Despite Falling Brick-and-Mortar Sales, Mall REITs' Cash Flows Should Stay Positive
Mall closures shifted sales online in the second quarter, but we expect shoppers and positive cash flow will quickly return.
Mall closures shifted sales online in the second quarter, but we expect shoppers and positive cash flow will quickly return.
Brick-and-mortar retail saw a dramatic decline in sales in the second quarter of 2020 as the coronavirus pandemic closed most malls and many nonessential businesses. While total retail sales have declined as the U.S. economy enters a recession as a result of the pandemic’s fallout, e-commerce sales growth has taken off as consumers are forced to stay home and shop online.
The fear many investors have is that the change in consumer behavior will be sticky and the loss in sales will further erode brick-and-mortar retail’s share of total sales, which will pressure the mall real estate investment trusts to produce positive cash flows and stay solvent. However, our analysis shows that outside of recessions, e-commerce sales growth follows a predictable, downward-sloping curve over time. Since we believe that the impact of the pandemic will have dissipated at some point in 2021, we expect e-commerce sales growth will return to its prior level of low-double-digit growth in 2022, which should produce very low but positive sales growth for brick-and-mortar retail. The impact on the mall REITs will be severe in 2020 as the companies will have to deal with the drop in sales lowering market rents and thus re-leasing spreads, retailer bankruptcies causing significant occupancy declines, and unpaid rent and rent relief potentially turning into permanent rent concessions to keep existing tenants.
While all these factors will cause revenue to decline in 2020, we believe that the Class A mall REITs still have plenty of cushion between the lower revenue level and the operating expenses and financial obligations they face. Even in our bear-case scenario, we don’t believe that these companies will face negative cash flows longer than a few quarters, largely thanks to the strength of the Class A mall portfolios these companies own, which shoppers are likely to return to once the pandemic has passed and thus should help attract new tenants. Even though uncertainty surrounding the potential future of brick-and-mortar retail has increased, we think that the fears are overblown. Class A mall REITs Simon Property Group (SPG) and Macerich (MAC) are currently trading at very attractive discounts to our fair value estimates.
Our Key Takeaways
Simon Property Group Looks Attractive at Current Prices
While both Macerich and Simon are trading at significant discounts to their fair value estimates, we recommend investors consider adding Simon to their portfolios, given the company’s lower level of risk. After the coronavirus pandemic passes, we believe that Simon’s Class A mall portfolio will recover and show solid growth over the next decade even as e-commerce applies increasing pressure to brick-and-mortar retail. While many lower-quality malls and retail centers are likely to close in the next few years, Simon’s dominant portfolio should thrive as retailers continue to hold on to their highest-productivity stores and the reduced competition pushes more foot traffic to Simon’s properties.
Additionally, Simon has been a leader in introducing online-only retailers to physical retail. It has created spaces across its portfolio that can be filled with customizable, smaller storefronts on short-term leases for e-tailers looking to experiment with physical stores before they consider rolling out to a larger footprint and more stores. We believe that Simon will be able to convert its online competition into tenants and will have built relationships with these rapidly growing companies as they look to expand into more high-quality locations. The company should see revenue growth strong enough to produce positive cash flows and allow it to meet all its financial obligations with relative ease. We think that the shares have been oversold by investors and that Simon is currently trading at a very attractive discount, given its high-quality portfolio and exemplary management team.
Kevin Brown does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.