REIT Rankings: Shopping Centers
Shopping Center REIT Sector Overview
A post-vaccine revival? Shopping Center REITs have been the best-performing property sector over the last month, surging more than 40% following the release of a pair of positive coronavirus vaccine trial results and signs of stabilization in third-quarter earnings reports. Shopping Center REITs are not out of the woods yet, though, amid a recent spike in infections across the world and struggling service-oriented small-shop tenants may not survive a “third wave” of economic lockdowns that have cascaded across the country. In the Hoya Capital Shopping Center REIT Index, we track the 17 largest open-air shopping center REITs, which account for roughly $40 billion in market value.
We divide the retail real estate universe into three sectors: enclosed regional malls, open-air shopping centers (also called “strip centers”), and free-standing (“net lease”) retail. While we’ve remained bearish on retail REITs as a whole, we continue to believe that the long-term outlook for open-air strip centers remains far more promising than their enclosed regional mall peers as we discussed last quarter in Shopping Center REITs: An Essential Bargain. While small-shop tenants are unquestionably struggling, open-air shopping center REITs are the primary “distribution center” to many thriving “essential” retailers. Following the frenetic post-vaccine rebound, however, these REITs are no longer the “essential bargain” that they were last quarter. We’ve turned cautious on the sector, but we still see value in select higher-quality REITs.
Within the sector, we separate the space into three sub-categories, generally consistent with the ICSC classifications: Grocery-Anchored, Power Center, and Street Retail. The lines between these categories are blurry, however, with many “big-box” retailers like Walmart (WMT), Costco (COST), and Target (TGT) now offering full-service grocery offerings. These REITs have been proactive in recent years in transforming their tenant mix into a more “experience” and grocery-oriented portfolio that is, in theory, less threatened by disintermediation. Roughly half of the retail centers owned by shopping center REITs include at least one full-service grocer. Grocery-anchored centers have historically commanded premium valuations relative to power centers and certainly relative to malls, a premium that has expanded in recent years.
As we’ll analyze in more detail below, strong leasing activity was the positive highlight of third-quarter earnings reports, offsetting another ugly quarter for the “headline metrics” including Funds From Operations (“FFO”) and same-store Net Operating Income (“NOI”). According to NAREIT T-Tracker data, shopping center REITs reported a sequential improvement in their (still rather ugly) same-store NOI metrics, recording an -11.8% year-over-year decline in Q2, up from the -18.8% decline in the second quarter. Unlike their mall REIT peers, however, leasing volumes picked up in the third quarter, and leasing spreads remained firmly positive – rising by roughly 7% year-over-year – which is only a tick lower from the average spread over the past three years.
Unlike malls, the majority of shopping center tenants – particularly grocery stores and “big box” retailers – remained operational as “essential businesses” even amid the peak of the lockdowns. While mall REITs have continued to report significant difficulty in collecting rent from their tenant base, shopping center REITs have seen rent collection metrics improve to around 90% in Q3, up from an average of around 75% in Q2, and we believe that the underlying fundamentals may be a bit better than these metrics suggest. Shopping center REITs have been able to negotiate non-monetary concessions in exchange for rent deferrals including waiving co-tenancy clauses, lifting use restrictions, extending lease terms, and/or requiring enhanced sales reporting that we believe should bear fruit over time.
Occupancy rates will remain under pressure, however, given the ongoing substantial headwinds and “shadow bankruptcies” pending for small-shop service-oriented tenants including restaurants, salons, and fitness studios. For landlords, it’s tough to pay dividends if you’re not collecting all of the rent. As projected last quarter, Retail Value (RVI), which pays an annual distribution, cut its dividend last week, became the 14th shopping center REIT – and 66th equity REIT – to reduce or eliminate its dividend in 2020. Federal Realty (FRT) however, managed to increase its distribution to keep its five-decade-long streak of increasing dividend distributions alive. Grocery-anchored REITs Regency Centers (REG) and Saul Centers (BFS), meanwhile, have managed to maintain their dividend distributions at prior levels.
Shopping Center REITs Rebound On Vaccine Optimism
After plunging more than 50% early in the pandemic, positive vaccine news has revived the struggling shopping center REIT sector, which has been the best-performing property sector over the last month and the third-best-performing sector over the past quarter. The rally began last week after Pfizer (PFE) announced positive trial results for its COVID-19 vaccine candidate, a potentially major breakthrough hailed as a “great day for science and humanity.” Then this week, Moderna (MRNA) announced that its vaccine was 94.5% effective at protecting people from Covid-19 and expects to submit for an Emergency Use Authorization (EUA) “in the coming weeks.”
The clock is ticking to get approval and begin distribution, as reported coronavirus cases have continued to rise in the United States and globally over the last two months. Shopping center REITs are now lower by 28.6% in 2020 compared to the 12.0% decline on the Vanguard Real Estate ETF (VNQ) and the 12.1% gain on the SPDR S&P 500 ETF (SPY). Mall REITs, by comparison, are lower by nearly 40%. Interestingly, retail landlords have woefully underperformed the performance of their tenants as the SPDR S&P Retail ETF (XRT) has gained more than 18% in 2020 while the Amplify Online Retail ETF (IBUY) has surged nearly 90% this year.
Diving deeper into the company-level performance, the prevailing trends within the shopping center REIT sector this year have been the clear “flight to quality” and the outperformance from grocery-anchored REITs. Performance trends have closely mirrored balance sheet quality as the nine REITs with investment-grade S&P credit ratings are lower by an average of 27% this year while the non-investment-grade REITs are lower by more than 50%, on average. As of the end of September, 12 of the 17 REITs in the sector had Debt Ratios above 50% as tracked by NAREIT, while 5 REITs currently have debt ratios above 60%: Cedar Realty (CDR), Retail Value (RVI), RPT Realty (RPT), Whitestone (WSR), and Acadia Realty (AKR).
For these highly-levered shopping center REITs – and even the distressed mall REITs – there are still reasons for some optimism. Retail sales have rebounded far faster-than-expected over the last six months, regaining all of the lost ground during the pandemic. Naturally, led by Amazon (AMZN), e-commerce sales have led the charge this year, with online sales now higher by nearly 25% from last year, and brick-and-mortar sales are also now higher by 2.0% from last year. The recent strength of several shopping-center-centric categories including the grocery, electronics, and home improvement categories shouldn’t be overlooked, either. Recent earnings reports from Home Depot (HD) and Lowe’s (LOW) have been historically strong.
Deeper Dive: Shopping Center Sector Dynamics
After a development boom during the 1990s and early 2000s, only a limited amount of retail space has been created since the Financial Crisis. Despite that, the US still has more retail square footage per capita than any other country in the world. Elevated levels of store closings in recent years, spurred by the rise of e-commerce, have created ample “shadow supply” of recently vacated space which has negatively impacted retail REIT fundamentals, although shopping center REITs entered the pandemic on far more steady footing than mall REITs. Together with malls and free-standing net lease properties, retail REITs comprise roughly 12-15% of the REIT Indexes.
Helping to offset the clear headwinds from the continued uptick in retail store closures, the growing usage of alternative (and higher-margin) “delivery” options including in-store pickup, “curbside” pickup, and delivery-from-store has been a tailwind for well-located shopping center REITs. While nearly 90% of total retail sales are still completed through the traditional brick and mortar channels, e-commerce sales account for roughly a fifth of “at-risk” retail categories, and the market share loss has been most significant for the traditionally mall-based retail categories, including department stores, clothing, sporting goods/books, and electronics retailers.
Shopping center REITs have also seen recent success in “de-boxing” larger vacated store footprints into several smaller store layouts that can command higher total NOI. According to Coresight Research and our estimates, while the store closing count surged significantly in 2019, seven of the eight largest contributors to store closings were in the mall category, a trend that has continued in 2020. Shopping center REIT fundamentals were actually quite solid heading into the pandemic – certainly far better than their mall REIT peers – and we had expected 2020 to be the year that shopping center REITs snapped their four-year streak of underperformance.
On that point, shopping center REIT same-store NOI growth outpaced the REIT average in 2019 for the first time in nearly a decade while leasing spreads showed a modest acceleration in the back-half of 2019. As noted above, while NOI growth has seen a sharp plunge related to deferred or delayed rents, the relatively solid leasing trends that we saw before the pandemic were present again in Q3 as leasing spread remained positive by nearly 7% in Q3 on a high volume of activity, suggesting that “market rents” have remained fairly steady throughout the pandemic.
While shopping center REITs are no longer the “essential bargain” that they were last quarter, we continue to see select pockets of long-term value in the larger grocery-anchored REITs. Additionally, the “suburban revival” theme that we’ve discussed extensively should provide a favorable tailwind over the next decade for shopping center REITs as a whole. However, these REITs are more dependent on now-struggling small business retailers and independent franchises to fill small shops. Below, we present our framework for analyzing the REIT property sectors based on their direct exposure to the COVID-19 effects as well as their economic and interest rate sensitivity.
Shopping Center REIT Valuation and Dividend Yield
As they have for most of the past half-decade, retail REITs screen as inexpensive across most traditional REIT metrics, but have produced FFO growth that has lagged the broader REIT averages during this time. Shopping center REITs trade at 12.5x Price-to-FFO (Funds from Operations) multiple, which is below the REIT average of 20.5x P/FFO, but higher than their sub-10x average multiple last quarter.
A sharp disconnect has persisted between private market valuations of retail real estate assets and the REIT-implied valuation, forcing retail REITs to be net sellers of assets for nearly a half-decade. Shopping center REITs have disposed of $1.5 billion in assets, on net, over the last 12 months, and are expected to remain net sellers until valuations improve. Shopping center REITs now trade at a 30-40% estimated discount to net asset value (“NAV”). REITs are at their best when they’re utilizing their superior access to equity capital to fuel external growth via accretive acquisitions and development, but discounts this large make it nearly impossible to accretively acquire properties.
Despite the 14 dividend suspensions, shopping center REITs currently pay an average dividend yield of 3.5%, which is slightly above the market-cap-weighted REIT sector average of 3.3%. The cuts from the 14 REITs do help to bring down the FFO payout ratio to below 50%, which is among the lowest in the REIT sector. Thirteen shopping center REITs currently pay a dividend while four REITs have not yet reinstated their dividends.
As we’ve discussed since the start of the pandemic, for investors looking purely for dividend safety, Regency Centers and Federal Realty would be the “safest bet” to maintain their dividend amid the pandemic based on their low payout ratio and sector-leading balance sheet. Among small-cap under-the-radar names, Saul Centers and Urstadt Biddle (UBA) are in the quality tier immediately below the aforementioned sector stalwarts.
Key Takeaways: No Longer An “Essential” Bargain
Shopping Center REITs have been the best-performing property sector over the last month, surging more than 40% following the release of positive coronavirus vaccine trial results. Strong leasing activity was the highlight of third-quarter earnings reports, confirming that the long-term outlook for open-air strip centers remains far more positive than their enclosed regional mall peers. Shopping Center REITs are not out of the woods yet. Struggling service-oriented small-shop tenants may not survive a “third wave” of economic lockdowns that have cascaded across the country, and “headline” metrics including FFO and same-store NOI growth remain ugly.
Following the frenetic post-vaccine rebound, Shopping Center REITs are no longer the “essential bargain” that they were last quarter. We’ve again turned cautious on the sector and see better opportunities in the “essential” sectors including technology and housing, but we still see select pockets of long-term value in the larger grocery-anchored REITs in names like Regency Centers and Retail Opportunity Investments (ROIC) with resilient fundamentals that should further benefit from the ongoing “suburban revival.”
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