The coronavirus pandemic took a significant toll on the mall real estate investment trust (REIT) sector. Two of the property niche's largest names went bankrupt in 2020, and another is already on the rocks in 2021. But industry giant Simon Property Group (NYSE: SPG) isn't willing to take a bad leasing deal just to fill its empty malls. Here's why, and why it can take that aggressive, and shareholder friendly, stance.
A differentiated portfolio
Mall REITs were already facing hard times before the coronavirus pandemic hit, as the so-called retail apocalypse was leading to retailers closing stores. Although often oversimplified as a shift toward online shopping, the trends here were far more complex, including excessive use of leverage and retailers falling behind consumer trends (including, but not limited to, online shopping). Either way, vacancies were on the rise, and mall landlords like Simon were increasingly having trouble filling empty space.
The pandemic sped up the trend, with stores that had been struggling but surviving getting forced over the edge by government-mandated shutdowns and social distancing. That, in turn, pushed mall REITs like CBL & Associates and Penn REIT into bankruptcy court. Once again, however, the problem was more complex than it first seems. Retailers closing stores was a key issue, but so too was heavy leverage. Adding another layer here was the location and quality of the malls owned by the REITs -- which gets to the crux of Simon Property Group's stance on leases now that vaccines are helping the world get a handle on the coronavirus pandemic.
Malls fall along a scale, just like any property type, from good to bad. The best malls are generally located near large population centers filled with wealthy buyers. They also tend to be well maintained. Lesser malls are often in rural areas with smaller and less affluent populations and are frequently older and sometimes suffer from a lack of investment. It isn't particularly complex; retailers want to be in the best malls. Simon's portfolio of around 200 or so malls and outlet centers are generally well-positioned on this front relative to peers.
Positioning for the future
The pandemic, however, upended the normal functioning of the retail industry, and even good malls are facing elevated vacancy levels. Simon's occupancy, for example, was 95.1% at the end of 2019 but just 90.8% at the end of the first quarter of 2021. That's a brutal drop in just 15 months, mostly related to the impact of the coronavirus. The company has worked with tenants to keep its malls occupied, but it hasn't been willing to acquiesce to any old offer from retailers. In fact, it even took took GAP to court over the retailer's refusal to pay rent.
Simon's contention was basically that some retailers were using the pandemic as an excuse to push unreasonably hard bargaining stances, even though they had the financial strength to live up to their contractual obligations. As Simon continues to work through this difficult period, it's inking new leases and renewing older ones.
Indeed, business has to keep moving forward. It's clear, however, that the pandemic has weakened the mall REIT's bargaining position, given the low occupancy level. It has been willing to cut deals that it might not have done in a different environment, including adding more leases that are tied to sales performance.
CEO David Simon was pretty frank about the occupancy issue during Simon Property Group's first-quarter 2020 earnings conference call. He explained that it could take until 2023 to get back to pre-COVID occupancy levels because the REIT is taking a "tactical" response. According to the CEO, "If they're not paying what we think is fair, we'd just rather sit on empty space." In other words, Simon refuses to be taken advantage of just so it can fill empty spaces. Moreover, taking a bad deal from one tenant could weaken the landlord’s hand in negotiations with other tenants.
The strength of the REIT's portfolio is a key reason it can take this stance. In fact, during the quarterly call, the CEO noted that, in the first quarter, "our leasing volume in both number of leases in square feet was greater than the volume in each of the first quarter of 2020 and 2019." So it isn't exactly struggling to find tenants, but it does have a deep hole to dig out of. Thus, management has some leeway to take what some might call an aggressive stance even if it delays a return to higher occupancy levels.
Investors, however, should see this is a good business decision, given mall leases can last for a decade. Indeed, Simon isn't thinking about next year so much as it is thinking out to two, three, and four years, when being saddled with bad leases would leave it earning less than it might otherwise be capable of. That, in turn, would limit its ability to maintain its properties and return value to investors via dividends.
The right move
Investors should be pleased with this decision, even if it means a slower occupancy recovery for Simon. It’s actually compelling that the mall REIT isn't willing to short-sell its properties over the long term just so it can report a better occupancy statistic in the near term. That's a hard choice, but likely the correct one for the REIT and its shareholders. So, as you watch the mall REIT recovery, don't get too caught up in the occupancy numbers -- there's much more at stake than that.