AA: How much of a differential are you seeing today between top-tier malls and the rest of the mall sector?

Goldfarb: It’s night and day between the top and bottom tier. The top tier can still get financing and have a waiting list of tenants who want to come in. Dominant malls don’t necessarily mean those that can be redeveloped into mixed use. It just means malls that have a value that is greater to tenants who aren’t there and want to be there versus malls where they’re struggling to keep anyone there.

van Dijkum: We believe the vast majority of value in the mall industry is in the A rated malls but by number they likely account for just under 30% of the surviving malls. We estimate that four owners account for 80% of the A rated malls in the U.S. These properties could see more than 5% annual underlying NOI growth over the next years, due to a combination of increased occupancy, positive rent spreads, fixed annual rent bumps, and higher tenant sales. We expect lower quality and over-leveraged malls will continue to wither and close over the next few years.

St. Juste: The productivity gap between top-tier malls (A/A+) malls and B/C malls has widened. For example, Macerich’s Broadway Plaza and Scottsdale Fashion Square are at approximately $2,000 per square foot (psf) and about $1,800 psf in sales, respectively, while we estimate that Class B/C malls are about $500 psf or lower.

AA: How have REITs positioned themselves to deal with challenges and opportunities in the mall space?

St. Juste: Balance sheet liquidity and flexibility are of utmost importance as the transaction market for malls is very light and owners cannot sell malls to pay down debt.

van Dijkum: Mall REITs have been selectively pruning their portfolios as debt on highly leveraged lower quality malls comes due or conversion opportunities arise. Malls rely significantly less on anchors than typical open-air centers. Anchors account for less than 5% of mall annual base rent (ABR) and department store boxes typically don’t generate meaningful tenant sales.

Mall landlords have been creatively repositioning many of these boxes, which often come with significant land for parking, into more appealing uses. Mall owners have turned anchor spaces into other retail uses like restaurants, junior anchors, or grocers. In addition, mall owners have added mixed-use assets like hotels, apartments, bowling alleys, and gyms. Repurposing former anchor space can cost capital, which highlights the benefits and advantages of low leverage.

AA: Are retailer bankruptcies an ongoing concern and are there associated benefits to having a turnover in tenancy?

Goldfarb: While bankruptcy is always a concern, I’m not too worried about it right now, simply because there is a dwindling amount of quality retail and there are more tenants who want in than want out.

van Dijkum: Tenant bankruptcies are simply part of the retail business, with bad debt typically accounting for between 1% to 1.5% of annual revenues. COVID and the so-called “retail armageddon” flushed out nearly all teetering retailers, and current at-risk tenants are a lower percentage than historically, particularly for mall-based tenants. Retailers come and go, yet mall management teams have much greater insight into tenant performance due to monthly reported sales data. As a result, mall owners can proactively position tenants to limit risks from weakness or potential tenant bankruptcies.

St. Juste: Yes, bankruptcy remains front and center, especially given the slowing macro climate. However, this has and will continue to vary by quality and productivity. For instance, we see turnover in Class A malls as a good thing, giving a chance to refresh the mall offerings and introduce higher rents. Conversely, in lower-performing malls, there is generally less demand and landlords also face a greater chance that rents will be signed at a lower level or negative leasing spread.

AA: Are you seeing differences in the shopping habits of Gen Z compared with previous generations, and are malls adapting to that?

St. Juste: We suspect that buy online pick-up in stores (BOPIS) and other omni-channel strategies will continue to be relevant, along with food and beverage continuing to be an important source of leasing demand. Looking at digitally native brands that are looking to establish a brick-and-mortar presence is also important.

Goldfarb: Retail is constantly changing. What makes a mall great is location. If you have a mall that’s in a dominant trade area that has remained strong, that mall is going to be healthy, whether that mall stays as a pure mall or whether it transforms into more of a town center.

Gen Zs like to shop, but the beauty of retail is that not everyone shops every single store. Everyone shops different brands, and that’s what makes the overall retail environment healthy. When retail sales go down, it’s not as though it goes down evenly across the board. And let’s not forget the 80/20 rule: 80% of your sales are coming from 20% of your shoppers. So that’s really who you need to look at. As long as a retailer has a good customer base, they’re going to do fine.

van Dijkum: Gen Z utilizes online avenues to shop at a significantly higher rate than older generations. However, many brands that cater to younger generations and have historically utilized direct-to-consumer or online-only models are increasingly shifting to brick-and-mortar business models. The store is where retailers generate typically 25% or more higher operating profits compared to ecommerce, based on our published reports.

Examples of online migrating to the store include retailers like Apple, Warby Parker, LuluLemon, Athleta, and most recently Shein. This large, Asian-based fast fashion brand had grown its business selling extremely low cost, trendy clothing online. The company has recently partnered with Simon’s JV-owned retailer SPARC to operate Shein stores in existing Forever 21 locations. We expect this relationship to expand over time to allow Shein to open more stores in Simon malls.

AA: Do you see the potential for M&A in the REIT mall space?

van Dijkum: The mall sector is already concentrated with four owners controlling approximately 80% of the A rated malls in the U.S. Simon is the largest owner and historically has used its balance sheet strength and more than $1 billion of annual excess cash flow to grow its ownership of high-quality malls. We have written that Simon could also monetize part of retailer investments to fund strategic mall acquisitions.

St. Juste: We do not expect public-to-public M&A or privatizations in the current environment given the clear cost of capital headwinds across the sector and concerns around the slowing macro environment and incremental tenant risk. Instead, we would expect public mall REITs to spend more on redevelopment and densification to add other uses and to improve the quality of existing malls.

AA: What trends are likely to have the most impact on REITs operating in the mall sector over the next year or two?

Goldfarb: The biggest trends, unfortunately, are going to be capital, just higher interest rates that makes refinancing more expensive. That’s a headwind. I’m less concerned about demand, but the earnings headwind of interest rates is real.

More positive trends are the lack of supply. The golden age of mall building was the 1970s, 1980s, 1990s, into the early 2000s, and then it stopped. So, the average mall is old, and the area around the mall has really built up. That provides a tremendous amount of leverage for landlords because the tenant wants to be in the best assets in their respective markets, so that limits the pool of where they can go. And at the same time, the separation between the bottom generic mall and the top tier is widening. That means that as the average generic to low end mall sputters, the top malls will pull ahead.

van Dijkum: We believe the eventual exit of Unibail-Rodamco-Westfield (Euronext Paris: URW) from the U.S. will be the next major catalyst for mall REITs. While URW had originally planned to exit the market by the end of 2023, the company’s recent short-term refinancing of A++ rated Century City has extended their exit strategy by six to12 months, based on our estimates. A hard landing recession would be a threat to operations for all REITs, though we don’t expect such an event to occur over the medium term.

St. Juste: Recession risk. The post-COVID spending boom may taper if we go into a recession, which will weigh on foot traffic, sales per foot, and leasing demand. Meanwhile, higher interest rates and interest expense will likely offset progress made with leasing, and the elevated cost of capital may make it incrementally more difficult for mall REITs to continue executing on densification and development/redevelopment projects given higher hurdle rates and return requirements.

AA: Thank you for your insights.

Floris van Dijkum is managing director and senior research analyst at Compass Point Research & Trading, LLC.
Alexander Goldfarb is a managing director and senior research analyst at Piper Sandler.
Haendel St. Juste is managing director and senior REITs analyst at Mizuho Securities USA LLC.