Despite Falling Brick-and-Mortar Sales, Mall REITs' Cash Flows Should Stay Positive

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

• The coronavirus pandemic has had a massive impact on the retail industry, causing large year-over-year declines for most sales categories. After growing 4.0% in the first quarter, total retail sales (excluding motor vehicles) declined 10.0% in April and 0.7% in May. However, these numbers were supported by grocery store sales, which grew 12.4% in April and 14.5% in May, and by nonstore sales (which includes most of e-commerce sales), which grew 22.8% in April and 30.8% in May. Restricting our definition of retail sales to the categories of retail that constitute the tenants of most malls and shopping centers results in total brick-and-mortar retail sales dropping 29.9% in April and 16.9%% in May.
• Despite brick-and-mortar stores across the country closing for part of the quarter, e-commerce sales growth decelerated in the first quarter of 2020 to 14.8%, from 16.6% in the fourth quarter of 2019 and 17.3% in the third quarter of 2019. These figures produce spreads over total retail sales that are all relatively in line with the historical trend of downward-sloping e-commerce sales growth. While nonstore sales growth, which is a close proxy for e-commerce sales growth, picked up in April and May, we believe that e-commerce sales growth will match the historical trend once the current crisis has passed.
• We believe that the recession caused by the pandemic will cause modified retail sales to decline 3.5% in 2020, but the economy should recover quickly in 2021 and retail sales should see 6.7% growth. We forecast e-commerce sales will see 15.8% growth in 2020, which is nearly 20% above total retail sales, as people staying home during the pandemic will do much of their shopping online. However, the one-time nature of the event will make year-over-year growth slow in 2021 for e-commerce sales to just 8.2%. These assumptions lead to brick-and-mortar retail seeing an 8.9% decline in sales in 2020 followed by a 6.7% recovery in 2021. We assume that retail will resume its long-term trends in 2022, but that the 2020 shock leads to some shopping habits permanently shifting online, slightly reducing our outlook for brick-and-mortar sales over the rest of the decade.
• The 2020 sales decline will lead to market rents falling for most retail centers. As a result, the mall REITs will see their re-leasing spreads decline from double-digit positives over the past decade to negative territory over the next decade. Additionally, we believe that retailer bankruptcies will lead to lower occupancy rates and that unpaid rent and rent concessions in 2020 will reduce the revenue for the mall REITs substantially in 2020 and beyond.
• Despite the declines in revenue, we believe that Macerich and Simon Property Group will continue to produce positive operating cash flow, which should help both companies avoid any major issues with repaying their debt upon maturation. Macerich has already reduced its dividend to $0.10 per share, a step that we estimate will help keep the company cash flow positive through the current crisis. With Simon's recent cut in its dividend to $1.30 per share from $2.10, we believe that the company should be able to continue producing positive operating cash flows while still meeting the dividend requirements necessary to maintain its REIT status.
• In our bear-case scenario, we assume that e-commerce sales will continue to see growth through the rest of 2020 close to the level it saw in the second quarter, and 2021 will see only a small relative decline in sales growth. We also assume that the REITs will see greater occupancy declines and be forced to make greater rent concessions. Even with these conservative estimates, we still project Macerich and Simon as producing positive cash flow as early as 2021. Both companies are trading about 35% below our bear-case fair value estimates of $13.50 for Macerich and $92 for Simon.

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.