Simon Sets the Industry Standard

We think mall owner and operator

Although bigger is not necessarily better, Simon has amassed and refined a portfolio of high-quality, geographically diversified, productive regional mall and outlet properties that we believe will remain an important part of retailers’ increasingly omnichannel retailing strategies, earning the firm its narrow economic moat.

We also expect Simon to remain an exemplary steward of shareholder capital, remaining disciplined in its investment approach and reinvesting in its assets while maintaining an enviable and flexible fortress balance sheet, supporting future performance.

Despite its massive scale and the ongoing pressure from e-commerce on retailers, Simon still possesses several avenues for growth. Occupancy cost for Simon’s tenants currently averages roughly 13%, below the midteens level we believe tenants can sustain, giving additional room for rent growth if not a buffer for potential weakness in tenant sales. Also, Simon’s premium outlets have experienced stable, robust demand as retailers continue to capitalize on consumers’ shift toward finding value. And with its growing international presence in Asia and Europe, Simon increasingly represents an effective retail distribution channel and partner across a wide range of attractive geographies and customer segments for retailers, potentially bolstering demand across its portfolio. Even though the transitioning future of retail will require Simon to aggressively manage and actively reinvest in its portfolio, we are confident that the underlying quality of the company and its assets will continue to set the industry standard.

Network Effect and Efficient Scale Dig Narrow Moat Retailers ultimately want to be in distribution channels where their customers shop and where they have the best chance of financial success. To this point, Simon's malls tend to be premier retail centers located in trade areas catering to demographically attractive customer segments. Additionally, Simon spends significant capital on advertising and redeveloping its properties with the goal of maintaining upscale shopping, dining, and entertainment experiences and environments that appeal to consumers who will browse and buy from multiple stores. In turn, the desirable characteristics of the firm's properties and customers drive demand from top retailers to lease space in Simon's malls. The firm's overall U.S. mall and outlet portfolio tops tenant sales of $600 per square foot, above the rule of thumb for healthy and productive Class A malls of roughly $500, while Simon's top malls surpass $1,000 per square foot. This proven tenant sales productivity further attracts potential tenants, allowing Simon to maintain high levels of occupancy, optimize its tenant mix, and draw more customers and elevate tenant sales, building a beneficial network effect that is realized by the company being able to charge higher rents. This enables Simon to reinvest more in the property.

Simon also benefits from the efficient scale that high-quality, well-located regional malls provide. Class A malls generally represent a critical mass of appealing retail tenants; once retailers have chosen their optimal locations, they are unlikely to open additional stores within a competing trade area that would cannibalize existing store sales, while additional demand for mall retail space is most effectively served by an existing mall leasing out existing space or by expanding the mall. Building a new mall would require significant capital, given the sheer size, representing hundreds of millions or billions of dollars in cost over a time frame that could be multiple years, in addition to the executional risk of acquiring a critical mass of attractive tenants not already in the market or competing for existing tenants, most likely reducing overall market returns and making the project unfeasible. In the case where new mall and outlet construction would be feasible domestically and increasingly internationally, we suspect Simon is one of only a handful of firms with the strong tenant and industry relationships, operational infrastructure, and financial ability to be able to successfully execute. Recent new development targets a 7%-10% rate of return. This, along with the meaningful hurdle to new supply, should allow Simon to capture excess returns into the future.

The strength of Simon’s properties as premier retail locations is evident in the firm’s performance through economic cycles. In 2009, the firm was able to support relatively healthy occupancies of 92% for its regional mall portfolio and 98% for its outlets while maintaining positive re-leasing spreads, increasing average rents, and growing comparable net operating income amid a decrease in tenant sales volume. The natural cyclicality of retail sales and tenant bankruptcies will continue to affect Simon. However, we believe the firm’s properties represent some of the most productive retail locations in their respective markets that retailers are less likely to voluntarily vacate, even in times of economic weakness.

Unlike many other assets, economic returns for long-lived commercial real estate assets depend on both current income and asset price appreciation, ideally calculated through an investment’s internal rate of return. However, it is challenging to attribute excess returns generated through sustainable structural competitive advantages versus those realized through market timing due to the nature of commercial real estate. Also, unlike many assets, which are generally assumed to have shorter, finite lives through depreciation or obsolescence, commercial real estate market values can significantly appreciate and vastly differ from either replacement cost or book value. In the absence of IRR calculations, we attempt to approximate Simon’s economic returns through analyzing an adjusted return on invested capital.

By adjusting our traditional ROIC calculation to only include an estimation of economic depreciation, which we approximate as annual maintenance capital expenditures instead of accounting depreciation, we calculate that Simon has earned an adjusted ROIC 150-300 basis points above our 7.1% weighted average cost of capital estimation over the past 10 years, a very healthy spread within our REIT coverage. These results may be obscured by a significant level of transaction activity, which we predict to continue in the medium term as Simon acquires and develops additional properties, reinvests in its existing properties, and refines its portfolio, given a changing retail industry.

Dependent on Health of Tenants Retail landlords depend on the health of their retail tenants. Several of Simon's major inline tenants have experienced declining sales, expect to close stores, or are in various states of transition, including Gap and Abercrombie & Fitch. Similarly, several major anchors face uncertain futures, such as Macy's and Sears. Anchors do not typically pay significant rent and mainly own their own real estate, but they still contribute to a mall's overall health and can be part of certain co-tenancy clauses with other mall tenants. Cyclicality and tenant bankruptcies are not new to retail; benefiting from its portfolio quality, Simon has been able to successfully re-lease space (sometimes at favorable terms) and maintain occupancies throughout prior cycles and high-profile retailer bankruptcies. Nonetheless, should the general economic or retail outlook deteriorate, demand for retail space may weaken and tenants may pursue better lease terms, pressuring Simon's performance.

While we believe strong regional malls in areas with attractive demographics will remain relevant for the foreseeable future, uncertainty surrounding the eventual effects of increasing e-commerce adoption on retailers’ strategies and demand for physical retail space across various segments will affect Simon’s malls and outlets.

Although Simon’s overall U.S. mall and premium outlet portfolio exhibits healthy operations as measured by average tenant sales productivity and occupancy, there may be several properties where absolute performance falls short. While some assets might be dominant in their local markets, they will be more vulnerable to future economic weakness or volatility. In cases where properties chronically underperform, Simon may be required to invest significant capital or potentially divest when performance and value cannot be recovered.

As a REIT, Simon is required to pay out 90% of its taxable income to shareholders as dividends. Therefore, it has limitations to how much cash from its operations it can retain for investment decisions and relies on capital markets to raise funds for expansion and debt repayment. However, we think Simon has unrivaled access to capital markets in general, given its current strong balance sheet and a large, higher-quality, unencumbered asset base. The company’s common dividend represents 61% of our 2017 estimate for funds from operations, a comfortable payout level allowing for continued dividend growth. We expect mid-single-digit annual increases over the medium term.

Management Is Exemplary Simon has done well by shareholders over the years, delivering shareholder returns that far outpace returns on the market in general. Since its initial public offering in 1993, Simon has produced a nearly 3,000% total return, roughly 5 times that of the S&P 500. We think the firm's dedication to maintaining a quality-focused portfolio will continue to benefit investors as the retailing landscape changes, while we expect disciplined capital allocation to sustain a fortress balance sheet and produce ROICs well above our estimation of Simon's cost of capital. Simon has demonstrated its ability to make meaningful investment decisions, including the spin-off of lower-quality retail assets into a separate publicly traded REIT in 2014 and a failed bid to acquire peer Macerich in 2015. While management recently said it's out of the "big deal" business, we believe it will still make decisions that ultimately benefit shareholders.

The company has been led by chairman and CEO David Simon since 1995. President and COO Richard Sokolov has been with Simon since 1996, previously serving in multiple executive roles and finally as CEO of DeBartolo Realty, a mall REIT purchased by Simon in 1996. The board of directors is made up of primarily independent, well-accomplished members who are elected annually.