Lately, the news coming out from the REIT sector has been very negative.
Tenants are missing rent payments.
Some are not renewing leases.
Cash flow is taking a hit.
And as a result, REITs have missed expectations, cut dividends, and their share prices have been highly volatile:
As if that wasn’t enough, there also are significant concerns about how this crisis may affect the need for commercial real estate in the future:
Will people want to shop at malls?
Will we still work in office buildings?
These two questions are vital for mall and office REITs. If demand drops, but supply remains intact, rents and values will need to adjust lower. It’s economics 101.
And it’s potentially very bad news for REIT investors.
Technology is changing the world and some landlords (and by association, REITs) will be left behind.
But every crisis also is an opportunity in disguise for sophisticated investors who know how to sort out the worthwhile from the wobbly.
We believe that many REITs have dropped far lower than they should because of overblown fears. In today’s article, we discuss how the bad news for certain property owners could turn into good news for others.
Mall REITs: Deeply Troubled, But Not Out
The mall space has been oversupplied for years already. Many retailers were operating on tight margins and had too much leverage heading into this crisis.
Not surprisingly, a lot of them have had to file for bankruptcy protection and now need to reconfigure their leases with landlords.
From the top of my head, here a few major retail bankruptcies that will impact malls: J.C Penney (OTCPK:JCPNQ), Neiman Marcus (NMG), J. Crew, Gold’s Gym, G-Star, Lucky Brand, Ascena (ASNA), Brooks Brothers.
This is very bad news for the owners of Class B, C and D malls that already were fighting a tough battle before the crisis.
Rent collection rates have dropped like a rock. Lease defaults are soaring. Occupancy is declining. And the bargaining power of landlords is quickly eroding. Some properties may never recover, especially if the landlord is overleveraged and runs out of liquidity.
What the market has completely ignored is that quality matters. The crisis for lower-quality malls could turn into a major opportunity for higher-quality class A malls as they capture market share from dying Class B, C and D malls.
Malls are just like any other market. There’s a supply side and there’s a demand side.
Today many malls are dying, but these are not the Class A malls. In fact, Class A mall REITs Macerich (MAC), Simon (SPG), and Taubman (TCO.PK) reported new record high sales per square foot and rents in 2019. They have and will continue to co-exist with Amazon (AMZN) because they serve very different needs.
Today, Class A malls represent today only ~25% of the mall sector, and as the remaining 75% becomes much smaller, it will lead to less supply and lower competition for the remaining malls that survive the crisis.
Imagine that a city has three major malls. One of them is clearly the highest quality mall, but then there are also two lower quality malls that also are competing for customers.
Now suddenly, the lower-quality malls die, and the higher-quality mall is left on its own. It leads to consolidation of traffic and the higher quality mall becomes the “only game in town.”
We expect retailers to close a lot of stores at lower-quality malls and reposition themselves towards exclusively higher-quality malls which will serve as their flagship store and fulfillment center in major demographic hubs.
To be clear, Class A malls also will suffer a big hit in the short run. However, this is not an existential crisis for them and we expect them to thrive again in the long run:
- Less mall supply the benefits remaining Class A malls.
- Shoppers are redirected toward Class A malls.
- Retailers refocus their strategy on Class A malls.
And finally, it will allow Class A malls to finally get rid of weak retailers that have hurt malls for years. Replacing a failing Sears or J.C Penny anchor with other uses such as apartments and restaurants will lead to more traffic to the entire mall, more sales, and higher rents in the end.
We are confident that well-located Class A malls will adapt and recover. Yet, many of these REITs are priced at up to 80% discounts to NAV and just 3x cash flow. This is a case of short-term pain for long-term gain and we think that it’s a great opportunity for contrarian, long-term oriented investors.
It may sounds “too good to be true,” but we expect to triple our money on two mall REITs. This is exactly what happened in the aftermath of the last crisis:
Office REITs: Trophy Properties Only
We believe that office REITs are more troubled than Class A mall REITs.
With Class A mall REITs, we know that there will be great near-term pain, but we have little doubt that they will recover in the long run. People will always want a place to shop, dine, meet, connect, and entertain themselves.
However, office buildings face much greater long-term uncertainty. They are resilient right now as evidenced by the near 100% rent collection rates, but the work from home revolution could leave long lasting pain to office landlords.
Even if most workers return to the office, many of them may continue to work from home 1-3 days per week. We expect many employers to offer such flexibility as additional incentive to attract top talent. A lot of work can be done from home and going to the office every day of the week may not be needed.
Green Street Advisors estimates that we will see a 10%-15% reduction in overall office demand:
On the other hand, some office tenants may need to rent additional space for the safety of their employees. Right now, workers have very little space in highly urban markets where rents are high. To obey by the social distancing guidelines, they may need to rent more, not less, space in the future.
Therefore, landlords of trophy properties in highly urban markets are likely to do better than average. Companies do not lease office space in trophy building because they have to, but because it boosts their image. Think for instance about law and consulting firms. They want to be in a prestigious building in Manhattan for the location and image more than anything else. These properties are not immune to the crisis, but we expect the demand to be stickier than most would expect.
Empire State Building – property owned by Empire State Realty (ESRT):
On the other hand, the owners of suburban low-rise office buildings with short leases will fare much worse. The biggest risk to a lower-quality office building is always vacancy. It’s difficult and expensive to release space, and therefore, these landlords have lower bargaining power with their current tenants.
At High Yield Landlord, we only own one REIT with office buildings, and fortunately, these are highly urban trophy properties.
The Best Opportunities Lie in Other Property Sectors
The entire REIT market gets a lot of bad rep because of two property sectors: Malls and office buildings.
We agree that these two property sectors are deeply troubled, but investors should realize that these sub-sectors represent only ~10% of the REIT market.
There’s a vast world of REITs that invest in highly-defensive properties that are not greatly impacted by the recent crisis. Good examples include:
- Apartment communities
- Manufactured housing
- Self storage
- Industrial parks
- Data centers
- Cell towers
- Ground leases
Most of these REITs continue to enjoy near 100% rent collection rates and they are doing just fine. Yet, many of these REITs have dropped in association with the troubled mall and office REITs and now trade at enormous discounts to fair value.
This is where we are investing most of our capital. Defensive, yet undervalued REITs that have significant upside potential in the recovery.
What would be a good example?
Independence Realty Trust (IRT) is the owner of ~50 Class B apartment communities in high growth sun-belt markets.
After trading at nearly $17 earlier this year, its share price has dropped to just $11, despite enjoying very resilient fundamentals.
People need affordable shelter, no matter what. IRT has enjoyed near 100% rent collection rates and even posted positive same property NOI growth for the second quarter.
They also noted that they are experiencing very strong leasing, even stronger than last year. This confirms our thoughts that Class B communities would do particularly well as residents of more expensive Class A communities move to cheaper communities to save on their rent bill.
We expect IRT to continue producing good results because it rents real estate that’s absolutely essential to its tenants. It pays a sustainable 4.5% dividend yield that’s well covered, and it has ~50% upside potential as it returns to its former highs in the recovery.
This is exactly the type of defensive, yet discounted REITs that we like to target at High Yield Landlord.
There’s a lot of bad news in the REIT market right now, but every crisis is an opportunity in disguise for sophisticated investors who know how to sort out the worthwhile from the wobbly.
The entire market is focused on mall and office REITs. In reality, 90% of REITs invest in other property sectors that are much more defensive and now is a great time to be a buyer while others are fearful.
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Disclosure: I am/we are long IRT; MAC; SPG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.