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Date: October 28, 2019
Category: Real Estate

Retail’s Stratification is Evident to the Eye

Twenty-first century retail is the victors and the vanquished. Prior to the 1990s, malls were an efficient way to check off many items on a shopping list in one central location. Now, the world’s product catalog is available anytime, anywhere, with the click of the mouse. Many malls are not worth the time investment, unless they make it so. And that’s where we see the vast discrepancy between those succeeding and those shutting their doors. The same may hold true for the REITs holding these properties.

Out with the old, in with the new

A mall experience only focused on shopping won’t succeed. There’s Amazon for that. Older malls reliant on a few big anchor stores and a bunch of full-size retail stores just won’t cut it. Neither will an “experiential” philosophy that highlights a food court. Today’s vibrant, flourishing Class A malls are full of energy, with a focus on dining, mixed-use spaces, modern amenities, and true experiences like movies, bowling, and even TopGolf. These concepts can’t be recreated with a Prime membership.

The department store risk

Green Street lays out the divergence in stark terms. Roughly 270 malls rated Class A represent nearly 72 percent of total mall value. The balance of over 700 Class B/C malls complete the picture.

The anchor store set-up was implemented to generate traffic, in turn pushing shoppers to the mall’s interior. Again, it worked when malls were considered a one-stop shop. Now, as customers are more invested in the social value malls can provide, stores like JCPenney, Sears, and Macy’s rank near the bottom of major anchor tenants in sales per square foot. The new anchor tenants in many cases are grocery stores, gyms, or movie theaters.

JCPenney is a sobering example of the failing blueprint. Its same-store sales have declined by 30 percent over the last decade and gross profit is down three percent.1 Massive closures across the country appear imminent. This will place a heavy burden on mall operators, who in many cases must then invest major capex to renovate and replace the large footprint.

Also, half of properties with a JCPenney have at least one vacant anchor. The domino effect will curb a quick turnaround to backfill. Struggling malls are thinking outside of the box – almost to the level of parody. One mall in Minnesota is converting an old anchor tenant location into a haunted house this October. While others, unintentionally, look just as scary with shuttered, vacant storefronts.

The investment corollary also presents a problem. Mall REITs have substantial exposure to JCPenney. This exposure will cut into occupancy and rent growth, potentially curbing net operating and investment income.

Overall investment trends aren’t promising

Mall and retail outlet asset values are broadly declining. The public markets for retail companies are currently pricing at well below private market values – a dynamic that makes it near impossible for public companies to actively grow through acquisitions. This lack of deals is a flashing warning sign, as wide bid/ask spreads are limiting the dialogue. Many potential buyers are underwriting more pessimistic assumptions, most notably that major capex is needed to renovate vacant department store space. In-line mall occupancy has also declined, and Green Street believes it will remain pressured for the foreseeable future.

Only the experience-driven Class A malls are expected to avoid declining occupancy and market rents. And this puts mall REITs in peril. With hardly any new malls being constructed, mall REITs can only grow organically, through redevelopment, international investment, or new acquisitions. Without significant cost of capital advantages, the last three options are in most cases off the table. That leaves organic growth as the last resort.

A tactical approach to mall investing

Investors should focus on quality – though its definition has changed. The brand-name anchors are no longer safe bets, requiring them to think as differently as the operators trying to meet their customers’ social needs. Make sure to look under the hood at a mall REIT’s underlying assets and dissect their business plans. Remember not all retail is struggling.

Is the mall leveraging data, artificial intelligence, or any big tech to give it a competitive advantage? Is it moving beyond the philosophy of a box with four walls? Think about that feeling you may get when you walk into a mall investing in a mix of shopping, dining, and nightlife. Make sure REITs are investing in those as well.

1 Green Street Advisors. Mall Sector Update. August 14, 2019.

Resource Securities LLC, Member FINRA/SIPC.

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