The Retail Recession
The retail landscape has undergone a transformational shift over the past year and the struggles aren’t over. Retailers are closing stores at a record pace and it has caused quite the scare for many investors. The threat of e-commerce is growing and many retailers are still trying to adapt. Just the mention of Amazon will make retail analysts start shitting bricks.
Here’s a list provided by Business Insider on the announced store closings for 2017.
Simply put, it’s a crowded space where you have hundreds of retailers trying to sell a basic T-shirt for $50 and hoping that consumers will buy it. But with the entrance of fast fashion retailers like H&M and increasing competition from e-commerce players like Amazon, the current model is being challenged. That same T-shirt can now be purchased for $10 or less. For retailers to succeed in the new retail landscape, they need to focus on the value proposition they offer customers. This is why I believe niche retailers will win big in this environment. But there also other less obvious opportunities.
Among all this chaos, retail REITS have been getting hammered without much regard to the underlying fundamentals. This lead me to purchasing Simon Property Group (NYSE: SPG) back in May as I believe just the value of the real estate assets alone is worth around $205 per share. On top of that SPG is growing revenues at 3.2%, experiencing NOI growth at 3.8% and continues to maintain an occupancy rate of over 95%. The numbers look good, but the stock sold off anyway. This presents an opportunity for long-term investors such as myself, which lead me to purchasing the stock when it was trading around $155 (currently trading at $165), but I think there is still strong upside from these levels. The 4.35% dividend yield is not bad either. It didn’t hit me to share this investment opportunity with my readers since I bought the stock a few months ago (before I even thought about blogging!), but it finally hit me when I was writing Portfolio Update: October 2017 when I mentioned SPG would be one of my main return drivers moving forward. I believe there is still decent upside to be had so I feel inclined to share. After all, sharing is caring right? I outline my thesis below.
Opportunity In Real Estate
The “retail apocalypse”, as this event is being called, started in 2016 and it is estimated that over 4,000 physical retail stores will be affected and roughly half of the 1,200 shopping malls in the U.S. will close. Those are pretty shocking numbers. However, after analyzing the potential drivers that lead to these store closures, it becomes clear that this is really just a supply and demand story.
Shown in the chart above, there has been a complete oversupply of retail space across America when compared to other developed countries. But not all retail space is created equal. There is a growing divergence between Class A real estate and the lower tiers. Class A real estate consists of properties located in affluent areas with high foot traffic and strong demographics. These are prime trophy properties that also tend to attract a lot of tourism.
Check out this chart from J.P. Morgan showing the divergence from Class A malls and Class B malls. Class B properties are still located in decent areas, but might be a little older or run down (with renovation it could become Class A).
So what does it all mean? It means that consumers are shifting towards Class A malls while lower tier malls will have to repurpose or go out of business. The current strategy for Class A retail is to move away from the old “just go there to shop” model and more towards an “experience” model. If you live near a Class A mall, notice that they are redeveloping space previously held by defunct department stores and putting in bars and restaurants. Malls want people to show up for more than just shopping.
Here’s an interesting chart showing the growth trend in the restaurant business. In the midst of retail struggles, restaurants will be willing to step in.
This is more profitable for malls too. Department stores used to attract the most foot traffic to a shopping center, which allowed them to get steep discounts on rent. With all the department store closures, malls have the opportunity to redevelop that space and rent it out to new tenants at a higher rate. As a real life example, Seritage Growth Properties (NYSE: SRG) has been able to increase rent by an average of 4.4x the previous rental rate after re-leasing vacant properties formerly held by Sears.
So the future is actually looking good for Class A retail. Regardless of the Amazon threat, the tenant mix will inevitably change, but the demand for Class A properties remains strong.
The retail REIT sector has been the largest laggard YTD within the real estate sector. According to REIT.com, the total return for retail REITs as a whole was -10.82% (hint: that’s not good). But where there is blood in the streets is where the opportunities are. As you can see in the chart below, the Price/FFO (REIT equivalent to the P/E ratio) across all mall REITs is 9.96x. Shopping centers also look pretty attractive at 13.66x.
Given the average P/E ratio for the S&P is 25x, there is a pretty large valuation discrepancy between retail REITs and the overall market. I don’t see many cheap stocks out there, so when I stumbled across these attractive valuations it immediately peaked my interest. Purchasing a top tier REIT for ~14x, like I did with SPG, is a real bargain at these levels.
I believe in any sell-off there needs to be a clear distinction made between the losers who are structurally doomed and the good companies that sell off in the mayhem. This is done by looking at the catalysts of the sell-off and trying to quantify what is driving the market. In the case of retail REITs the selloff is due to a struggling retail environment, an overbuild of retail space and the rising fear of Amazon. However, the trick is being able to look through each of these issues and determine which of these fears are overblown. I believe long-term that investing in Class A real estate will have limited downside as there will always be demand for premier real estate. The retail model may continue to change as stores may come and go, but the real estate assets will live on.
Those are just my thoughts, curious to know what you think? Feel free to comment below!