Outlet Sale at Tanger

The consideration received for these five centers seems low, considering that they represent 14% of Tanger's presale 37-asset consolidated center portfolio. Four of the five centers were sold for an aggregate $44 million, or an average of $11 million each, far below what we think Tanger's average center is worth. We think this low average price reflects relatively higher near-term capital expenditure requirements and lower growth prospects as well as smaller size (roughly 110,000 square feet per center versus more than 300,000 square feet for the rest of Tanger's consolidated portfolio), lower productivity ($252 in tenant sales per square foot versus roughly $400), and small aggregate net operating income (less than 2% of total portfolio net operating income).

While Tanger also deems the fifth asset sold as noncore, it is a very productive center, with tenant sales per square foot of $803. The fifth center generated 2.5% of Tanger's net operating income, and Tanger received $106.7 million for this asset, representing a 5.8% cap rate.

Asset sales in the outlet industry are generally rare, and these transactions provide current data points for investors to consider the potential implied value of Tanger's portfolio. The fifth center's 5.8% cap rate is more in line with our expectations for Tanger's centers in general. Applying a 5.8% cap rate to our forecast for 2016 adjusted net operating income implies a price per share of $41, in line with our fair value estimate.

Tanger remains one of our favorite REITs. With an expected 2016 cash flow yield of 6%-plus at recent prices (using our 2016 estimate for normalized adjusted funds from operations) combined with at least mid-single-digit growth prospects, Tanger offers investors an attractive total return opportunity, in our opinion.

Positioned Well, Even if Interest Rates Rise We estimate that Tanger's in-place rents are roughly 10% below current market rates, providing nice prospects for internal growth over time. Tanger's tenants' average cost of occupancy of roughly 9% of sales is low both relative to the 10% or so Tanger targets on new leases and the low- to mid-teens level normally associated with traditional malls. We think Tanger's tenants can pay higher rates over time, and we think retailers' demand for outlet space will remain strong, given the outlet channel's lower costs and higher profits than traditional malls. Tanger's recent levels of high-90s occupancy reflect retailers' strong demand for outlet space. Retailers' product strategies have evolved, with many now having separate products and strategies for the outlet channel as opposed to simply using it to move excess or damaged full-price inventory. This retailer interest drives demand for Tanger's existing centers as well as new construction, as does end consumer demand, which tends to hold up well in both good and bad economic times.

We think the North America outlet channel may be able to support an increase in square footage of as much as 60%, providing Tanger and Simon Property Group SPG (the other major outlet landlord) long potential runways for growth in this property type. We expect Tanger to win its fair share of incremental developments in the United States and Canada, consistent with its current pipeline of projects.

While we view potentially higher interest rates as a headwind for REITs in general, Tanger is well positioned, given its prospects for cash flow expansion and its conservative capital structure, both of which should help it mitigate potentially higher interest rates better than the average REIT we follow. As such, we expect cash flows to support higher dividends, which have been increased each year since its 1993 initial public offering, averaging 4.6% annual growth.

Efficient Scale Results in Narrow Moat To build a successful new outlet center, landlords need strong retailer support. Without agreements that retailers will open stores in newly developed locations, the economics of outlet developments are unattractive. Furthermore, retailers are reluctant to open new stores in locations that might cannibalize sales at existing locations. Consequently, outlet development has largely been rational over the years, regulated by aggregate retailer demand for incremental space. Although outlets have traditionally been located outside urban centers in areas where land is available for incremental construction, overbuilding has not been a problem, because it is difficult to get retailer and financier support for projects that need to take share from existing centers to pay off. Landlords that own successful centers can generally construct additions and/or upgrade tenant rosters to make them even more attractive to retailers and consumers--and even harder to challenge with new developments. As a result, we think Tanger's outlet centers benefit from efficient scale.

Furthermore, outlet channels tend to be one of the most profitable distribution platforms for retailers. Occupancy costs are lower than full-line stores, staff and other operating costs required to run the stores are usually lower, and sales per square foot are often higher. As a result, an increasing number of retailers have pursued expanded outlet strategies over time, a trend we expect to continue. For this reason, we think the outlet distribution channel benefits from a cost advantage relative to traditional retail distribution channels. Although we do not explicitly attribute this as a source of competitive advantage for Tanger, we do think it supports our positive long-term outlook.

In our opinion, Tanger's financial and operating results reflect its narrow moat. The severe economic downturn during the global financial crisis does not seem to be reflected in its financial results. Since 2008, year-end occupancy has bounced between 96% and 99%, with an average near 98%. The property net operating income margin stayed in a range of 65%-68%, with an average of roughly 67%. Same-store NOI growth averaged nearly 4%, without any annual declines. We view these results as outstanding, especially in light of the performance of many other retail REITs that suffered meaningful declines in occupancy and same-store NOI during this time.

We attribute Tanger's moatworthy financial performance to an outlet retail concept that enjoys consumer demand across economic cycles and gradually increasing acceptance by retailers, an operating platform that offers retailers wide distribution without saturation or cannibalization of full-price stores, and leases that allow Tanger to share in tenants' increased sales over time. These factors have enabled tenants to be successful at Tanger centers and allowed the company to maintain high occupancy rates, driving stable financial results and higher rents over time.

Waning Demand Is Biggest Risk Tanger depends on the health of its retail tenants, which ultimately depends on the health of the U.S. consumer, levels of consumer spending, and consumers' attitudes toward outlet center wares. During times of economic weakness, some tenants may pursue better lease terms, scale back expansion plans, or even file for bankruptcy. Many of Tanger's outlet centers are located in tourist destinations, so they may be hurt by reduced travel. International travel may be hurt by a strong dollar, and Tanger is somewhat exposed to this, given its exposure to properties in Canada. In addition, tenant concentration could be a risk, as its top 10 tenants occupy 36% of its total gross leasable area.

Simon and new entrants Taubman TCO, Macerich MAC, and CBL CBL, among others, bring intensified competition to the outlet center industry. As other landlords catch on to the attractiveness of the outlet format, future returns may come under pressure. This concern has gained prominence lately, as the industry's development pipeline (along with Tanger's) has increased. Tanger's aggressive external expansion projects, including recent and potential future acquisitions and new developments in the U.S. and Canada, add risk and uncertainty relative to the generally stable cash flows of its legacy portfolio, although we remain comfortable with Tanger's disciplined capital-allocation policies. Potentially, the biggest risk to our bullish thesis on Tanger's business is waning consumer and retailer demand for the outlet concept.

Stewardship Is Exemplary Since its 1993 initial public offering, we estimate that Tanger has delivered total returns to shareholders averaging roughly 15% per year, far outpacing the sub-10% returns of the S&P 500 index. Furthermore, Tanger has increased its dividend all 22 years it has been a public company, including during the global financial crisis, a rarity among REITs. Average annual dividend growth since the IPO has been 4.5%. We think these desirable results are a combination of Tanger's solid strategy focusing on outlets, an area of retail that has blossomed since the company's IPO, and its disciplined approach to developments.

Capital allocation has been very good historically, with the firm walking away from projects where preleasing falls short of requirements and/or return prospects are below desired thresholds. Furthermore, Tanger has recently shown a willingness to partner with others (including peer Simon) on projects where the local market is unlikely to support multiple new developments. Currently, Tanger expects stabilized returns on U.S. development capital of 9%-11%, which is very attractive compared with our 7% or so estimate for Tanger's weighted average cost of capital.