The brick-and-mortar retail industry is certainly undergoing a transitionary period. The traditional mall setup consisting of a few big department stores, a food court, and many smaller retailers isn't working too well these days.
Fortunately, there are some real estate investment trusts, or REITs, that specialize in malls that are well positioned to not only survive but to thrive in the new retail world. Here's an overview of what REITs are, why you might want to add some to your portfolio, and three mall REITs that could be big long-term winners.
Image source: Getty Images.
What is a REIT?
A real estate investment trust, or REIT , is essentially a pool of investor money that is used to invest in real estate assets. Equity REITs , which are the most common type, invest in commercial properties. Just to name a few of the property types they own, there are equity REITs that specialize in apartment buildings, offices, industrial properties, healthcare facilities, hotels, and malls, as we're focusing on here. There are also Mortgage REITs , which own assets such as mortgage-backed securities and mortgage servicing rights, but not physical properties. However, when we refer to "REITs," we're generally talking about equity REITs, so for the rest of this discussion, all of the REIT topics I mention will be tailored to equity REITs in particular.
REITs benefit from an advantageous tax structure in exchange for meeting certain requirements. Specifically, a REIT must invest at least three-fourths of its assets in real estate investments and must derive at least three-fourths of its income from rent or other sources derived directly from its real estate investments. Furthermore, a REIT must also distribute at least 90% of its taxable income to shareholders.
If a REIT meets these requirements, it will not be taxed at the corporate level -- a big advantage. Investors in most companies effectively pay taxes twice. When a company earns a profit, it typically has to pay corporate tax before it can use its profits to distribute to shareholders. Once a dividend is paid, investors can be taxed again on this dividend income. A REIT's income is only taxed once -- after it is paid to shareholders.
5 Important metrics for REIT investors
Before we go any further, it's important for REIT investors to know certain metrics that can help evaluate this unique type of stock. Simply put, some of the most common metrics used by stock investors, such as "earnings per share," don't translate well to REIT applications. With that in mind, here are a few metrics REIT investors should know.
- Funds from operations (FFO): This is the most important metric for REIT investors to know, as it is the "earnings" of the REIT world. The simplified version of why this is needed is that real estate investments are allowed to be depreciated over a number of years. In a nutshell, depreciation essentially means that a certain expense is written off for tax purposes, a little bit at a time. This depreciation looks like a big expense for a REIT, even though the company isn't actually spending a dime. The effect of this is that a REIT's "earnings" or "net income" looks much lower than it actually is. FFO solves this problem by adding depreciation back in, as well as by making some other adjustments in order to accurately depict a REIT's income.
- Adjusted/core/normalized FFO: These are similar in nature to FFO as described above, and some companies use these to account for company-specific adjustments, one-time items, and other factors in order to give investors the best possible picture of how much money the REIT is earning. For example, if a REIT made an uncharacteristically large sale of properties, it could distort the company's FFO. Or, if a REIT has lots of foreign exposure, foreign exchange fluctuations can easily make FFO look like the company did significantly better or worse than it actually did.
- Net asset value (NAV): Because of how depreciation works, it makes it look like a REIT's property values decline over time, when in fact the opposite is generally true. Net asset value, or NAV, is the actual market value of a REIT's properties, minus any debts.
- Capitalization rate: Also referred to as " cap rate ," this is a real estate metric that is used to express the profitability of properties, relative to cost. It can be calculated by dividing a property's annual income by its acquisition cost. For example, a 6% cap rate on a $1 million property implies that the property produces $60,000 in annual income.
- Debt to equity: Most REITs use some level of debt to finance their properties in order to boost return potential. However, too much debt can be dangerous. So, it's useful to use debt metrics such as debt to equity or debt to capitalization to determine if a company uses an appropriate level of debt. For example, if the average hotel REIT has a debt-to-equity ratio of 30% and you're evaluating a REIT with a 50% debt to equity, it could be a sign that the company is carrying too much leverage.
Why invest in REITs?
There are several reasons why REITs can make good long-term investments.
First off, because of their advantageous tax structure, REITs tend to pay higher-than-average dividends. To be clear, REIT dividends are typically treated as ordinary income and not as qualified dividends, which are entitled to favorable tax rates. For example, if you're in the 32% tax bracket in 2018, your REIT dividends would generally be taxed at this rate, while qualified stock dividends would be taxed at just 15%. This also makes REITs an excellent choice to hold in tax-advantaged retirement accounts like IRAs.
REITs can also help add diversification to your portfolio, meaning that they can help you spread your investment dollars across different asset classes. Many financial advisors suggest that investors should keep a portion of their assets in real estate, and REITs can allow you to do that without the hassle of owning rental properties.
REITs can be excellent "total return" investments over the long run. A total return refers to an investment's dividend yield plus its share-price appreciation. For example, a dividend yield of 4% and stock-price appreciation of 6% would equal a 10% total return. Not only do REITs generally produce higher-than-average dividends, as I already mentioned, but they also benefit from property values that (hopefully) increase over time. This combination can produce some impressive total returns.
Wait, aren't malls in trouble?
Sort of. It would be silly not to acknowledge the headwinds malls are facing right now. If you look over a list of retail bankruptcies from the past few years, you'll see several high-profile names that were largely mall-based, such as Aeropostale, Pacific Sunwear, and Radio Shack, just to name a few. In all, 24 major retailers went bankrupt in 2017 alone, not to mention countless smaller mall tenants.
In addition, many other retailers are closing large numbers of stores, choosing to focus more on their online business instead. Even once-great department stores like Sears and J.C. Penney are struggling to survive . In fact, Sears recently announced plans to close an additional 72 unprofitable stores in 2018, on top of the 381 locations the company has shuttered during the past year alone. Closings of these anchor stores can be devastating to many malls, as they leave a massive amount of vacant space that can be difficult to fill without substantial modifications.
Simply put, e-commerce has made the traditional mall business model difficult to profit from. Pricing pressure is driving many traditionally full-priced (nondiscount-oriented) tenants out the door.
However, not all malls are in the same position when it comes to the next step after troubled tenants leave. Lower-quality malls, which are often referred to as "B"- and "C"-level malls, are certainly feeling lots of pain. Many readers know of a mall nearby with tons of vacancies that has gone downhill over the past few years.
On the other hand, so-called "A" mall operators are doing quite well. These are operators of top-notch malls with modern amenities, lots of dining options, and with malls located in highly desirable areas. More importantly, these are the mall operators with the financial flexibility to adapt to the changing retail environment. For example, one of the mall operators I'm about to discuss plans to convert closing Sears and J.C. Penney stores into spaces such as hotels, entertainment complexes, and even more dining options.
To illustrate this, consider that retail rental rates have grown at an average of 1% annually since 2011, and Class A malls are largely fueling this. In fact, Class B and C malls have seen negative 3% annual rent growth during that time.
3 top mall REITs to consider
With that in mind, here are three mall REITs that are certainly worth a look. Two of them are "A" mall operators, while another specializes in another type of retail property that is well positioned for the changing retail environment: discount-based retail.
Here are my three favorite mall REITs now and why each one could be a smart addition to your portfolio.
Price to FFO
Simon Property Group (NYSE: SPG)
Tanger Factory Outlets (NYSE: SKT)
Macerich (NYSE: MAC)
Data Source: TD Ameritrade . Prices, yields, and P/FFO metrics as of June 13, 2018. P/FFO based on the midpoint of each company's 2018 guidance.
The largest mall REIT has the best ability to adapt
Simon Property Group is not only the largest mall REIT, but it is one of the largest REITs of any kind in the market. The company operates 217 retail properties, including those under its "The Mills" and "Premium Outlets" brand names. Among Simon's portfolio are some of the most valuable and high-end malls in the U.S., with five of the 10 most valuable REIT-owned malls and many others that are very high end.
Just like most other U.S. mall operators, Simon is absolutely feeling the effects of the changing retail landscape. The big difference is that Simon has the financial flexibility to adapt to these changes, thanks to its size, deep pockets, and high credit rating that gives the company more borrowing ability than its mall REIT peers.
One big component of Simon's current strategy is to transform its properties into "mixed-use" centers, which incorporate elements that are outside the retail realm, such as hotels, apartments, office buildings, and entertainment properties.
During 2017 alone, Simon opened three hotels, a 120,000-square-foot office space, and a 300-plus unit residential development at its malls. Simon and Marriott recently announced plans to open at least five hotels in Simon's retail properties over the next few years. Basically, the logic is that if people are staying, living, working, or being entertained at a mall, there's a natural source of foot traffic to the retailers.
Furthermore, because of its vast resources, Simon views closures of department stores as some of its biggest opportunities to stand out from the competition. In fact, after Sears announced its most recent wave of closures, Simon issued a press release expressing its intention to transform former Sears locations into new retail, fitness, dining, and entertainment concepts, as well as more mixed-use properties. As Simon's Chief Operating Officer Michael E. McCarty said, "As Sears continues to liquidate its stores, it's a terrific opportunity for us to recapture this real estate and redevelop it in a brand-positive way."
In a nutshell, Simon may be the best-positioned mall REIT to adapt to the changing retail environment, and as a result, should end up even stronger as a result. And in the meantime, the stock is trading for a remarkably low price-to-FFO valuation thanks to the aforementioned retail headwinds, as well as pressures on the entire REIT sector caused by rising interest rates, and will pay you a dividend yield of more than 4.7% .
Outlet retail should do just fine, and this pure-play outlet REIT is a bargain
Tanger Factory Outlet Centers, as the name implies, is a pure-play REIT on outlet malls. Tanger owns 44 outlet centers in 22 states and Canada, with about 15.3 million rentable square feet. This puts Tanger's outlet portfolio in a distant second to Simon's, but it's important to point out that Tanger is much larger than any other competitors. In other words, when it comes to outlet malls, there's Simon, Tanger, and everyone else.
Discount-oriented retail is doing well, even with the rise of e-commerce. You can see this with the recent results from Five Below , TJX Companies , and many other discounters. Tanger is also a recession-resistant business, as most discount-oriented forms of retail are. As CEO Steven Tanger has said, "In good times, people love a bargain, and in tough times, people need a bargain."
To be clear, outlet retail is made up of discount-based stores, but they are generally discount versions of full-price retail, which has been susceptible to e-commerce headwinds in recent years. However, outlets have the advantage of easily reconfigurable stores. Typically, outlet retail isn't nearly as "built out" as a retailer's full-priced stores, and refitting the space for a new tenant is relatively easy.
Since Tanger's 1993 IPO, the company has ended every single year with occupancy of 95% or more, and currently has 96% of its rentable space occupied. While sales per square foot have dropped a bit over the past few years (down less than 3% since peaking in 2015), considering the big shift to e-commerce, this is actually quite mild.
Another reason I love Tanger is for its long-term growth potential. The outlet shopping industry is relatively small -- the total high-quality outlet space in the U.S. is approximately the same as the retail space in the city of Chicago alone. In other words, there's room for growth. And Tanger is only in a small portion of its addressable markets.
It would be fair to call Tanger Factory Outlet Centers the riskiest stock of the three mentioned here, so if you invest, be prepared for some volatility, at least in the near term. However, the stock's rock-bottom valuation of just 9.2 times expected 2018 FFO and its 6.3% dividend yield make it an attractive long-term play for investors with the time and patience to let the new retail environment continue to evolve.
Top-notch malls in attractive markets
Macerich owns shopping centers and malls, and although it is significantly smaller than Simon Property Group, it is still one of the largest retail REITs in the market.
Macerich's strategy is to develop "town squares," which is the company's term for shopping centers that also have residential, hotel, office, and/or entertainment components. Like Simon, a big part of Macerich's strategy is adding components to their malls that enhance the in-person retail experience, such as fitness centers, entertainment options, and more.
"Flagship" stores are also a big focus area of Macerich -- larger apparel, electronics, and other types of stores are doing a great job of attracting foot traffic. Companies such as Apple , Tesla , and Sephora are emphasizing these types of locations, and have leased a significant amount of space in Macerich's properties during the past three years. Meanwhile, the percentage of rent that comes from traditional department stores like J.C. Penney and Sears has declined by 22% over the past five years.
The majority of Macerich's properties are located in affluent, densely populated areas. Macerich's malls generated $686 in sales per square foot during the first quarter of 2018, 47% higher than the U.S. mall average. They are located in areas where the population is forecasted to grow faster than the national average, and where household incomes are nearly $10,000 higher on average.
The numbers show how well Macerich's properties are doing in the new retail environment. The company's malls are 94% occupied, and same-center NOI (net operating income), which is a metric that tells us how much income growth a REIT is seeing in properties that it has held for over a year, has grown at an impressive 4.7% rate over the past three years, 200 basis points higher than the average mall REIT.
Finally, Macerich has done a good job of capital recycling -- that is, disposing of underperforming or non-core assets and reinvesting in more attractive long-term opportunities. Since 2013, the company has sold 21 of its mall properties, bringing in a total of $1.5 billion, and has invested in redevelopment of some of its most promising properties.
Invest from a long-term perspective
As a final thought, it's important to point out that equity REIT investments like these should be approached with a long-term mentality.
While I completely believe that all three of these REITs' businesses will do just fine over time, there are short-term headwinds that could make them quite volatile over shorter periods. For example, REITs tend to be rather vulnerable to interest rate fluctuations . Rising interest rates tend to put pressure on income-focused investments like REITs, which is actually the main reason REITs have underperformed the market over the past couple of years.
In a nutshell, income investors expect to get a risk premium when they buy stocks (like REITs), as opposed to risk-free investments like Treasury bonds. (Note: The 10-year Treasury is generally a good indicator for REIT pressure.) When the rates paid by these risk-free investments rise, REIT yields tend to rise as well, which translates to lower share prices.
There are also some headwinds specific to mall REITs that could cause short-term volatility. For one thing, there's no telling what retailers could be next to file bankruptcy, and when situations like that arise, it could weigh on these stocks as the companies figure out the best way to move forward.
The point is that there's no way to tell how well these stocks will perform over the next few months or even the next year or two. However, if you invest in these for the long run, you'll be able to take full advantage of the long-term compounding power of these winning mall REITs.
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Matthew Frankel owns shares of Apple and Tanger Factory Outlet Centers. The Motley Fool owns shares of and recommends Apple and Tesla. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool recommends Five Below. The Motley Fool has a disclosure policy .
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of NASDAQ, Inc.