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Mall owners go from first to last in REIT market

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Shopping mall owners, the best-performing U.S. property stocks for four years, have tumbled to the worst as sluggish retail sales and limited opportunities to expand drive investors to look elsewhere for earnings growth.

Real estate investment trusts that own regional malls reported the smallest increase in tenant sales per square foot in three years in the second quarter, according to data compiled by Bloomberg. This came as major mall retailer Nordstrom Inc. cut its revenue forecast for the year and Macy’s Inc. and Aeropostale Inc. disclosed declines in consumer purchases.

Slowing sales among retailers and rising borrowing costs are sparking concern that mall landlords, including the two largest, Simon Property Group Inc. and General Growth Properties Inc., could be hurt, too. Mall REITs have enjoyed strong tenant-sales growth since the credit crisis and recession, letting them increase rents. Now they face difficult comparisons to past results and limited avenues for external expansion.

“REITs have had a tough year across the board, and the mall REITs have had a tougher year in general,” said Benjamin Yang, an analyst at Evercore Partners in San Francisco. “Fundamentals are good but they’re slowing down.”

The Bloomberg mall REIT index has fallen 5.4 percent this year, the worst performing part of the industry, after posting the biggest increases from the start of 2009 through 2012. Even shares of outlet-center operator Tanger Factory Outlet Centers Inc., whose sole business is in one of the best-performing segments of the retail-property market, are down 5.5 percent this year.

Growth peaks

Growth in mall-tenant sales, which rose 4.3 percent in the second quarter from a year earlier, peaked in the three months through June 2012 and has slowed each quarter since, according to Bloomberg Industries.

Simon Property and General Growth last quarter beat analysts’ estimates for funds from operations, a measure of cash flow used by the REIT industry. While results have been positive for mall REITs overall, they’ve been overshadowed by the potential impact of higher borrowing costs on property valuations, said Keith Bokota, an analyst at Principal Global Investors, part of insurance and financial services company Principal Financial Group Inc.

“When we look at the fundamentals that these companies are delivering, they’re strong,” said Bokota, whose Des Moines, Iowa-based firm owned shares of mall REITs including Simon and Taubman Centers Inc. at the end of July. “The rising interest rates have impacted the way REITs have traded recently.”

Treasury yield

The 10-year Treasury yield has climbed to 2.9 percent, from 1.63 percent on May 2, its low for the year, while the Bloomberg mall REIT index has fallen 18 percent since May 21, its high for 2013. The cost of raising money from the commercial mortgage-backed securities market has also increased.

Top-ranked bonds linked to commercial mortgages are yielding 129 basis points more than Treasuries from 88 basis points on Jan. 14, according to a Bank of America Merrill Lynch index. The spread peaked at 153 basis points, or 1.53 percentage points, on July 8.

Shares in Indianapolis-based Simon have fallen 18 percent since May 21, even as the company on July 29 reported an increase in second-quarter funds from operations and raised its FFO forecast for the year as it redevelops centers domestically and expands overseas.

“Our business is strong and our cash flow is growing,” CEO David Simon said.

Borrowing costs

Aside from higher borrowing costs, REITs have few chances to buy high-quality malls because those properties rarely come on the market, with publicly traded landlords owning most of the best-performing centers, said Rich Moore, an analyst at RBC Capital Markets in Solon, Ohio.

“They’re so lucrative that no one gets rid of them,” he said.

Regional-mall transactions are down 49 percent, to $4.5 billion, this year from the same period in 2012, according to Real Capital Analytics Inc., a commercial-property research firm in New York.

“There continues to be robust demand from investors for these high-quality assets,” Bokota said. “There’s just a scarcity characteristic.”

Slowing sales in the second quarter were reported by retailers including traditional mall anchor Macy’s, and apparel chains Aeropostale and Abercrombie & Fitch Co. said traffic at stores declined.

Sales forecasts

Nordstrom, the Seattle-based department-store chain, last month lowered its total-sales forecast for the year to an increase of 3 percent to 4 percent, down from a previous estimate of 4 percent to 6 percent. Cincinnati-based Macy’s cut its forecast for earnings for the year ending in January as sales at stores open at least a year fell 0.8 percent in the second quarter from a year earlier.

Aeropostale, a New York-based clothing store that targets young people, said on Aug. 22 that second-quarter net sales fell 6 percent and comparable sales, including online sales, dropped 15 percent.

Mall owners may be cushioned from the impact of their tenants’ slowing sales because occupancies are high, said Cedrik Lachance, an analyst at Green Street Advisors Inc. in Newport Beach, Calif.

Vacancies fall

At regional malls, which typically include department stores, vacancies fell to 8.3 percent in the second quarter from 8.9 percent a year earlier, and rents rose to $39.62 a square foot from $39.12, according to data from New York-based research firm Reis Inc.

“The malls currently are better occupied than they’ve ever been,” Lachance said. “That does provide some pricing power to the landlords despite some softness emerging in retailer sales and retailer profitability.”

The struggles of J.C. Penney Co. have led to questions about the health of malls. While the decline in sales has slowed under new CEO Mike Ullman, they were down 12 percent in the second quarter. That compared with a 23-percent decline a year earlier, when former CEO Ron Johnson led the company. The company owns 429 of the 1,104 department stores it operates in the U.S. and Puerto Rico, according to the company’s latest annual report.

Even if J.C. Penney got into more serious trouble, the impact on mall REITs would be minimal, and “it’s highly unlikely” it will disappear, said Rich Moore, an analyst at RBC Capital Markets in Solon, Ohio.

Big box

“Most of the landlords would tell you they would love to get their J.C. Penney box back,” Moore said, adding that the stores could be rented to another department-store chain or torn down and replaced with smaller shops, movie theaters or restaurants. “Most of these guys would say, ‘Great.’”

Outlet centers, where brand-name retailers sell goods at discounted prices, are performing better than other retail-property types as consumers seek more-affordable apparel and other goods, according to Craig Guttenplan, a REIT analyst at CreditSights Inc. in London.

“Consumers like the bargains still,” he said. “They’re still cautious on spending.”

The popularity of outlet centers has led some traditional-mall REITs, including CBL & Associates Properties Inc., Taubman and Macerich Co., to enter the business.

‘Good price’

Chudi Aguanunu, who works at Street Talk, a mobile-phone accessories kiosk in Macerich’s Shops at North Bridge on Chicago’s Michigan Avenue, goes to outlet malls or online when he wants something. The Shops at North Bridge, which caters in part to tourists, has stores including Nordstrom and Hugo Boss.

“It’s got to be at a good price,” said Aguanunu, 25, a former walk-on offensive lineman with the University of Illinois football team. “I’m not going to spend $100 for a T-shirt.”

The shares of Tanger, which operates only outlet malls, may be under pressure because of increased competition from other landlords expanding into the business, said Yang of Evercore. Greensboro, North Carolina-based Tanger owned and operated 36 outlet centers as of June 30, and held stakes in seven other properties, including three in Canada, according to a regulatory filing.

“There’s clearly an abundance of new players in a sector that for the most part is much healthier than the malls,” Yang said. “During and following the recession, consumers were clearly looking for value.”

Top performers

Hoteliers and self-storage landlords are the top-performing REIT sectors this year. Since REIT shares peaked on May 21, lodging and storage companies have fallen less than other groups, while the performance of single-tenant, health-care and mall REITs—which have longer leases, giving them less flexibility to raise rents—has been among the worst as other REIT types become more appealing to investors.

“It’s all about choices,” Yang said. “There appear to be more-attractive, better-accelerating core growth stories, perhaps, in some of the other sectors.”

With few high-quality malls for sale, landlords are focusing on sprucing up their existing properties to boost traffic and rents at their properties.

“The one other growth avenue that a lot of the companies are pursuing is active redevelopment,” Bokota said. “That’s where they’re putting a lot of their cash flow and new dollars to work.”

Redevelopment spending

Simon had $212 million in mall-redevelopment projects in progress in the second quarter, with a projected rate of return of 8 percent, according to a regulatory filing. The figure is Simon’s share of construction costs at properties it owns outright or has an ownership stake. Chicago-based General Growth has invested $356 million on redevelopment and expansion with an expected return of as much as 11 percent, according to a regulatory filing.

Shares of Simon—which has 22 buy ratings from analysts, five holds and no sells, according to data compiled by Bloomberg, and is the largest U.S. outlet-mall owner—have fallen 18 percent since the REIT slide began in May.

That decline led Paul Adornato, an analyst at BMO Capital Markets in New York to upgrade Simon’s shares on Aug. 23 to outperform, the equivalent of a buy, based on the company’s valuation.

“We like their business mix,” Adornato said. “They have the greatest exposure to the outlet business.”

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