Turnaround stories can be very appealing, but investors need to go in with a full appreciation of the risks. That's the big-picture framework needed to properly examine Pennsylvania Real Estate Investment Trust (NYSE: PEI) today. In the end, most investors interested in this mall landlord will probably prefer a different name in this real estate niche. Here's why.
Penn REIT's shares have gained 90% so far this year. That is a massive advance, nearly double that of mall real estate investment trust (REIT) giant Simon Property Group (NYSE: SPG), which is "only" up around 50% or so. The main reason for the price gains at both is that investors have come to the realization that malls continue to be important in the retail landscape, proven out by recovering foot traffic and sales.
For example, Penn REIT's second-quarter results included 92.6% occupancy and record sales per square foot of $549 at core malls. Simon, meanwhile, increased its full-year outlook in both the first and second quarters.
Although the mall industry was effectively left for dead in the early days of the coronavirus pandemic, it is clearly showing material staying power. Humans are social animals and shopping is a social activity, so this isn't all that shocking. However, there's a big difference between these two mall names, and chasing stock performance today would be a mistake. Highlighting this, Penn REIT, despite the still-huge year-to-date gain, is roughly 40% below its highs in June. Meanwhile, Simon's stock is only about 5% below its recent highs.
What's going on?
The first thing to note is that Penn REIT highlighted core malls. That's because it has been streamlining its business, jettisoning lesser assets to focus around its best properties. This is a solid business call, but part of that process involved a trip through bankruptcy court in pandemic-hit 2020. That's not exactly something investors should be overjoyed about. Simon bought a competitor in 2020 and made a number of investments in retailers, showing just how much better positioned it was going into the industry downturn.
To be fair, Penn REIT didn't wipe investors out when it declared bankruptcy, which is fairly impressive. However, it also didn't do much to mend its balance sheet, which is a problem given that excessive leverage was a big part of why it needed to restructure in the first place.
To provide some context here, the company's financial debt-to-equity ratio is roughly 10 times today versus 0.65 times for Simon. Leverage reduces a company's flexibility, and Penn REIT is still highly leveraged even after seeking bankruptcy protections. Effectively the biggest benefit of the bankruptcy was getting out from under lesser malls it owned, which is positive but not a complete solution.
Then there's a more fundamental issue about REITs, which are designed to pass income on to shareholders. Penn REIT stopped paying dividends in 2020 and has yet to resume them. Simon cut its dividend nearly 40% last year but has already started to increase it again, with hikes announced in June and August. Clearly, Simon has managed this difficult period better than Penn REIT.
So the real question when it comes to Penn REIT is whether the turnaround opportunity in the stock is worth the material risks. Indeed, with no dividend, that's all the REIT has to offer right now. And, with a still-massive debt load, any further industry headwinds, like the newest variant of the coronavirus, could easily turn into a major problem. In other words, the risk here seems much greater than the potential rewards right now.
Caution is in order
It's super easy to look backward and say which investments were the best ones. Indeed, hindsight is 20/20. The problem is that investing involves making educated guesses about the unknowable future. Sure, Penn REIT's stock has been a bigger winner than Simon's so far this year, but when you dig into the story just a little, it's very clear that Simon is the better positioned mall REIT. Don't get caught up in the excitement around Penn REIT's fast-moving stock price; it's simply not worth the inherent risks. Simon's risk/reward balance is much more attractive.