate increases haven't helped, either, as income-seeking investors have less need to take on the risk of investing in REITs.
As a result, a wide range of retail REITs, including CBL & Associates Properties (NYSE: CBL), The Macerich Company (NYSE: MAC), Pennsylvania Real Estate Investment Trust (NYSE: PEI), and Washington Prime Group Inc. (NYSE: WPG) have posted big share-price declines over the past three years. Even including the impact of dividends, all four are in negative territory:
Retail REIT stock performance: Data by YCharts.
This REIT stock bloodbath has made shares of CBL, PREIT, and Washington Prime incredibly cheap. (Macerich has a higher-quality portfolio and deservedly carries a much higher valuation.) Yet while CBL and Washington Prime face serious threats to their business models, PREIT is better-positioned. As a result, PREIT stock looks undervalued -- and is now at the top of my watchlist.
The retail REIT sector has changed
In theory, retail REITs have a simple business model. They collect rent checks from tenants and pass most of their income through to shareholders in order to avoid owing taxes. (REITs don't have to pay corporate income tax if they pay out at least 90% of taxable income as dividends.)
In reality, retail REITs have had to act more like developers in recent years. With department stores closing locations left and right, property owners have been scrambling to find replacement tenants for anchors that have closed or are likely to do so in the near future. Typically, this has involved investing a substantial amount of capital to carve up a large department-store building for several smaller tenants.
Finding the capital to fund these redevelopment projects has been challenging in some cases. REIT taxation rules make it hard to retain capital, as most income has to be paid out as dividends.
Meanwhile, rental income has been under pressure due to bankruptcies and store closures among in-line tenants. Many REITs have found themselves forced to invest huge sums of capital just to keep net operating income (NOI) and funds from operations (FFO) stable. This is a key reason why retail REIT stocks have plunged in recent years.
Steadily improving the portfolio
PREIT has certainly faced its share of challenges in recent years. However, management was quick to adapt to the changing retail landscape. Over the past several years, PREIT has been working hard to upgrade its portfolio, both by sprucing up existing properties and by selling off underperformers.
PREIT is steadily replacing department stores with more desirable tenants. Image source: PREIT.
Indeed, PREIT's sales per square foot for in-line tenants (weighted by the NOI contribution of each property) surpassed $500 earlier this year, up 25% from four years earlier. It is steadily moving to replace department stores with more successful tenants that will drive additional traffic to its malls while also paying higher rents.
PREIT has completed several anchor replacements during the past year. It recently announced that it has signed leases with Burlington, Dick's Sporting Goods, and Edge Fitness to replace a Macy's store at the Plymouth Meeting Mall near Philadelphia. All three will open next spring. PREIT is in active negotiations with an arts-and-crafts retailer and a craft brewery to complete that redevelopment project.
Meanwhile, at Willow Grove Park Mall -- PREIT's best mall, as measured by sales per square foot -- a high-end movie theater has leased part of a former J.C. Penney store. This will help PREIT continue to push this property upmarket.
A huge catalyst is coming soon
For the trailing-12-month period, sales per square foot for PREIT's 20 core malls reached $501 (weighted by NOI) or $489 (weighted by gross leasable area). Its top five properties produced nearly 42% of the company's total NOI and averaged sales per square foot of $607 for in-line tenants.
The average quality of PREIT's portfolio will take a big step up next fall upon the opening of its Fashion District Philadelphia development, part of a joint venture with Macerich. This project, located in the heart of Philadelphia, could quickly become PREIT's No. 1 property in terms of sales per square foot.
As a result, PREIT's share of this property's net operating income will likely reach $15 million to $20 million as soon as 2020. That's significant compared to its total annualized NOI of about $230 million. Additionally, following the opening of Fashion District Philadelphia, an even greater percentage of PREIT's income will come from high-quality properties.
PREIT's valuation doesn't make sense
Management expects PREIT to produce adjusted FFO per share of $1.50 to $1.60 in 2018. The stock currently trades for around $10 -- less than seven times estimated FFO. Meanwhile, its dividend yield is a juicy 8.4%.
Shares of Washington Prime and CBL are even cheaper. Washington Prime stock sells for less than five times its projected 2018 FFO per share of $1.48 to $1.56, and has a sky-high 13.6% dividend yield. Meanwhile, CBL trades for a seemingly ridiculous 2.4 times the midpoint of its 2018 FFO guidance and has an 18.8% dividend yield:
2017 Sales per Square Foot (In-line Tenants)
2018 Adjusted FFO Multiple
CBL & Associates
Washington Prime Group
Data sources: PREIT June 2018 presentation, Yahoo! Finance.
As the above chart shows, CBL and Washington Prime's rock-bottom valuations are driven by the low quality of their properties. In 2017, sales per square foot were well below $400 for both companies. That correlates to higher exposure to struggling tenants. It's no coincidence that CBL had to slash its dividend by 25% last year, and recently warned that another cut could be on the way. By contrast, Macerich has a far superior real estate portfolio and trades for a very respectable 15 times FFO.
While PREIT carries a modest stock-market premium over CBL and Washington Prime, its valuation is far closer to those low performers than that of Macerich. However, it already has a significantly stronger asset base. By 2020, it will look even more like Macerich and less like CBL and Washington Prime, thanks to the completion of several anchor redevelopments that are currently underway and the opening of Fashion District Philadelphia.
As PREIT continues to improve the average quality of its portfolio and shows that it can raise its dividend over time rather than cutting it, investors are likely to reward it with a higher valuation. I haven't bought the stock yet, but these qualities have put PREIT at the top of my watchlist.
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