This is an abridged version of the full report published on Hoya Capital Income Builder Marketplace on May 20th.

REIT Rankings: Mall REITs

One step forward, one back. After nearly doubling in value last year, mall REITs have been the worst-performing major property sector in 2022 as the stimulus-fueled retail strength has stalled. The REITs that managed to survive the pandemic – Simon Property (SPG), Macerich (MAC), Tanger Factory Outlet (SKT) – had been seeing encouraging signs of stabilization in recent quarters, but their upside momentum has been challenged by signs of “cracks in the consumer.” For the lower-tier mall segment, it’s been a bull market only for bankruptcy lawyers as Pennsylvania REIT (PEI), CBL & Associates Properties (CBL), and Washington Prime have seemingly been caught in an endless loop in and out of Chapter 11 restructurings and exchange delistings.

Meanwhile, Seritage Growth (SRG) – which emerged from the Sears bankruptcy and now owns 170 properties in primarily Class B and C mall locations – announced in late March that it will no longer be a REIT and is in the midst of a “comprehensive review of strategic alternatives.” Other major U.S. mall owners include France-based Unibail-Rodamco-Westfield (OTCPK:UNBLF) – which announced last month that it wants to sell most of its two-dozen U.S. properties by the end of 2023 – as well as Canada-based Brookfield Asset Management (BAM) – which took its mall REIT subsidiary private last year. There are approximately 1,000 malls operating in the U.S. which are categorized into A-through-C quality buckets with the roughly 200 “A Malls” commanding the highest rents and steady occupancy rates while the “C Malls” are struggling to remain relevant.

Retail Rout Dims Mall Momentum

The recent “retail wreck” – in which the iShares SPDR S&P Retail ETF (XRT) has dipped more than 40% over the past six months – comes as mall REITs were just starting to gather some momentum in the wake of the pandemic. Despite the Omicron surge in early 2022, foot traffic and tenant sales levels at middle-tier and higher-tier mall properties returned to pre-pandemic levels during the first quarter according to commentary from these mall REITs while rent collection has finally fully returned to the pre-pandemic average. MAC reported that foot traffic during the first quarter was 95% of pre-pandemic levels while SKT and CBL each noted that traffic in Q1 essentially matched its 2019-level.

As discussed in our REIT Earnings Recap, mall REITs earnings results were actually quite encouraging with Simon Property and Tanger Outlets as the upside standouts. Simon raised its full-year guidance by 60 basis points while hiking its dividend for the fourth time in the past year. For SPG, the full-year target would bring its FFO back to within 3% of pre-pandemic levels – substantially ahead of its peers, while Tanger also lifted its full-year guidance by 170 basis points while Macerich reiterated its guidance. While Simon is back to the cusp of pre-pandemic FFO levels, however, Tanger and Macerich remain 20-40% below pre-pandemic FFO levels. For the pair of lower-tier mall REITs that remain – both of which entered and emerged from Chapter 11 over the past year – a return to pre-pandemic FFO remains unlikely, but first-quarter results were at least a small step in the right direction.

PREIT reported similar trends of improving occupancy rates and rental spreads, but investors have been unimpressed by the pace of its asset sales as it seeks to raise capital to pay down its substantial debt load CBL, meanwhile, also reported decent Q1 results, highlighted by a 290 basis point increase in portfolio occupancy but rental rates remain under pressure with renewal spreads dipping another 11.8% – in part due to a shift towards higher use of “percentage rent” in lease agreements. Encouragingly, occupancy rates appear to have stabilized and halted a multi-year downtrend – at least for the moment – as each of these five REITs reported a sequential improvement in same-store occupancy led by PREIT and CBL.

In addition to these short-term rental agreements, landlords have also made increased use of “percentage rent” deals which can result in higher rent payments when times are good, but sharper declines in rent during downturns. Leasing spreads – perhaps the best leading indicator of future same-store NOI – have shown some signs of stabilization. Tanger recorded a 1.3% increase in blended rental rate on renewed leases, snapping a twelve-quarter streak of negative rent spreads dating back to Q1 of 2019. While SPG no longer provides leasing spreads, commentary suggested that the pricing environment has improved with David Simon noting, “We are in a better position today to negotiate a fair deal for us than the last couple of years.”

Despite the stabilizing fundamentals, our view remains that the traditional indoor regional mall segment will continue to be a flat-to-negative growth business for the foreseeable future. That said, we do see a compelling case for Simon Property, which owns some of the few malls across the country that are truly thriving – along with a valuable brand portfolio purchased for “pennies on the dollar” through its creative capital allocation strategy. Through its 50/50 joint venture with Authentic Brands on the SPARC Group – and a separate partnership with Brookfield – SPG has accumulated a portfolio of brands with value that extends beyond the immediate benefit of keeping these tenants in business. This vertical retail integration strategy is consistent with our long-held view that mall REITs would actually benefit if they performed more like retailers – which have substantially outperformed their REIT landlords across most measurement periods.

Cracks In the Consumer After Record-Year

Fueled by WWII levels of fiscal stimulus, retail sales delivered record growth in 2021 with full-year growth of nearly 20%, and the momentum had been continuing into early 2022 before the surge in fuel prices. The Census Bureau reported last week that retail sales rose at a stronger-than-expected rate in April and recorded its fourth-straight month of growth. Total Retail Sales rose 0.9% in April – slightly below the 1% estimate – but the absolute dollar figure was higher than expected after upward revisions to prior months which pushed the year-over-year increase back to over 8%. Revealing potential emerging “cracks in the consumer” economy, however, Target (TGT) plunged last week after reporting a “rapid slowdown” in key categories, which followed a similar dive from Walmart (WMT) earlier in the week.

The growth-to-value rotation – which has driven outperformance for many of the previously-beaten-down REIT sectors – hasn’t benefited mall REITs much in 2022 as the sector continues to significantly lag behind its retail REIT peers. Slumping consumer confidence, rising gas prices, and disappointing commentary from retailers have weighed on malls throughout 2022. Mall REITs are now lower by 30.2% this year, significantly underperforming the 18.8% decline on the broad-based Vanguard Real Estate ETF (VNQ) and the 18.0% decline on the SPDR S&P 500 Trust ETF (SPY).

Mall REITs did manage to snap their dreadful six-year-long streak of underperformance in 2021, however, delivering the strongest returns in the REIT sector with total returns of over 93%. Before the rebound last year, mall REITs had underperformed the REIT sector average in each of the prior five years and had not recorded a year of positive returns since 2015. Amazingly, no other REIT sector has seen more than 2 consecutive years with negative total returns since the end of the last recession. Between 2015 and 2020, mall REITs produced an annualized average total return of -10.6%, the worst among major property sectors.

Tanger Outlets has been the upside standout in 2022, while Pennsylvania REIT has been the laggard, continuing a slide that began in mid-2021 as the clock is ticking for the troubled landlord to raise capital through asset sales to pay down its substantial debt load. After nearly doubling last year, Simon and Macerich are each off by more than 30% for the year. Also of note, a year after delisting from the NYSE, CBL Properties is back on the big board as of last November after shedding $1.6B in debt and preferred obligations through its Chapter 11. Washington Prime appears less likely to reemerge as a public company after delisting last September.

Mall REIT Dividend Yields

Helped by a series of dividend increases from the higher-tier mall REITs this year, malls have now become one of the higher-yielding REIT sectors with an average yield of 5.7% – well above the REIT sector average of 3.3%. Helped by the large weighting of Simon Property and Macerich which have relatively low payout ratios, mall REITs appear to have plenty of dividend-paying capacity remaining as the sector distributes less than 60% of their FFO.

Five mall REITs – SKT, WPG, CBL, PEI – eliminated their dividend in 2020 while two others – SPG and MAC – reduced their dividend during the pandemic. The tide has turned – at least for the higher-tier mall REITs – since mid-2021 as Simon has raised its dividend five times over the past year while SKT – which was formerly a so-called “dividend aristocrat” – resumed its dividend in 2021, as did MAC. Both REITs, however, continue to pay dividends well below their pre-pandemic rate and mall REITs remain near the basement of the REIT Rankings on 3 and 5-year dividend growth.

Balance sheet quality is a key determinant of dividend-paying capacity and future dividend increases. Mall REITs entered the pandemic with elevated debt ratios, which subsequently surged to nosebleed levels during the worst of the drawdown with all mall REITs besides Simon reporting debt ratios above 80% in mid-2020. Improving fundamentals have stabilized balance sheets, particularly for Simon Property – which still owns one of the few coveted A-ratings from S&P on its long-term debt and completed a very timely, $1.2 billion note offering last quarter at a 10-year fixed rate of just 2.65% while it also refinanced seven mortgages for a total of $1.1 billion at an average interest rate of 2.92%. Elsewhere, Tanger’s balance sheet has essentially been fully-repaired after seeing its debt ratio spike in 2020, but Macerich still has work to do. The situation is far more urgent for the lower-tier mall REITs – CBL and PEI – which operate with debt levels above 80%.

Takeaways: One Step Forward, One Step Back

One step forward, one back. After nearly doubling in value last year, mall REITs have been the worst-performing major property sector in 2022 as the stimulus-fueled retail strength has stalled. While lower-tier malls continue to face nearly insurmountable secular challenges and leasing trends remain a concern, the outlook for higher-tier malls – most of which are now owned by Simon Property – was clearly brightening before the recent surge in fuel prices and concerns of “cracks in the consumer.” Consistent with our “4 Critical Cs of Brick & Mortar Competition” framework, we believe that well-located high-productivity malls that have the critical mass and “network effects” to offer a value-added retail experience can remain relevant as retailers value a physical presence in the digital retail environment. We see “sum-of-the-part” value in Simon, which owns a valuable retail brands portfolio alongside its property portfolio, and we see value in its position as the “last man standing” in the sector with ample access to capital, which we believe will eventually translate into accretive consolidation of high-productivity assets.

For an in-depth analysis of all real estate sectors, be sure to check out all of our quarterly reports: Apartments, Homebuilders, Manufactured Housing, Student Housing, Single-Family Rentals, Cell Towers, Casinos, Industrial, Data Center, Malls, Healthcare, Net Lease, Shopping Centers, Hotels, Billboards, Office, Farmland, Storage, Timber, Mortgage, and Cannabis.

Disclosure: Hoya Capital Real Estate advises two Exchange-Traded Funds listed on the NYSE. In addition to any long positions listed below, Hoya Capital is long all components in the Hoya Capital Housing 100 Index and in the Hoya Capital High Dividend Yield Index. Index definitions and a complete list of holdings are available on our website.