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Simon Gets an Upgrade -- but Don't Get Too Excited

Apr 25, 2021 by Reuben Gregg Brewer
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Wall Street likes news because it provides something to trade on. Just recently, mall-focused real estate investment trust (REIT) Simon Property Group (NYSE: SPG) saw a bit of a headline-grabbing event, as it was upgraded by Jefferies. That's interesting, for sure, but is it really newsworthy? Here are some things investors should consider about this analyst call.

A not-so-simple situation

In a nutshell, Jefferies upgraded Simon Property Group to "buy." The big call here is that the analyst believes investors are underestimating the value offered by the REIT. Not shockingly, investors bid up Simon's shares on the news. However, before jumping aboard this train, investors really need to question: Why is Simon undervalued today?

The quick answer is that malls were particularly hard-hit by the coronavirus pandemic in 2020. When governments around the world shut down nonessential businesses, malls had to close. Rent collection rates plunged across the industry, with Simon actually taking some of its largest tenants to court in an effort to ensure it got paid what it was owed. That's an ugly situation, to be sure, and Simon was forced to cut its dividend by roughly 40%.

When malls were eventually allowed to reopen, foot traffic was light because people were still being asked to socially distance. Although Simon argued early on that walking a mall was little different than walking through a Walmart (NYSE: WMT), consumers still weren't willing to rush out to a property purpose-built to bring people into a group setting.

All of this exacerbated the toll online retail was already taking on the physical retail world, often referred to as the retail apocalypse. The retail apocalypse involves much more than just the shift toward online shopping, of course, but there's little doubt that retailers struggling before the pandemic ended up struggling even more during it. Many went bankrupt, while some surviving nameplates decided it was time to rationalize their footprints and close stores.

Cheap for a reason

Given that backdrop, Simon's stock fell sharply in the early days of the pandemic. And while it has since started to recover, the shares are still 20% below where they started out in 2020. And they're roughly 50% below the highs reached in 2016. So the undervalued call isn't outlandish at all, even noting that funds from operations (FFO) fell 24% in 2020. In reality, that's a pretty solid showing, given the terrible business backdrop last year.

But here's the problem with this situation. In 2021, Simon is calling for FFO to be between $9.50 and $9.75 a share. FFO in 2020 was $9.11 per share. So the projected growth here is somewhere between 4% and 7%. Even the top end of the range isn't exactly a huge increase. In other words, there's no quick turnaround in the cards here.

That makes complete sense when you consider what has to be done. Simon's malls have lost tenants. Replacing them is a process that requires careful consideration, because malls are an ecosystem within which each store impacts all the others. You not only have to find a new tenant, but one that fits well within the property. It takes time to do this, including upgrading the vacant space so it can be occupied.

While you're working on that, other tenants won't be happy because vacancies make malls less attractive to consumers. So a mall landlord might have to offer rent concessions to keep retailers in place. Thus, rents here might have to be built back up over time as well.

So while Simon may represent a value in the mall space today, there's no clear reason to expect a quick recovery in its business. This suggests that it could remain relatively unloved on Wall Street for a while. At the very least, if you buy it, you will have to wait for the recovery to really take hold and show up in the numbers. All in, Simon is, at best, in the early stages of a multi-year turnaround effort. If you buy the stock, you need to understand this fact.

The cleanest dirty shirt

Compared to peers, Simon is performing fairly well right now. But that's not actually saying a whole lot, since some of its peers have taken trips into bankruptcy court. While it's reassuring to see Wall Street recognize Simon's success and the prospects for its turnaround, investors should go in with their eyes wide open. This mall REIT has a lot of work ahead of it, and progress is likely to be slow because of the nature of the business. That's not a knock on Simon, just a fact you need to understand before getting too excited about an analyst rating upgrade.

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Reuben Gregg Brewer owns shares of Simon Property Group. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.