In summary, we underestimated the market’s willingness to accept top line growth over profits, as well as the customer’s proclivity to shop online for items we previously thought needed to be in-store (i.e. shoes, furniture, and even cars!). As we came to this realization, we dramatically reduced exposure to retail REITs in the Chilton REIT Composite, taking it from 30.0% (a 1,300 basis point overweight versus the MSCI US REIT Index) on February 28, 2018 to 7.0% as of February 28, 2020 (a 360 basis point underweight). Note that we consider February the last month of pre-COVID conditions.
Then COVID happened, creating the largest drop in retail sales in history, as shown in Figure 1 on the blue line. Stores were not even allowed to be open, and therefore anything that could be done online moved to e-commerce. Compounding the effects of the shutdown were the massive job losses, which peaked at over 40 million. In response, we trimmed the retail REIT exposure further, taking it down to 1.9% by March 31, 2020.
Remarkably, the government stimulus package announced on March 27 bridged the retail sales decline better than we ever could have imagined; the problem for brick and mortar retail was that e-commerce took an inordinate share of the rebound. While stores and restaurants are gradually reopening, we do not believe that consumer behavior will completely revert to pre-COVID ‘norms’ anytime soon, even when a COVID vaccine is readily available to everyone. Thus, any investment into brick and mortar retail today must be made with some view on how consumers will behave post-COVID. Similar to our theme in other property types, we believe there will be the ‘haves’ and ‘have-nots’, with retailers in both camps possibly realizing that the physical store is not as essential as previously thought.
The rebound in retail sales is nothing short of remarkable. Whether it was the stimulus, higher unemployment pay, the Paycheck Protection Program, or using savings from staying at home, the US consumer again proved to be the strongest in the world. Similarly, the stock market rebounded just as quickly helped by the Federal Reserve’s decision to cut short term interest rates to zero and provide record liquidity to the bond market. As a result, the S&P 500 hit all-time highs in September, and the unemployment rate declined from a peak of 14.7% in April to 7.9% in September. The low interest rates also fueled home-buyers, driving up home prices to record highs as well. The summation of both of these resulted in all-time high consumer net worth, which we believe will lead to continued momentum in retail sales even as stimulus runs out.
At the same time, there has been little to no building of new retail space, as shown in Figure 2. Thus, under normal conditions from the past, retail real estate would be enjoying excellent fundamentals. Unfortunately, ‘normal conditions’ have been redefined, and we are currently in the early innings of a long term transformation in consumer behavior that is changing what ‘normal’ is. Basically, COVID has altered life as we know it, accelerating changes that may have taken decades to materialize.
When the ‘stay-at-home’ orders were being issued in March and April, the country found out what the government deemed as truly essential. Grocery, healthcare, home improvement, pet stores, and alcohol got the stamp of approval from local municipalities, while apparel, restaurants, spas, movie theaters, and gyms did not. While no one should be faulted for starting a retailer that wasn’t considered essential during a pandemic, the reality is that the many months of being closed or unprofitable wreaked havoc on their balance sheets.
The Paycheck Protection Program (or PPP) that was part of the stimulus plan only provided forgivable loans for businesses that kept employees working, so the non-essential businesses that could not be open will have to payback some or all of their PPP money. Similarly, many non-essential retailers were able to get relief from landlords either through rent abatements or deferrals.
Again, unfortunately however, the damage done to many retailer balance sheets is beyond repair, which has led to a record number of bankruptcies, and we believe many more will come. In essence, even if these companies have access to capital, what is the point of going further into debt in hopes that a vaccine will help the business rebound to pre-COVID levels? Instead, these companies can take their medicine now, restructure the balance sheets, or even shutter completely, in hopes of starting a new business when a vaccine is available. We place a high uncertainty on the repayment of such loans or rent deferrals given to non-essential retailers.
Regional malls, already under pressure from the rapid rise in e-commerce, now face even more daunting challenges to remain relevant and safe to the consumer. The US has over 1,000 malls and we believe most are destined to close and/or reimagined under the weight of department store closures, declining mall occupancy, and lower rental income. For example, Gap recently announced it will close over 350 Gap and Banana Republic stores over the next three years that were principally mall-based. Furthermore, the staggering capital expenditures that will be required to re-position the physical spaces to alternative uses could be difficult to source from traditional lenders.
Pre-COVID, mall owners were already underway substituting vacant department store space with experiential tenancy such as restaurants and bars, fitness centers, and theaters in hopes to attract shoppers. Millions in capital expenditures now appear suspect since this is where tenant fallout will be the greatest since most fall into the non-essential category. As evidence of the struggles that are weighing on the sector, mall owners CBL Properties (NYSE: CBL) and Pennsylvania REIT (NYSE: PEI) filed for Chapter 11 bankruptcy protection on November 2 in an effort to free up capital to spend on redeveloping and re-leasing vacant space.
Lifestyle centers are threatened as well since they typically blend local retail of a shopping mall with other mixed uses such as lodging. In a forced shutdown, local tenants are much more at risk of permanent closure versus national credit tenants that have much better financial staying power. Thus, we believe both mall and lifestyle owners faced with declining cash flows and higher capital requirements for the foreseeable future.
Street retail, most popular in major urban centers (such as New York City), is now witnessing the worst fundamental environment in decades given work from home mandates that have devastated daytime population. Not surprisingly, COVID-related store closures have been widespread, and many will never re-open. Street retail rents are falling dramatically and, in many locations, are back to 2010 levels. The spike in crime rates brought on by poor political action such as defunding the police are not helping inspire confidence that New York City is a place one wants to live and work. As a result, Vornado Property Trust (NYSE: VNO), a prominent owner of NYC street retail, recently announced a $100 million impairment on its NYC retail joint venture portfolio.
Power centers are typically quite large and include three or more ‘big box’ stores as anchor tenants and include smaller retail shops and restaurants that are either free-standing or located together much like a strip center with a shared parking lot. Many of these tenants such as book stores, office supply chains, apparel retailers are increasingly at risk of closure due to e-commerce. Even though some of these tenants have access to capital and potentially have staying power, there are no other tenants to replace them, giving all of the negotiating power to the tenant instead of the landlord. Likewise, outlet centers, heavily reliant on apparel tenancy, face huge challenges maintaining occupancy, which will lead to lower rents.
Despite the gloomy assessment for many property types above, there are segments of brick and mortar retail doing just fine, including grocery stores. The shift away from eating at restaurants to more home prepared meals has translated into a strong growth in supermarket sales, both in-store and online. Increasingly, consumers are using e-commerce to obtain household needs, either employing BOPIS or delivery services. For example, Kroger (NYSE: KR) reported a 127% increase in its digital sales and Albertson’s (NYSE: ACI) came in at +243% in the second quarter. In-store sales for both companies are up double digits. As a result, grocer share prices have been rising dramatically, affording them a cost of capital to expand, both online and in-store. Kroger is approaching a four year high, and is up almost 50% in the past year. The higher share prices also prompted Albertson’s to commence an initial public offering, raising $800 million in equity. Furthermore, as a follow-up to its purchase of Whole Foods in 2017, Amazon also plans a national roll-out of Amazon Go grocery stores.
The beneficiary of the intense grocer competition will be the grocery-anchored shopping center owners. Current landlords get the benefit of an enhanced credit profile, along with a tenant that is willing to invest in its space to meet the needs of the neighborhood. Traditionally, these centers are ideally located close to the consumer and provide ‘essential’ services to the local clientele. Instead of large boxes leased to credit tenants or small boxes leased to ‘internet vulnerable tenants’, grocery-anchored centers should have negotiating power with its small shop tenant base. For example, if a barber shop is asking for a rent cut, the landlord doesn’t have to feel pressured given that another operator should be interested in serving that population that still needs a place to get a haircut.
While the credit quality may not be as high as the big box tenants, the amount of prospective tenants that can backfill a 2,000 sqft vacancy at a grocery-anchored center is much higher than that of a 10,000 to 25,000 sqft space at a power center. In addition to service tenants, healthcare, drug store, and to-go restaurants are filling up vacant spaces due to COVID. Furthermore, the landlord can ‘afford’ to have a few small boxes vacant, and still boast occupancy above 90%. In contrast, a vacant big box could result in negative cash flow at a power center.
In addition to maintaining and even growing rent and occupancy, grocery-anchored centers are also at an advantage when it comes to capital expenditures. Big box tenants can use their negotiating power in times like these to ask landlords for significant capital to renovate their space, or even ask the landlord to ‘cut up’ the space (not an inexpensive endeavor), still leaving vacancy that needs to be leased.
The public retail REITs, including those that are tilted toward grocery-anchored centers, have been some of the worst performers year to date. As of October 31, the year to date performance of the Bloomberg Regional Mall REIT Index (Bloomberg: BBREMALL), which includes outlet centers, was -54.1%. In comparison, the MSCI US REIT Index (Bloomberg: RMZ) produced a total return of -19.2% over the same period. Though not as bad as malls, the -47.2% year to date performance for the Bloomberg Shopping Center REIT Index (Bloomberg: BBRESHOP), which includes power centers, lifestyle centers, street retail, and grocery-anchored centers, also ranks near the bottom.
The decline in prices since their peak in 2016 has resulted in a much smaller presence in the benchmark. As of October 31, the weights of the regional mall and shopping center sectors in the RMZ were 3.0% and 3.6%, respectively. In contrast, the Chilton REIT Portfolio had no exposure to regional malls and a 1.2% allocation to shopping centers as of the same date. The underweights reflect the operational risks relayed above, as well as uncertainty on valuation, which remains elusive given the lack of transactions and the difficulty to project future cash flows of a national portfolio. The only Chilton retail REIT holding as of October 31 was Alexander Baldwin (NYSE: ALEX), which derives 66% of its net operating income from grocery-anchored shopping centers in Hawaii. We believe Hawaii is particularly attractive for retail real estate due to the need to transport goods by air or water to consumers, which should slow e-commerce penetration. The other 34% of the portfolio is comprised of industrial, office, and ground leases on freestanding buildings in Hawaii, which are all faring well in this environment.
From a balance sheet perspective, retail REITs have done as much as they can to ensure they have liquidity to endure the period of transformation. As of June 30, the weighted average net debt/EBITDA ratios for the regional mall and shopping centers REITs were 7.9x and 7.2x, respectively. The share price performance has shut down access to equity capital, but some REITs have issued debt. For example, Kimco (NYSE: KIM) issued $500 million in unsecured bonds at a 2.8% coupon in July with a 10 year maturity. Most other retail REITs have relied on their lines of credit. ALEX had a net debt/EBITDA ratio of 6.6x as of September 30, 2020, which will come down as the company sells non-core assets.
Almost all retail REITs have cut or suspended dividends in order to preserve cash. While rent collections have improved dramatically since the second quarter, even the REITs that are producing positive cash flow need to hold onto cash to pay for re-tenanting and re-positioning of properties. When re-instated, we expected dividends to be set at the taxable minimum to remain a REIT. ALEX has suspended its dividend, though we expect a distribution by the end of the year to maintain its REIT qualification.
As shown in Figure 3, both shopping centers and regional malls are rated as very high risk given the low multiples at which they trade. Referring back to our original ‘essential REIT decision tree’, the cash flow uncertainty means that many properties need to be valued at land value, or potentially even less, given the costs to demolish and re-permit. As such, we agree with how the market has ascribed risk to both sectors.
We are maintaining a significant underweight to retail REITs due to the low predictability of fundamentals caused by COVID and the resulting recession. While BBREMALL and BBRESHOP index prices are up 33.3% and 16.9% from their bottom on April 2, respectively, we believe they will be dealing with the fall-out from closing stores and bankruptcies for years. Not helping is GAAP accounting that is obscuring the true magnitude of tenant fallout occurring already. Quarterly results announced are not based upon cash but accrual accounting and thus, it is difficult to accurately evaluate rent collections, when deferred rent may be received, if ever, and the appropriateness of bad debt charges. This makes it extremely difficult to project near term and long term stabilized net operating income.
We believe that grocery-anchored centers, if not in a portfolio weighed down by other centers, will be able to thrive even in the current difficult environment. Our position in ALEX, which is comprised 66% of grocery-anchored centers on Hawaii, isolates this theme and is undervalued in our opinion, particularly when applying market multiples on the industrial and ground lease portion of the portfolio.
We are closely monitoring other retail REITs with grocery-anchored centers for similar opportunities. We will consider adding exposure when we get more conviction on the valuation and cash flow trajectory of the non-grocery-anchored center portion of their portfolios. Similarly, despite the deeply discounted valuations in the mall sector, we are not comfortable with the risk of long term dilution from vacancy, declining rents, and capital expenditures.
Matthew R. Werner, CFA
Bruce G. Garrison, CFA
RMS: 1940 (10.31.2020) vs 2402 (12.31.2019) vs 346 (3.6.2009) and 1330 (2.7.2007)
Previous editions of the Chilton Capital REIT Outlook are available at www.chiltonreit.com/category/library/reit-outlook/.
An investment cannot be made directly in an index. The funds consist of securities which vary significantly from those in the benchmark indexes listed above and performance calculation methods may not be entirely comparable. Accordingly, comparing results shown to those of such indexes may be of limited use.
The information contained herein should be considered to be current only as of the date indicated, and we do not undertake any obligation to update the information contained herein in light of later circumstances or events. This publication may contain forward looking statements and projections that are based on the current beliefs and assumptions of Chilton Capital Management and on information currently available that we believe to be reasonable, however, such statements necessarily involve risks, uncertainties and assumptions, and prospective investors may not put undue reliance on any of these statements. This communication is provided for informational purposes only and does not constitute an offer or a solicitation to buy, hold, or sell an interest in any Chilton investment or any other security.
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