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REIT Rankings: Shopping Center

REIT Ranking Overview

In our “REIT Rankings” series, we introduce readers to one of the 13 REIT sectors and the individual REITs that comprise these sectors, focusing only on the larger, internally managed REITs with proven track records of performance.

We rank REITs within the sectors based on both common and unique valuation metrics, presenting investors with numerous options that fit their own investing style and risk/return objectives. We plan to update these rankings every quarter.

We encourage readers to follow our Seeking Alpha page (click “Follow” at the top) to continue to stay up to date on our REIT rankings, weekly recaps, and analysis on the REIT and broader real estate sector.

Shopping Center Sector Overview

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(M Street, Georgetown DC. Acadia Investor Presentation)

If baseball is America’s favorite pastime, shopping is a close second. American are projected to spend nearly $5 trillion at the retail cash register in 2016: an increase of over 30% from the depths of the recent recession. Despite the gloom and doom that encumbers many discussions of brick and mortar retail, the vast majority of those sales (roughly 92%) are purchased in one of over 100,000 shopping centers in the United States.

The US has the most retail space per capita in the world, though this ratio has steadily moderated since the recession as population growth has outpaced new construction of shopping centers.

Shopping centers, as we categorize them, are all open-air multi-tenant retail centers. These are distinct from closed-air malls and single-tenant properties, which we cover in separate REIT rankings.

Shopping centers are typically grouped into roughly 10 categories based on the typical tenant mix, trade size area, and average gross lease area (GLA). Below we highlight the official categorization of The International Council of Shopping Centers (ICSC). Shopping center REITs typically own a mix of community, neighborhood, strip, power, and lifestyle centers, of which there are roughly 115,000 in total comprising 6 billion square feet.

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(ShoppingCenters.com)

The quality and value of a shopping center is typically a function of the demographics of its trade area; large, affluent populations tend to command higher average base rent (ABR) per square foot. The characteristics of the anchor tenant(s) are also critical; grocery-anchored shopping centers generally attract more traffic and are less prone to future weakness related to e-commerce.

E-commerce is the elephant in the room when it comes to brick and mortar retail. In Q2 2016, 8.1% of retail sales are done through e-commerce channels: an increase from 1% at the start of the millennium with few signs of slowing down. We do believe, though, that there is a natural limit to e-commerce as a percent of total retail sales, as many stores and items are simply internet-proof. While the “brick and mortar is dying” sentiment may be in-vogue right now, at some point, e-commerce sales will reach a plateau as a percent of retail sales. Whether that percent is 10% or 30% is up for debate and has significant ramifications for shopping center REITs.

Following the rapid expansion of America’s retail footprint, from 1980 until the recession of 2008, construction of new shopping center facilities has come to a screeching halt. Shopping center supply growth, as highlighted in a slide form Kimco’s Investor Presentation below, has hovered around 0% since 2009. While the media jumps at the opportunity to point out when major retailers are closing stores, they typically fail to point out that many of these same stores, along with new and growing retailers, are opening stores in other locations.

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(Kimco Investor Presentation)

Shopping center owners, as highlighted in Regency’s investor presentation below, differentiate between different levels of “internet risk.” Grocers, service-based retailer, restaurants, gyms, and medical facilities are largely immune from the rising share of e-commerce. Omni-channel retailers such as home improvement, pharmacies, financial services, and clothing stores are generally in a “moderate risk” category.

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(Regency Investor Presentation)

Retailers continue to see significant brand-shaping value in having a brick and mortar presence to compliment their e-commerce focus. Amazon itself plans to open up to 100 stores by 2017 according to Business Insider reports: perhaps the biggest testament to retailer’s perceived value of the in-person retail experience. Finally, the “high internet risk” category tends to include book stores, electronics retailers, and office supply stores.

Like malls, the performance of shopping center real estate is a function of the supply/demand fundamentals for the underlying retail space. Over the past half-decade, shopping centers REIT performance has been a “supply-driven” thesis; a lack of new construction has given real estate owners negotiating power to raise rents and operate at near-full occupancy.

Thus, over the short and medium term, the ability to raise rents on retailers is primarily a function of the pure quantity of retailers competing over a finite amount of retail space, rather than on the operating performance or profitability of those retailers. Over the longer term, data related to the growth in retail sales and the percentage of those retail sales that are completed online are determinants of demand for retail space. In the short-term, don’t expect shopping center REITs to correlate perfectly with strong or weak retail sales data in the same fashion as the retailers themselves.

Finally, investors should note the lease characteristics of the shopping center sector. New leases for anchor tenants are typically 20 years or more. Strong anchors that attract foot traffic, like Whole Foods, tend to be able to command very favorable rental rates, as shopping centers are able to charge higher rents on other stores that will benefit from the anchor’s presence. Smaller store leases tend to be in the 5 to 10 year range, which is still above the broader REIT average lease length. We will discuss the investment implications of these characteristics throughout the report.

Shopping Center REIT Overview

Shopping Center REITs comprise roughly 10% of the REIT Index (NYSEARCA:VNQ). Within our market-value-weighted shopping center index, we track twelve of the eighteen shopping center REITs within the sector, which account for roughly $70 billion in market value:

American Assets (NYSE:AAT), Brixmor (NYSE:BRX), DDR (NYSE:DDR), Equity One (NYSE:EQY), Federal Realty (NYSE:FRT), Kimco (NYSE:KIM), Regency Centers (NYSE:REG), Retail Opportunity (NASDAQ:ROIC), Retail Properties of America (NYSE:RPAI), Urban Edge (NYSE:UE), and Weingarten (NYSE:WRI).

Below we show the size, geographical focus, property focus, and quality focus of the twelve shopping center REITs we track. Like other REIT sectors, shopping center REITs tend to specialize in certain specific property-type within a shopping center space, a specific geographic area, or a specific value quality.

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(Hoya Capital Real Estate)

As we described above, “quality” is determined by the average value of the shopping center facilities within the REIT’s portfolio, which is a function of location and tenant quality. Below, Regency’s Investor Presentation illustrates some of the ways that the quality of these portfolios are evaluated. Note the importance of the demographics of the trade area and the presence of high quality anchors like grocers.

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The quality of the portfolio translates into higher average base rents (NYSE:AVB) per occupied square foot, and this tends to be accompanied by higher capitalization rates. RPAI’s slide below shows the direct liner relationship between ABR and the implied market value of the REIT portfolio.

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(RPAI Investor Presentation)

Recent Performance of the Shopping Center Sector

Even with all the gloom and doom surrounding brick and mortar retail, shopping center REITs have actually outperformed the broader REIT index over the trailing one, two, and three-year periods. The shopping center index is up 33% over the prior 3 years, 24% over the prior 2 years, and 19% over the prior 1 year.

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(Hoya Capital Real Estate)

Much of the outperformance this past year, though, was tallied in the early part of the period. The 1-Year Relative Performance chart shows that shopping centers performed well through the early part of 2016, but have actually underperformed the REIT index over the prior six months and quarter.

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(Hoya Capital Real Estate)

Multiple Valuation of the Shopping Center Sector

On a cash-flow basis, shopping center REITs appear quite expensive.

Shopping Center REITs are the third most expensive sector based on current and forward Free Cash Flow multiples. At 27x current and 25x forward FCF, shopping center REITs are trading at premiums to the sector average of roughly 24x and 22x, respectively.

When we factor in two-year growth potential, the sector appears slightly more expensive relative to other sectors. We use a modified PEG ratio, using the forward FCF multiple divided by the expected 2-year growth rate, which we call FCF/G. Based on an FCF/G of 8, shopping center REITs still screen as expensive compared to the average FCF/G REIT multiple of 4.5.

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(Hoya Capital Real Estate, company financial statements)

Expected to grow FCF at roughly 8% over the next two years, shopping center REITs are roughly inline with the broader REIT sector’s expected growth rate of 7.5%.

Dividend Yield and Payout Ratio

Based on dividend yield, shopping center REITs, yielding 3.3%, are roughly inline with the sector average of 3.4%. These firms, though, pay out only 86% of their cash flow towards dividends, towards the upper range of REITs, leaving less room for dividend expansion or growth via retained cash.

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(Hoya Capital Real Estate, company financial statements)

Sensitivities to Interest Rates and Economic Growth

Followers of our research know that we put a lot of emphasis on factor analysis, specifically looking at how REITs have historically responded to changes in the broader equities market, interest rates, and to movements in the REIT index itself. We believe it is critical that investors understand how their investments will respond to different economic environments.

Using our Beta calculations, shopping center REITs are neither clearly “bond-like” nor “equity-like.” With relatively average sensitivities to both equity movements and treasury bond movements, we classify the sector in the “hybrid” category and naturally have a balanced exposure to economic and interest rate factors, unlike many REIT sectors which are highly exposed to one or the other.

For a more specific explanation of these calculations, we highlighted the dynamics of bond-like and equity-like REITs in our previous articles, “Are REITs Bond Substitutes” and “REITs Without Interest Rate Risk.”

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(Hoya Capital Real Estate, company financial statements)

Individual Shopping Center REIT Performance

We now move into rankings and analysis of the specific REITs that comprise the sector.

As we highlighted, shopping center REITs have been among the strongest performing REIT sectors over the past several years, but have struggled over the past six months. Regency, Federal Realty, and Retail Opportunity are the three top aggregate performers over the prior three years.

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(Hoya Capital Real Estate)

Shopping Center REIT Performance Relative to Shopping Center Index

We find it very useful to analyze how individual REITs perform relative to their peers to identify sector-neutral performance patterns. We are looking for trends (size, geographical, quality focus) that explain how the particular REIT’s strategy focus contributed to the performance. Note that these performance figures are relative, not absolute.

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(Hoya Capital Real Estate)

We see why this exercises can be useful. The following two trends stick out that are worth exploring and show the importance of understanding the strategy focus of REITs when constructing a balanced or targeted portfolio.

First, there is a divergence in the operating performance between the REITs that have focused on higher quality assets and those with lower quality assets. Of the four REITs that fall into the “Low” quality focus category, only one has outperformed over the prior three-year period, but all four have outperformed over the prior year. Clearly, market sentiment surrounding these lower quality assets improved considerably over the past year.

Second, from a geographical perspective, REITs that have west coast exposure have outperformed over nearly every period. American Assets, Equity One, Regency, ROIC, and Weingarten have been among the strongest performers, independent of quality-focus.

Shopping Center REIT Valuation Rankings

As we always highlight, in efficient markets, high multiples are a function of an expectation of stronger future operating performance, as well as the predictability and sustainability of future cash flows.

Some companies, particularly those with management teams that have a proven track record of Net Asset Value growth, warrant a persistently high multiple, while other companies achieve a higher than warranted multiple through a shorter-term market inefficiency.

Equity multiples have added operational significance for REITs. As REITs must raise equity capital to fuel growth, equity that can be sold at a premium is cheaper and thus more likely to result in NAV accretion. In that way, equity valuations for REITs have self-reinforcing characteristics. Thus, cheap REITs have a tendency to stay cheap and expensive REITs tend to stay expensive.

As described above, shopping center REITs are some of the more expensive REITs based on both FCF multiples and FCF/G ratios. As we see, though, high FCF/G ratios in DDR and RPAI seems to have inflated the average due to their slow expected growth rate in FCF over the next several years, and there are quite a bit of attractive valuations within the sector.

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(Hoya Capital Real Estate, company financial statements)

As implied by the ABV vs. Cap Rate chart discussed earlier, Brixmor and Weingarten, both pursuing strategies of owning lower quality assets, screen as the cheapest across these cash flow metrics. Investors may interpret this to imply that these names are undervalued, or that the market demands a higher discount for these lower quality assets.

American Assets and Kimco, appearing as expensive based on FCFx multiples alone, actually appear quite attractive based on FCF/G, a reflection of their anticipated growth rates over the next several years.

Sensitivities to Interest Rate and Economic Growth Factors

On average, Shopping Center REITs don’t exhibit particularly high sensitivities to either interest rates or equities. As expected, REITs with a lower quality focus tend to be more sensitive to movements in the broader equity market, while REITs with higher quality and more predicable assets tend to be more bond-like and sensitive to interest rates.

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(Hoya Capital Real Estate)

Dividend Yields

Finally, when it comes to dividend yields, there is quite a bit of variation within the shopping center REIT sector.

Investors seeking above-average yields may turn to the lower-quality focused names: DDR, RPAI, or WRI.

Investors that are less concerned with immediate income may prefer the more moderate yielding REITs that retain more cash flow for acquisition or future dividend increase such as AAT, REG, and FRT.

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(Hoya Capital Real Estate, company financial statements)

Bottom Line

Contrary to the headlines, brick and mortar retailers are not going away anytime soon. While their space is undoubtedly being encroached upon by e-commerce, the true reach of e-commerce as a percent of retail sales is limited. Whether that limit is 10% or 30% is at the crux of one’s decision to invest in retail real estate. Shopping centers are adjusting their retail mix accordingly and positioning their strategy around tenants that are more immune from the threats of online commerce.

As an investment, shopping center REITs have several attractive qualities. First, these REITs exhibit only a moderate amount of sensitivity to interest rates and economic data unlike many other REIT sectors that are highly exposed to at least one of those factors. Second, the amount of “players” in the shopping center REIT space allow informed investors to tailor their portfolio to make a call on specific quality-focused or geographic-focused assets. For example, investors that recognized the growth in west coast retail were able to outperform considerably over the prior three years. This type of tailoring is not achievable in all REIT sectors.

Cash flow multiples rank the sector as one of the most expensive, as investors don’t appear to be phased by the negative headlines that seem to plague retailers. As discussed, the shopping center sector is really a “low-supply-driven thesis,” with almost 0% supply growth over the prior 5 years and very low growth expected in the future, shopping center REITs will continue to perform well if there is even moderate growth in demand for space from retailers.

Let us know in the comments if you would like us to expand on any part of the analysis. Again, we encourage readers to follow our Seeking Alpha page (click “Follow” at the top) to continue to stay up to date on our REIT rankings, weekly recaps, and analysis on the REIT and broader real estate sector.

Be sure to check out our other REIT Rankings articles, located on our author page. (Click to view)

Disclosure: I am/we are long EQY.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: All of our research is for educational purpose only, always provided free of charge exclusively on Seeking Alpha. Recommendations and commentary are purely theoretical and not intended as investment advice. Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. For investment advice, consult your financial advisor.