Mall Valuations Post GGP/BPY

This is my fifth post on high quality mall REIT valuations in less than a year. Going back to my first post on May 4, 2017 ( https://shulmaven.blogspot.com/2017/05/a-new-look-at-mall-reit-valuations.html) I noted that the 4.5% cap rates used by most REIT analysts were way to low and I argued that a 5.65% cap rate was more appropriate. This analysis did not receive much support when Unibail announced its acquisition of Westfield last fall that implied a cap rate for its U.S. assets in the high 4% range.

However, the Brookfield Property Partners (BPY) acquisition of the 64% of the shares of GGP that it did not own at an implied cap rate estimated to be in 5.8%-6% range validated my thesis. The BPY offer was valued at around $22 per GGP share, 19% below the Street consensus net asset value of $27.28. Warning: take Street estimates of NAV with a grain of salt.

If anything I was too optimistic. I argued then that high quality mall cap rates were under stress because the e-commerce challenge would require significantly high capital expenditures, lower future estimates of rent growth and cause a downgrading of approximately 15% of the those malls considered to be high quality over the next five years.  As of today the first two of my assumptions are now the conventional wisdom. I also argued that higher long term interest rates would pressure cap rates.  Since then the 10 year treasury yield has increased from 2.3% to 2.8%.

Yesterday mall stocks tanked on the GGP news. However, today the mall REIT shares are soaring on reports that President Donald Trump is out to get Amazon, their arch nemesis. As of 3:00 PM EDT AMZN was off by 5% and SPG, for example, was up by 3%. In my view today's stock market action is a transitory phenomena and the mall REITs will be revalued to reflect the GGP transaction. Simply put, AMZN ain't going away, Trump or no Trump.

What that means is that once the Street adjusts net asset values to reflect high quality mall cap rates in the high 5% range, the stocks will settle in to trade at about a 10% discount from the new asset values which implies moderately lower share prices. Why? There is still too much uncertainty in the space and in my view long term interest rates will be significantly higher by year end.

E-Commerce Dominates Holiday Sales

Although brick and mortar retail had a much better than expected holiday sales season, e-commerce dominated the retail scene. Between October and December e-commerce accounted for 49% of the growth in seasonally adjusted total retail sales and 60% of the growth in its addressable market (Defined as total minus autos, gasoline and food services and bars). What this means is that more store closings are on tap as traditional retail reconfigures its store base to account for the growing competition.  Needless to say this eventuality will not be helpful for the struggling mall REITs. The data are below:

                                            In  $ Millions

Category                     October       December      Change

Total                              489,468        495,381        5,913

Less: Autos                    102,794         102,060
          Gasoline                 39,322           40,497
         Rest. & Bars            56,884           57,549

Addressable Mkt.            290,468          295,275      4,807

Non-Store Retail                52,677            55,562      2,885

Non-Store Percent of Total Change  - 49%
Percent of Addressable Change        -  60%

A New Look at Mall REIT Valuations: Part 2

Earlier this month I posted my view on how to approach mall REIT valuations given the stresses engendered by online competition. (See https://shulmaven.blogspot.com/2017/05/a-new-look-at-mall-reit-valuations.html) Since then the mall REITs drifted lower rallied and then fell back a bit. Nevertheless I believe that the burden of proof is on the bulls with the mall REITs continuing to trade at substantial discounts to Street net asset values. (See below) If the Street is right then back up the truck, but my question with the world still awash in a sea of liquidity, where are the sovereign wealth funds and private equity? This is especially true for GGP whose CEO all but announced the company is for sale and where Brookfield already owns 29% of the company. The silence, up to now, is deafening. Thus if private equity or sovereign wealth funds don't come in soon to scoop up the apparent bargain, the Street, as I argued, is way off.

REIT   Street   Market Price   Discount   Mkt. Cap.
             NAV                                              (in $bil)

SPG       214                 157             27%        50
GGP         32                  23              28           20
MAC        79                  59              25              8.5
TCO         95                  62              35              4

In my view sophisticated buyers understand two things. One, there is a structural revolution going on in retail as result of online commerce and two, the retail bankruptcies that we have seen this year will look like child's play during the next recession. Remember we are witnessing an onslaught of retail bankruptcies when income, consumption and employment data are relatively benign, what will happen when the economy turns more hostile.

As a result the clock is ticking. In the absence of a major deal or a portfolio sale/jv (a one-off transaction won't really count) over the next few months, Street estimates of net asset value will have to come down. As they say, time will tell.

A New Look at Mall REIT Valuations

As most REIT practitioners know all too well, the mall sector has been hammered of late by fears of obsolescence engendered by the explosive growth of e-commerce causing the group as a whole to trade at a 30% or so discount to Street net asset value estimates. My explanation is that the estimates of value are way too high. How so?

At the present time the Street seems to be assuming that high quality malls are valued at a 4.5% cap rate, but in my opinion that doesn't take into account the increased capital spending required by mall owners to compete with the likes of Amazon. So instead of using a 4.5% cap rate lets use 5%. There is more though. Simply put some of the high quality malls are going to be degraded over time. My very rough estimate is that about 15% of the high quality malls will be re-rated over the next five years causing a cap rate increase to say 6% for those malls. Thus the weighted average cap rate should be 5.15%.

Now lets add another 50 basis points to allow for higher long term interest rates over the next few years yielding an adjusted cap rate of 5.65%. When you do this exercise you end up with a net asset value approximating current market prices. The arithmetic is below.

Net Operating Income   $45
Cap Rate Today                 4.5%
Firm Value                    $1,000
Debt @30%                       300
Equity Value                      700
Market Value                      490  (30% discount)

New Cap Rate                     5.65%
Firm Value                         $796
Debt                                     300
Pro forma Equity                  496
Market Value                        490

Thus the market might just have it right. You can play with my assumptions to your heart's content, but I think this is a reasonable analytical framework.

Amazon in the Mall: Putting the Fox in the Hen House

Last week General Growth Properties CEO Sandeep Mathrani noted on an earning conference call that Amazon was planning to open up from 300-400 mall stores. He quickly back-tracked by stating that his comment "was not intended to represent Amazon's plans." 

I have no idea whether or not Amazon will embark on such an ambitious plan, but what I do suspect is that Amazon is not going to blow up its business model by opening up a bunch of book stores on very expensive real estate. My guess is that if Amazon is going to go the physical retailing route it will be more than selling books and their proprietary hardware. 

Picture if you will a catalog store that offers the customer the entire Amazon product line in a very easy to use format that goes well beyond today's smart phones. Of a sudden the mall customer would be able to readily comparison shop the entire mall and with that the pricing structure within the mall will crater. This would not be a happy outcome for retailers and their landlords, the giant mall REITs.