1 9 Things You Should Know About Malls and Mall REITs 9 Things You Should Know About Malls and Mall REITs 1
2 Contacts Mike Brown, partner, New York Mike Moriarty, partner, Chicago Amiya Setu, principal, Dallas Andres Mendoza Pena, principal, Chicago Ivan Yiu, consultant, Toronto This material has been prepared by A.T. Kearney. This document is for information and illustrative purposes. It is not, and should not be regarded as, investment advice, or as a recommendation regarding any particular security or course of action. Opinions expressed herein are current opinions as of the date appearing in this material only and are subject to change without notice. Reasonable people may disagree about the opinions expressed herein. In the event any of the assumptions used herein do not prove to be true, results are likely to vary substantially. All investments entail risks. There is no guarantee that investment strategies will achieve the desired results under all market conditions and each investor should evaluate its ability to invest for a long term especially during periods of a market downturn. No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those discussed, if any. This information is provided with the understanding that with respect to the material provided herein, you will make your own independent decision with respect to any course of action in connection herewith and as to whether such course of action is appropriate or proper based on your own judgment, and that you are capable of understanding and assessing the merits of a course of action. A.T. Kearney does not purport to and does not, in any fashion, provide broker/dealer, investment consulting, or any related services. You may not rely on the statements contained herein. A.T. Kearney shall not have any liability for any damages of any kind whatsoever relating to this material. You should consult your advisors with respect to these areas. By accepting this material, you acknowledge, understand, and accept the foregoing.
3 Overview: The Making of the Mall Malls have had a long and storied history in America s consumer fabric since the first fully enclosed regional malls were designed in the 195s, one example of which was built by Victor Gruen in Edina, Minnesota. Over the decades, the mall has become ingrained in the American psyche, with generations of families making it the epicenter of their shopping and leisure time. Over time, ownership of these malls passed into public hands in the form of real estate investment trusts (REITs), then started to concentrate among a number of owners such that several of the regional malls are today owned and operated by a group of regional mall REITs. REITs were designed as a way for investors to participate in private real estate ownership, with the retail REIT sector paving the way for the sector s genesis in the early 199s. Within retail REITs, mall REITs are now some of the largest capitalized companies within the REIT sector. The mall model has always been a simple one: create attractive spaces for retailers to sell their goods, collect rent from retailers over a fixed period, and sign new tenants up at a higher rent than the existing base. Over the years, the highest-quality malls have continued to improve their physical spaces and services to entice new retailers and keep existing ones at increasingly higher rental fees. Consistent rent spread growth (the difference in rent from one year to the next) indicates the ongoing effectiveness of this model. Through the years, malls and mall REITs have weathered many challenges to their position, including failed retailers, recessions, and alternate shopping channels from catalogs and TV shopping to e-commerce. In addition, mall REIT stock prices have been subject to the vagaries of the stock markets, with adverse macroeconomic events such as high interest rates and inflation pressuring prices, sometimes on the basis of perception alone. Despite all of this, the mall REIT sector has continued to grow. This paper explores the mall REIT story by looking at past performance and the future outlook in the face of e-commerce advancements and evolving consumer behavior.
5 9 Things You Should Know About Malls and Mall REITs Performance 1. REITs have outperformed the S&P on a total returns basis since 1994, with retail REITs outpacing all other REITs Mall REITs have displayed stability in dividends and cash-flow growth, with mall REIT adjusted funds from operations (AFFO) outgrowing S&P earnings by 4 percent over the past 1 years REITs have generated mostly positive returns during rising interest rate periods over the past 2 years. Mall REITs have also deleveraged since 28 and have a laddered maturity debt schedule, better positioning them for future rising rates REITs are not correlated to the S&P 5 over the long run, making them potential candidates for investors with investment criteria that includes broad diversification among asset classes. 11 Retailers and Consumers 5. Leasing supply and demand dynamics in the next few years are favorable for regional malls Digital is not a challenge, but an opportunity to supplement the stores to better engage today s connected shoppers who prefer to interact with retailers through multiple channels Mall REITs are driven more by long-term discretionary consumer spending than the short-term performance volatility of retailers Faltering retailers are not new for mall REITs (for example, Montgomery Ward, JCP, Sears, Mervyns, W.T. Grant, Phar-Mor, and Jacobson Stores, among others); malls have been able to adapt in the past by re-leasing vacated space, and they continue to do so Published shopper traffic numbers may not truly represent the overall shopping activity that is occurring at malls. 21
6 REITs Historical Performance REITs, and particularly retail REITs, are not simply payout machines. They offer the chance for capital appreciation in addition to steady dividends. These two facts have led them to outperform the S&P 5 over the past 2 years. 9 Things You Should Know About Malls and Mall REITs 4
7 REITs have performed well compared to the S&P 5, with retail REITs outpacing others over five years REITs have outperformed the S&P 5 on an absolute basis by 32 percent and a 14 percent difference in CAGR (1.6 percent vs. 9.3 percent) over the past 2 years REITs have fared better than broader equities even while they pay out steady distributions. From 1994 to 214, the National Association of Real Estate Investment Trusts (NAREIT) equity index has outperformed the S&P 5 by 32 percent when taking into account both capital appreciation and dividends. REIT Returns vs. S&P 5 (2-year period from ) 1.6% 12,34 January 1, 1994 February 1, % 1, ,347 NAREIT Equity REIT Total Return index S&P Total Return Index Notes: REIT is real estate investment trusts. NAREIT is the National Association of Real Estate Investment Trusts. Sources: Bloomberg; A.T. Kearney analysis Returns in the REIT sector have been comparable, but retail REITs have outperformed other REIT sectors and the S&P 5 over a five-year period Retail REITs have been the strongest performer in the REIT sector since the 28 credit crisis and have continued the rebound from their pronounced dip. REIT Sector Performance Total Returns (29 214) 35% 3% 25% 2% 15% 1% 5% 5% One year Three years Five years 337% 274% 241% 257% 26% 182% 166% 56% 29% 69% 38% 49% 21% 3% 4% 5% 22% 9% 27% 14% 12% S&P 5 NAREIT Health Retail Apartment Office Industrial Notes: REIT is real estate investment trusts. NAREIT is the National Association of Real Estate Investment Trusts. Sources: Bloomberg; A.T. Kearney analysis 9 Things You Should Know About Malls and Mall REITs 5
8 Mall REIT Dividend Stability and Cash- Flow Growth Because of their payout requirements, REITs typically maintain their distributions even during market downturns. In addition, REITs have steadily grown cash flow, supporting capital appreciation and valuation. 9 Things You Should Know About Malls and Mall REITs 6
9 Mall REITs maintained stable payouts through the credit crisis while steadily growing cash flow In addition to performing well as equities, mall REITs have provided investors with cash-flow stability via dividends Mall REITs have consistently provided investors with strong cash flow via dividend distributions, even through volatile periods such as the 28 credit crisis. This payout stability can give investors a margin of safety during market downturns. Bloomberg Regional Mall REIT Index vs. S&P 5 (Dividends per share growth, ) 16% 14% Recessionary period Bloomberg Regional Mall REIT Index S&P 5 12% 1% 8% Note: REIT is real estate investment trusts. Sources: Bloomberg; A.T. Kearney analysis Mall REIT AFFOs have grown by about 67 percent since 25, outpacing S&P 5 EPS growth by 4 percent 1 Mall REITs have beaten the S&P 5 when it comes to growing their underlying valuation measure (FFO and AFFO for REITs vs. Earnings for the S&P) over the past 1 years. 2 Bloomberg Regional Mall REIT Index vs. S&P 5 (AFFO per share vs. EPS growth, ) 18% 16% 14% 12% Bloomberg Regional Mall Index (AFFO per share) S&P 5 (EPS) 4% Difference 1% 8% 6% Notes: REIT is real estate investment trusts. AFFO is adjusted funds from operations. EPS is earnings per share. Sources: Bloomberg; A.T. Kearney analysis 1 AFFO is adjusted funds from operations. EPS is earnings per share. 2 FFO is funds from operations. 9 Things You Should Know About Malls and Mall REITs 7
10 REIT Performance Under Rising Interest Rates Since 2, REITs have posted positive returns during rising interest-rate periods. Their efforts at lowering leverage since the 28 credit crisis, coupled with a laddered maturity debt schedule, may also help better insulate them against future rate increases. 9 Things You Should Know About Malls and Mall REITs 8
11 Mall REITs have performed well in high interest-rate periods; lower leverage will be positive for malls REITs have posted mostly positive returns during rising interest-rate periods over the past 2+ years Part of REIT positive performance during rising rate periods can be ascribed to better economies, which typically accompany rising rates. (For example, they can have better rent spreads.) 1-Year Yield vs. NAREIT Equity REIT Index (Total Return Index, ) Equity REIT Index ( ) % 6% +3% +27% +51% +15% +3% January 1995 January 2 January 25 January year bond yield NAREIT Equity REIT total return 1-year bond yield Notes: NAREIT is the National Association of Real Estate Investment Trusts. REIT is real estate investment trusts. Sources: Bloomberg, the National Association of Real Estate Investment Trusts, 1-K reports; A.T. Kearney analysis With lower leverage ratios since 28 and a laddered maturity debt schedule, mall REITs could be well insulated from high interest-rate periods After 29, the end of the credit crisis, mall REITs have achieved growth while keeping leverage steady. Additionally, the top mall REITs have a laddered maturity debt schedule, spreading out the amount of maturing debt in any given year. This could put mall REITs in a better position to weather rising rates. Bloomberg Mall REIT Index Debt-to-Equity and Debt-to-Asset Ratios (26 213) Top Mall REITs Debt Maturity Schedule Maturing Debt 1 (% of total debt as of fiscal year 213) Total debtto-equity 6x 5x 4x 3x 2x 1x Debt-to-equity Debt-to-assets.8x.7x.6x.5x.4x.3x.2x Maturing debt (% of total) 1% 15% 9% 6% e 216e 217e 1% 218e 5% Total debtto-assets Thereafter 1% Total 1 Maturing debt is fixed-rate debt. Note: REIT is real estate investment trusts. Sources: Bloomberg, the National Association of Real Estate Investment Trusts, 1-K reports; A.T. Kearney analysis 9 Things You Should Know About Malls and Mall REITs 9
12 Real Estate and Mall REITs as a Diversification Play Although mall REITs have tracked the broader equities index more closely in the past five years, private real estate has also displayed this behavior. Over the long term, REIT correlation to equities is relatively low, making REITs a diversification candidate. 9 Things You Should Know About Malls and Mall REITs 1
13 Long-term REIT correlation to the S&P is weak, making REITs a portfolio diversification candidate The S&P 5 and NAREIT indexes have only been very recently correlated, but this new phenomenon contradicts a long-run weaker correlation In a long-term investment horizon, the weak correlation of REITs to equities indicates the diversifying effect of REITs. The recent closer correlation to equities is not confined to REITs. Private real estate has also been closely tracking the S&P 5 since 28. NAREIT Index vs. S&P 5 Historical Price Correlation ( ) S&P 5 Index 2, 6 NAREIT S&P 5 5 1,5 4 1, R 2 (2-year period) = NAREIT Index Note: NAREIT is the National Association of Real Estate Investment Trusts. Sources: Bloomberg; A.T. Kearney analysis REIT correlation to private real estate has tracked more closely since 28 The NAREIT Index is more volatile than the National Council of Real Estate Investment Fiduciaries (NCREIF) Private Property Index, but the two have been relatively correlated with even closer ties recently. For diversification purposes, recent trends show there may be little benefit to selecting one over the other, although REITs have the added benefit of liquidity and financial transparency. NAREIT Index vs. NCREIF Property Index Historical Price Correlation ( ) NCREIF Index 2,5 6 NAREIT 2, NCREIF 4 1,5 1, 2 5 R 2 (2-year period) = NAREIT Index Notes: NAREIT is the National Association of Real Estate Investment Trusts. NCREIF is the National Council of Real Estate Investment Fiduciaries. Sources: Bloomberg; A.T. Kearney analysis 9 Things You Should Know About Malls and Mall REITs 11
14 The Mall Leasing Supply and Demand Story The 28 financial crisis was the worst since the Great Depression of the 193s. Supply flattened out during this period and has remained stable since then, while retailers continue to seek high-quality space. These factors paint a positive supply and demand picture for malls and mall REITs. 9 Things You Should Know About Malls and Mall REITs 12
15 Quality mall space is in demand, and malls are in a favorable position to benefit As the recovery from the 28 crisis has accelerated, occupancy has risen steadily and could continue growing until 217 With supply growing at about 1 percent per year and retailers seeing value in high-quality space, the supply and demand outlook for regional malls is favorable, especially given that historic peak occupancy of 94 percent won t be reached until 217 or beyond. Regional Mall Supply and Demand Dynamics Peak occupancy 25: 94% Gross leasable area (million square feet) 1, % CAGR +1% CAGR e 215e 216e 217e 95% 94% 93% 92% 91% 9% 89% 88% Occupancy rate Occupancy rate Forecasted occupancy rate Gross leasable area (million square feet) Forecasted gross leasable area (million square feet) Sources: International Council of Shopping Centers, Bloomberg, Reis, analyst reports, company filings; A.T. Kearney analysis With limited high-quality mall space available, mall REITs have been able to lease and re-lease space at favorable lease spreads Retailers are willing to pay higher rent when entering into new leases with regional malls. This demand is driven by retailers strong focus to enhance their brick-and-mortar operations, either as part of omnichannel or market expansion strategies. (Think H&M and Uniqlo.) Average Lease Spreads for Top Regional Mall REITs (29 213) Lease spread 2% 15% 1% 5% % Occupancy rate Lease spreads % 92% 91% 9% 89% 88% Occupancy rate Note: REIT is real estate investment trusts. Sources: International Council of Shopping Centers, Bloomberg, Reis, analyst reports, company filings; A.T. Kearney analysis 9 Things You Should Know About Malls and Mall REITs 13
16 The Challenge of e-commerce or the Omnichannel Opportunity Shopping malls have been the epicenter of shopping activity since the 195s, and they will continue to play a pivotal role for consumers, retailers, and investors. Although the retail world is evolving with the adoption of digital, consumers prefer to engage with retailers through multiple channels, with the store still playing a key role. Retailers that understand the complementary roles of stores and digital are winning in the new environment. 9 Things You Should Know About Malls and Mall REITs 14
17 Retailers that successfully meet consumer preferences for integrated channel experiences are advantaged 95 percent of sales are still made by retailers with a physical retail presence Multichannel retailers are in the best position to leverage and capture the significant benefits of doing business in an omnichannel world. How Multichannel Creates Momentum Multichannel shoppers are loyal and spend more $ E-commerce sales are higher in areas with a physical retail store Integrated channels spawn cross-sell opportunities Studies show that loyalty leads to more retailer and brand endorsements (multichannel consumers are 15 percent more likely to recommend retailer to others versus monochannel). The average spend of multi-channel consumers is twice that of monochannel. Clicks-to-bricks retailers report e-commerce sales lifts of three to five times in geographic areas where they open a physical location. A multichannel presence creates post-purchase sales opportunities: almost a quarter of consumers purchase further items when picking up an online order from a store. Of consumers returning an online item, 2 percent make an additional purchase. Source: Study conducted by Verde Group and Jay H. Baker Retailing Center at the University of Pennsylvania Wharton School, 211 The mall tenant mix is diverse with multiple category sales, and e-commerce only drives change in a few Categories such as books, music, and video, consumer electronics, and toys and hobby are the only ones where e-commerce penetration is significant. But as evidenced above, many e-commerce categories are still being driven by bricks-and-clicks retailers. Total Category Sales by Channel and Retailer Type (% split, 212) Store sales Bricks-and-clicks web sales Pure-play web sales 3% 2% 7% 5% 5% 1% 11% 24% 1% 2% 5% 5% 2% 37% 4% 8% 12% 15% 7% 15% 3% 11% 5% 1% 97% 91% 84% 72% 85% 79% 94% 58% 88% 72% 78% 85% Food and Beverage Health and Personal Care Home Improvement Apparel and Computers and Furniture and Home Accessories Consumer Furnishings Electronics Auto and Parts Sporting Books, Music, Jewelry Goods and Video Toys and Hobby Office Equipment and Supplies Pets Sources: emarketer, Forrester, Internet Retailer, edatasource, Bloomberg, company presentations, 1-K reports, International Council of Shopping Centers; A.T. Kearney analysis 9 Things You Should Know About Malls and Mall REITs 15
18 Mall REITs, Consumer Spending, and Retailer Performance A vibrant retail environment is undeniably important to the long-term success of the mall. However, a bad holiday season or faltering retailer does not immediately translate into lower revenue for malls, thanks to the long-term nature of leases. 9 Things You Should Know About Malls and Mall REITs 16
19 Mall REIT performance is tied to retail discretionary spending, not to short-term retailer performance The stock price of REITs is correlated to retail sales and spending. In a healthy retail spending environment, mall REITs tend to do well. For regional malls to succeed, a vibrant retail spending environment is vital. With retail spending in recovery since 28, mall REIT stock prices have continued to trend upward. Bloomberg Regional Mall REIT Price Index vs. Retail Sales Spend (2 214) Bloomberg Regional Mall REIT Price Index Bloomberg Regional Mall REIT Price Index Retail Sales Index 1 15 January 2 January 22 January 24 January 26 January 28 January 21 January 212 January Retail Sales Index Note: REIT is real estate investment trusts. Sources: Bloomberg, Reuters, CNN, The New York Times, company filings; A.T. Kearney analysis Mall REIT cash flow remains healthy in a strong retail sales environment and is not adversely affected by retailer performance volatility in the short term Even though a few retailers are struggling, overall long-term retail spending is healthy. This is ultimately what drives healthy cash flow for regional malls. Bloomberg Regional Mall REIT Index FFO vs. Retail Sales Spend (2 214) REIT Index Trailing FFO growth from 2 6% 5% 4% 3% 2% Montgomery Ward bankruptcy Circuit City bankruptcy Bloomberg Regional Mall REIT Index Trailing 12-month FFO Recessionary period Retail Sales Index Sears announces 12+ stores closing in 211 1% Mervyns JCPenney closes bankruptcy seven stores in January 2 January 22 January 24 January 26 January 28 January 21 January 212 January Retail Sales Index Note: REIT is real estate investment trusts. FFO is funds from operations. Sources: Bloomberg, Reuters, CNN, The New York Times, company filings; A.T. Kearney analysis 9 Things You Should Know About Malls and Mall REITs 17
20 The Effect of Faltering Retailers on Mall REITs Although faltering retailers are a concern for mall REITs, the impact on malls might not be as negative as the press would lead us to believe. Malls have successfully addressed and dealt with retailer bankruptcies in the past. 9 Things You Should Know About Malls and Mall REITs 18
21 Mall REITs have been able to overcome tenant failures in the past by re-leasing the space Mall REITs have weathered retailer bankruptcies in the past The last time mall REITs had a major anchor tenant fail was in 21, when retailer Montgomery Ward filed for Chapter 7 bankruptcy. Within a year, a major mall REIT was able to re-lease a significant portion of the 28 vacated stores. A Major Mall REIT s Repurposing of Montgomery Ward Stores after 21 Bankruptcy Anchors vacated Redesignated Re-leased December 21: + months March 22: +3 months June 22: +6 months September 22: +9 months December 22: +12 months and beyond Note: REIT is real estate investment trusts. Redesignated indicates tenant was found for premises. Sources: Credit Suisse First Boston (June 22 and September 22 data points), Salomon Smith Barney (March 22 data points), Bloomberg; A.T. Kearney analysis Top in-line tenants of major mall REITs do not appear to be at risk of default The top 1 tenants (by store count) in regional malls have a low risk of short-term default. These strong profiles show the resiliency of the leading in-line mall tenants and lower the risk of sudden occupancy and rent shortfalls caused by retailer failure. Short-Term Default Risk of Top 1 Tenants by Brand, Store Count (as of March 213) 9.5%.% 9.5% Likely Unlikely No likelihood Top ten tenants represent about 2 percent of total portfolio count for each mall REIT Note: REIT is real estate investment trusts. Sources: Bloomberg, mall REIT filings; A.T. Kearney analysis 9 Things You Should Know About Malls and Mall REITs 19
22 Shopper Traffic Relationship to Mall Performance Shopper traffic has been cited as one of the key influencers in mall performance. However, there are no authoritative sources of mall traffic available, and the subset of retailers that are tracked by available sources does not accurately reflect mall traffic and performance. 9 Things You Should Know About Malls and Mall REITs 2
23 Mall REIT performance continues to be robust due to efficient operations and underlying demand. Mall REIT performance has little to do with retailer traffic and is driven by two key metrics Current limitations of available third-party data sources that collect retail traffic counts can lead to inaccurate assessments and conclusions. Such limitations include the following: 1) Traffic counts come from only a small subset of retailers that do not reflect the actual mix in malls; 2) Often, traffic is not counted in the common areas of malls; 3) There may be inherent limitations to underlying counting technologies; and 4) Many of the largest U.S. malls do not participate in these counts. As such, investors should focus instead on meaningful key performance metrics that are currently available and that accurately reflect the performance of malls, namely funds from operations (FFO) and lease spreads. Meaningful Key Performance Metrics Funds from operations (FFO) Lease spreads FFO is the best determinant of mall REIT financial strength. Continued growth in FFO shows demand for mall REIT properties by retailers, as well as underlying operational strength and capability. Lease spreads and occupancy are the best indicator for underlying demand. Continued demand strength is shown when retailers and service providers sign on or renew at higher lease rates. Mall REITs have improved their performance since 29, with little correlation to reported retailer traffic As evidenced by the growth among the major mall REITs in lease spreads, and the upward trend in FFO, mall REIT performance continues to be robust due to efficient operations and underlying demand. How Mall REITs Have Increased their FFO and Lease Spreads (29 214) Combined FFO 1,5 16% 1, Four mall REIT FFO Four mall REIT annual lease spread 14% 12% 1% 8% 5 6% 4% 2% % January 21 July 21 January 211 July 211 January 212 July 212 January 213 July 213 January 214 Annual lease spread % Notes: Four mall REITs consist of General Growth Properties, Simon Property Group, Taubman Centers, and Macerich. FFO is funds from operations. Sources: Bloomberg; A.T. Kearney analysis 9 Things You Should Know About Malls and Mall REITs 21
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