Retail REITs have significantly underperformed the rest of the market as rising interest rate fears and growing Internet competition weigh heavily on brick-and-mortar retail properties. This article reviews the current state of one retail REIT in particular, Simon Property Group (SPG), and then concludes with our views on whether it’s safe to add shares of this depressed high-yielder (+5%) or if it’s just a dangerous value trap to be avoided.
The Business:
Simon owns, manages and develops retail real estate. It’s a member of the S&P 100, and its current market cap is approximately $54 billion. It’s organized as a real estate investment trust (“REIT”), and it generates the majority of its operating income (79.9%) from premium outlet malls, with the remainder from “The Mills” (11.1%) and international (9.0%).
The Narrative:
Simon’s share price has significantly underperformed the market (as shown in the following chart) due in large part to two very negative narratives.
For starters, because Simon is a REIT, it must pay out 90% of its income as dividends for tax reasons, and this means it relies on borrowing to fund growth. The problem is that the cost of borrowing has been rising, and it is expected to keep rising, as interest rates are on an upward trajectory. This higher cost of borrowing has thoroughly spooked a lot of investors as they’ve been shunning REITs like Simon, in favor of other less interest-rate-sensitive market sectors. And in particular, the fed’s minutes released this week showed discussions of a “slightly steeper” rate of future rate hikes, thereby causing SPG to sell-off ever further in recent days.
Secondly, there is a frightening narrative that Internet retailers (such as Amazon (AMZN)) are going to put all brick-and-mortal retailers our of businesses. And this narrative has been powerful as Amazon’s business continues to thrive (even though Amazon does other things besides online retail---Amazon Web Services is enormous), and many retailers (i.e. the stores that rent space from REITs) continue to struggle (e.g. bankruptcies, store closings, rent concessions).
The Reality:
Simon’s business continues to be very strong. For example, Simon recently posted full-year 2017 Funds from Operations (“FFO”) of $4.02 billion, or $11.21 per diluted share, compared to $3.79 billion, or $10.49 per diluted share in 2016. The company also has one of the strongest credit ratings, a high sales and rent per square foot, it is well within its debt covenants, a very strong FFO-to-dividend coverage ratio, and it actually just raised it’s dividend, as shown in the following charts (these are not the characteristics of a dying businesses).
Valuation:
In addition to a strong business, SPG is also trading at an attractive valuation. For example, even though FFO is rising (as we covered earlier), price is falling, which makes Simon’s price-to-FFO ratio attractive. More importantly, the company has provided a full-year 2018 FFO guidance range of $11.90 to $12.02 per diluted share. This means Simon is trading at approximately 12.5 times 2018 FFO expectations, which is dirt cheap for this strong blue chip REIT.
And for what it’s worth, Wall Street has a strong opinion of Simon, as well. For example, per the following chart, the average street price target for SPG is $183.23, which equates to more than 20% upside for the shares. Not bad considering you’ll keep collecting the attractive 5% yield in addition to any price gains.
M&A Activity:
The uptick in Mergers and Acquisitions (“M&A”) discussions within the retail REIT space is a good sign for Simon overall, in our view. Specifically, it suggests some smart, deep-pocketed, institutional investors believe the space is undervalued. For example, Unibail-Rodamco, Europe’s largest REIT, is buying Westfield (a mall owner in the US and the UK), and Brookfield Property Partners is trying to take over Chicago-based GGP (you can see GGP’s rent and sales per square foot, compared to SPG, in our earlier chart).
Speaking at a recent Citigroup conference, Simon’s COO said the company is NOT involved in any of the current mall group M&A, explaining:
“We have never done a stupid deal ... You may not like us, but at least you can give us the benefit of the doubt, based on 25 years of history.”
However, Simon has recently been indirectly involved considering it is the biggest shareholder of European REIT Klepierre (Klepierre has recently pursued an acquisition of UK-based Hammerson).
One concern for investors regarding the M&A activity is that they usually involve a larger company (like Simon) paying a premium for a small company (i.e. the share price of the smaller company does better when the acquisition is announced considering they’re receiving, not paying, the premium). Regardless, the fact that these types of discussions are occurring is a good sign for mall REITs in general, in our view.
Conclusion:
Simon Property Group is cheap. And it pays a big strong dividend. The question is whether the shares will get even cheaper, or if they have upside from here. We are making no attempt to call a near-term bottom in retail REITs, but we do believe Simon Property Group is undervalued, despite the growth of online retail and the increasing interest rate environment.
One way to "play" this opportunity is by selling out-of-the-money put options on SPG, which are currently offering attractive premium income due to the market uncertainty and fear surrounding retail REITs (uncertainty and fear cause premium income to rise).
If the shares were to get put to us at an even lower price, we’d be more than happy to buy-and-hold for the long-term. And if they never got put to us then we’d also be happy to simply keep the high premium income generated by selling the puts.