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No. of Recommendations: 38
Here's a post I did for Block Party early last month.


Last week one of the many crazoid radical Islamic terrorist groups (it’s hard to keep track of them all – and who wants to?) made headlines by urging followers to attack large shopping malls. The story highlighted the vulnerability of this property type to external terrorist threats, but also reminded us of another important fact: shopping malls remain, despite the inroads of e-commerce, a key feature of the Western lifestyle. Simply put, Americans and Europeans still love to shop, and many malls – especially the best of them – remain alive and well.

Despite recessions and the cyclicality of consumer spending, malls have been a rewarding commercial real estate property type for investors over long time periods. And, although e-commerce has negatively affected mall tenant sales, the most productive malls (measured by tenant sales per square foot) have not experienced difficulties in attracting successful retailers and willing shoppers. Those who believe that malls are “dead men walking” haven’t noticed that there are many shoppers still walking the malls today, and they are very much alive.

We can see this objectively in steadily increasing lease rental rates, as well as rising occupancy rates for small-shop tenants – which now average close to 95% and are at all-time highs. Same-center NOI growth, averaging in the low 4% range, is also hovering near historical highs. The scarcity of new mall developments is a huge tailwind, and is offsetting the impact of e-commerce. Mall tenant sales were flat last year, after a few years of surprisingly good growth coming out of the recession, but it appears from Q4 mall REIT earnings reports that the slowdown is bottoming out.

Solid internal cash flow growth will continue for at least another couple of years, driven by further (albeit more modest) occupancy gains, rent bumps on in-place leases, and impressive re-leasing spreads as rental rates on existing leases are re-priced to market rents upon expiration. But investors do need to be more careful: there will be winners and losers in this space, and it is becoming more important than ever to look for REITs that own malls that are attracting shoppers who have the willingness and wherewithal to spend money on merchandise that – let’s be honest – are non-necessities. Nobody goes to the mall to buy dog kibbles.

As is the situation elsewhere in commercial real estate today, cap rates have compressed and mall values have risen – especially for A-rated mall properties. There has been little change in the values of malls rated B and below. But even for the best malls, cap rates are still not crazy low. A December 3 report on mall REITs issued by Green Street Advisors estimated that cap rates for A and A- properties were, on average, 4.8% and 5.5%, respectively. This is at or about the average cap rates for offices and apartments. And mall REITs were, as of last week, trading at very slight premiums over their estimated NAVs (Macerich Company (MAC), however, is trading at almost a 10% NAV premium due to speculation that Simon Property Group (SPG) might offer to acquire it).

So we are seeing some good values among the mall REITs today. Some investors will look for mall REITs with lower P/AFFO multiples and higher implied cap rates, but these REITs own less-productive properties that have been generating sub-par same-center NOI growth. I favor mall REITs that own the most productive properties, including General Growth Properties (GGP), MAC, SPG and Taubman Centers (TCO), even though their shares are more expensive on those metrics. Except for MAC, they trade at modest to no NAV premiums – and TCO trades at a very substantial NAV discount. I think investors will do better with them, over time, on a total return basis.

Over the next several years, I believe the keys to investment success in the mall sector will be (1) consumer spending, and particularly consumer spending on non-necessities, and (2) the relative attractiveness of large shopping malls as consumer destinations, including their ability to compete with the rising tide of e- commerce. Let’s address these two key points.

We know that that amorphous “middle-class” – however we define it – has suffered from stagnating growth in spendable income. This has contributed to laments about “income inequality” and a rise in economic populism (“let’s stick it to the 1%”). But we’ve never been able to tax our way to prosperity, and rising wages and spendable income will have to come the old-fashioned way – from stronger economic growth. If this doesn’t happen, mall tenant sales will remain flat, and eventually mall lease rates will go sideways. The spending power of that 1% alone won’t propel retailers’ sales, even in the tawniest malls. So, while I am constructive on mall REITs for the next couple of years, I think it’s really important that US GDP and wages begin to grow more substantially over the medium-term.

It is also essential that mall REIT owners do whatever it takes to keep their malls attractive and alluring places that can draw shoppers. E-commerce enables those who need a specific product to shop from their office or den, and to easily compare prices. Malls need to bring the shoppers in, to see, touch and become enchanted with the merchandise. This can be a daunting task, especially when (as now) there are so many entertainment venues. The best mall owners understand that they are in the retail, as well as the real estate, business, and they will have to work harder than ever to help their retailers attract the shopping traffic necessary for continued success.

I believe they can do this, but they must truly understand retail, and perhaps entertainment as well. Malls are not like baseball’s Field of Dreams – even if you build it, they may not come. Mall owners need consumers who desire to spend discretionary income. In that sense, they are quite different from office buildings, where executives and employees need to work together on site, nor like apartment communities, where people need to live and shelter, nor even like warehouses and distribution centers, where goods need to be sent and then shipped off. But, just as Americans will always go to sports events, they will also spend much of their leisure time shopping – but only if the venue is unique, attractive and entertaining.

Shopping malls, while clearly in the commercial real estate mainstream, therefore have some very unique characteristics. Although location is certainly important, the character of the property is equally so. Owners and managers need to be very attentive to the retail – and even entertainment – environment, and they need to have very close relationships with America’s best and most innovative retailers. And they need to be creative in ways that are not as necessary for owners of other property types. It’s a challenging environment, and only the fittest will survive and prosper. Those that do should be able to deliver investment returns in the high single-digits for quite a few years.
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