No More Moats for Mall Owners

Our new take on the U.S. mall real estate investment trusts incorporates numerous headwinds facing the industry. We have reduced our fair value estimates for

Former moat sources for regional malls included efficient scale and network effect. While we do see traces of these moat sources in each of the mall REITs we cover, our uncertainty surrounding the physical retail environment is too high to award an economic moat. We see a diminishing network effect for all three names, as retailers shift strategies and place less emphasis on physical storefronts, a primary result of the move to e-commerce.

Occupancy cost ratios which, from a tenant perspective, compare the amount of rent paid with the sales produced from that space are on the rise. While these figures are still within an acceptable range, we fear that the upward trend, coupled with retail headwinds, will continue to financially pressure tenants and reduce mall owners’ abilities to push rents.

The rise of e-commerce has hit malls hard, and we think the pain has just begun. Although online sales account for only 10% of total retail sales, this percentage is climbing at a double-digit pace annually, softening demand for physical store space.

While we believe retailers desire a storefront presence to interact with customers and display and market their brands, we see malls taking a significant hit in an already overretailed environment. Many top mall tenants are rethinking their strategies: L Brands, a top tenant of the mall owners we cover, lowered its projected North America square footage growth guidance to between flat and up low single digits annually.

Another familiar face in malls, Gap, has shed about 4% of its square footage since 2014 while shifting its strategy online. We expect other large retailers to follow, given the headwinds facing the industry. Occupancy rates should remain high in the midterm, but we believe mall owners will need to ease on pricing to attract tenants in the future, as sales shift online and less emphasis is placed on physical locations. Malls are no strangers to shifts in trends and have largely adapted over the years, but we see e-commerce and technology as a never-before-seen disrupter that will change the game.

Our lower valuations are driven by the inevitable shift in pricing power from landlord to tenant. Mall owners will desperately attempt to keep storefronts occupied, as vacancies are aesthetically displeasing to shoppers and can further deter demand for space. Landlords will need to ease rents to attract retailers, and as a larger portion of sales shift online, we expect marginally profitable brick-and-mortar stores to slowly shutter, leaving mall landlords searching to backfill space. We believe double-digit leasing spreads are a thing of the past and see these slowly easing to the low single digits. Likewise, we see contractual rent bumps softening as tenants sign shorter leases due to industry uncertainties.

Mall landlords believe they can revitalize the shopping experience with lofty redevelopments, but this approach is highly capital-intensive and also carries great uncertainty, making it a risky endeavor. With the U.S. massively overretailed as it is, we think the industry as a whole will have a tough road ahead.