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At the Crossroads

What's the outlook for regional mall REITs? It depends whom you ask.

Investors have shied away from the sector in recent months and REIT analysts have begun to question valuations. But regional mall REIT managers maintain business is strong, fundamentals are solid and, if anything, they are in a stronger position than they were six months ago because market volatility is having a much greater impact on competitors such as private equity funds and other highly leveraged investors.

Fortunately, it won't take long to sort out the puzzle. At press time, regional mall REIT managers were busy preparing third quarter earnings reports, which will illuminate just how malls performed during the tumultuous summer and fall. Meanwhile, the holiday shopping season is set to begin. The next two months will establish the tone for regional mall REITs heading into 2008.

“I think the entire REIT world is stopping and holding its breath,” says Stephannie Mower, executive vice president and managing director of national investment services at Houston-based PM Realty Group. “Everyone is waiting for the other shoe to drop. And a lot of [REIT managers] say they are ‘getting back to fundamentals.’ But I find that scary because it means they're admitting that they got away from fundamentals.”

Investors pull back

From the investor perspective, regional mall REITs have become popular targets. The sector has been one of the strongest of all REIT sectors during the seven-year bull run. In the years 2000 to 2006, regional mall REITs averaged total returns of 31.1 percent, according to figures from NAREIT. This year that's all changed. At the end of September regional mall REITs had posted total returns year-to-date of just 2.5 percent.

For years, it seemed, the sector could do no wrong. But the longer any bull run lasts, the more skittish investors get. They begin to look for a reason to sell. And as the nervousness mounts, it means only a little nudge can send them fleeing.

That's where the deflating housing bubble factors into the equation.

Combine concerns about waning consumer spending along with fears that all real estate — not just houses — might be overvalued and retail REITs begin to look frightening, no matter what fundamentals might say.

The sector has seen some of its greatest volatility ever in stock prices. After beginning the year on a roll, the sector — along with all other REITs — plummeted. Through the end of April, regional mall REITs were still flying high. Total returns were at 16.1 percent, according to NAREIT and the sector was on pace for an eighth straight blockbuster year. But the summer brought a massive downturn. By the end of July, regional mall REIT total returns were down 11.2 percent. Things have calmed since then and regional mall REITs are back in positive territory for the year. But every company in the sector sits below its respective 52-week high.

Business as usual

The biggest indicator signaling the regional mall sector is doing just fine is major properties are trading hands and prices have not fallen at all.

For example, this summer in deals worth a combined $1.43 billion, Australian mall giant Westfield Group reached agreements with regional mall REITs CBL & Associates Properties Inc. and Simon Property Group Inc. that increases its footprint in Florida and exits St. Louis.

Analysts lauded the deal from all sides. For Westfield, the deal fits in with its “clustering” strategy by bulking up its presence in Florida where it already owns five other malls. Meanwhile, for Chattanooga, Tenn.-based CBL, shoring up its presence in St. Louis fits into its strategy of building a portfolio dominated by strong centers in secondary markets. It now becomes the biggest regional mall owner in St. Louis. Lastly, for Simon, the Florida properties came with its acquisition of Mills Corp. and selling them culls its portfolio of assets that don't fit.

CBL and Westfield estimate the valuation of the four St. Louis Westfield malls at $1.03 billion based on a capped 6.2 percent weighted average cap rate based on NOI after a management fee and a structural reserve is factored in. CBL is also projecting a five-year increase of 20 to 30 basis points on the initial yield of the investment.

In Westfield's other deal, it is acquiring the Westland and Broward malls for $400 million from Simon. Freidman, Billings, Ramsey & Co. Inc. REIT analyst Paul Morgan estimates the cap rate on that deal is a low 5.5 percent. A price that is “likely reflecting the upside redevelopment potential and attractive South Florida location of the two centers,” Morgan wrote in a research note.

Meanwhile, Macerich Co. acquired the vertical North Bridge Mall in Chicago in October for a reported $515 million — which equals a 5.2 percent cap rate, according to Morgan Stanley REIT analyst Matthew Ostrower. That indicates prices for regional malls — especially Class A assets — are not moving as much as some had anticipated would happen. The price is not out of line with prices paid for regional malls before market volatility kicked in. “We see the transaction as an initial sign that cap rates for retail assets are likely to move, but likely much less at the high end than the low end,” Ostrower wrote in a retail note.

Besides the CBL and Macerich deals, there's another potential acquisition that will further clarify pricing in the market. Waiting in the wings is Pyramid Cos. — one of the largest remaining private owners of regional malls — which is still trying to move the bulk of its portfolio on the market. And experts and analysts are expecting a deal to be announced before the end of the year with many mall REITs mentioned as possible acquirers.

Sales trends

Perhaps the most vexing problem facing regional malls are sales trends. Consumers are giving off mixed signals. Sales growth has been low all summer and through the back-to-school season. And retailers across the board have preached caution when it comes to holiday sales projections.

If anything, regional mall REIT tenants have fared worse than the retail sector at large. Freidman, Billings, Ramsey compiles a Malls Sales Monitor that focuses on tenants in regional malls — rather than the entire retail universe. The 38 chains it tracks did not fare well in September, posting same-store sales losses of 3.8 percent — greater than the expected 2.2 percent decline. Department stores fared even worse, posting a 4.0 percent loss on same-store sales.

But while those results may seem bleak, REIT managers and analysts stress that property fundamentals remain solid.

Take Indianapolis-based Simon, the largest player in the industry. The company recently threw light on its operations in advance of its third-quarter earnings results during an investor presentation.

The company now boasts more than 50 assets posting $600 per square foot or higher — about $200 above the industry average. As a whole, the company's assets are posting sales per square foot of $489 — up from $468 a year ago. Moreover, it has been able to increase rents. Throughout its portfolio, rents are up 3.7 percent annually.

Most importantly, the company is getting huge increases on expiring leases. The average expiring lease in its portfolio is worth about $36 per square foot, according to Simon CFO Steve Sterrett. In 2007, the company's new leases were closer to $45 per square foot.

At the same time, occupancies are up in its regional mall portfolio — 92.0 percent as of June 30 vs. 91.6 percent during the same period last year. (Meanwhile, occupancies at its premium outlet centers remained stable at 99.4 percent and occupancies increased at its community and lifestyle centers to 92.9 percent compared with 89.7 percent last year.)

Bright future

Perhaps one of the best signs that regional malls continue to have a bright future is that the sector has become trendy among teens. While the vast majority of construction in development and new development is now with mixed-use properties or lifestyle centers — formats that cater to the wealthy baby boomer demographic — Generation Y has shown an affinity for the regional mall sector. That bodes well since the spending power of Gen Yers will only increase (see “Back to the Future,” p.58)

“The junior category loves the enclosed mall,” CBL & Associates Properties CFO John Foy said during a recent consumer trend panel. So owners stand to gain the most by combining both formats. “On regional malls, we're building wings that are lifestyle-oriented to put Chico's, Coldwater Creek and those sorts of retailers.”

That speaks to another trend within the sector. While regional malls retain an audience, there are only limited opportunities to build new ones. Instead, regional mall REITs are devoting resources to develop lifestyle centers, mixed-use projects or to go back and renovate and expand older properties. Pursuing that strategy means things are healthy on the development front. For example, General Growth Properties and Taubman Centers Inc. recently debuted new, fully leased properties in time for the holiday shopping season.

In mid-October, Taubman Centers brought on line its new 640,000-square-foot Mall at Partridge Creek. The open-air regional center opened in Clinton Township, Mich.

About two weeks earlier, General Growth Properties Inc. opened the one-million-square-foot open-air Shops at Fallen Timbers in Toledo, Ohio.

For its part, Simon will invest $1.5 billion in development and $2 billion in redevelopments between 2007 and 2010 with anticipated average returns in the 9 percent to 10 percent range. And that doesn't include its so-called asset intensification program that entails adding non-retail uses to its centers — such as offices and residences. The company plans to spend another $750 million in those projects delivering projected unlevered returns greater than 8 percent.

On the flip side, however, Mower wonders if there may even be too much development going on, especially with retailers now hurting and potentially deciding to scale back on previously ambitious expansion plans.

“The retail market can change. We've all seen what Bombay Co. has done in filing for bankruptcy and announcing store closings,” Mower says. “There will be a few more behind them.”

As a result, Mower predicts that within the next few quarters, both retailers and REITs will begin quietly writing down previously announced expansion plans or developments. “We will see people rethink the size or rethink the launch of developments all across the country, especially in markets with low barriers to entry,” Mower says.

As of Sept. 30, 2007 Regional Malls Premium Outlet Centers Mills Community/Lifestyle Centers Other Shopping Centers Premium Outlets
Properties 188 37 17 59 10 50 8 379
GLA (MSF) 184.8 14.6 23.4 19 1.6 12.2 2.1 257.7
Percent of GLA 71.7 5.7 9.1 7.4 0.6 4.7 0.8 U.S.: 94.5
Int'l: 5.5
Source: Simon Property Group
Portfolio rents 2007 2006 Increase
Regional Malls $36.51 $35.10 4.00%
Outlet Centers 25.11 23.78 5.6
Community/Lifestyle Centers 12.03 11.65 3.3
Source: Simon Property Group
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