As the dust clears from several industry-shaking deals, REIT professionals weigh in on the sector's next evolution

By Phil Britt and Jada A. Graves

Consumer confidence and spending numbers have remained high in 2005, showing that there has been plenty of business in malls and shopping centers across the country. Retail REITs have been doing quite a bit of shopping of their own over the past 18 months. Among the larger deals making headlines in 2004 were General Growth Properties, Inc.'s (NYSE: GGP) $12.6 billion purchase of The Rouse Company and Simon Property Group's (NYSE: SPG) $5.2 billion acquisition of Chelsea Property Group. And don't forget Vornado Realty Trust's (NYSE: VNO) very profitable stake in Sears, which was purchased before the retail chain was bought by Kmart, as well as continued international expansion of global players like The Westfield Group (ASX: WDC), Simon, General Growth and others.

		Three Up, Three Down: Sector Performance? So many retail REIT strengths and weaknesses are general and cannot be divvied as exclusive to malls, shopping centers and freestanding stores.

Spurred by these and other industry transactions, increasing occupancy rates and a favorable interest rate climate, retail has been one of the most active and best-performing REIT sectors over the last few years. For the five-year period ending June 30, 2005, the retail sector produced a compound annual total return of 30.7 percent, according to NAREIT data. The three-year compound annual total return was a notch better at 30.8 percent while the one-year return was an outstanding 41.1 percent. REITs in general got off to a sluggish start in 2005, but the retail sector, comprised of 33 companies, still managed to post a total return of 8.4 percent in the first half of the year.

So what does all this mean for retail REITs and their investors in the short term? Industry analysts and company executives are optimistic that even though the sector's dynamics have changed it is still poised to outperform other REIT segments.

Cool Off For Consolidation

Consensus among industry executives and analysts is that the rapid consolidation should ease, due in part to larger companies incorporating existing deals into their operations and a reduction in the number of available acquisition targets. However, there is some varying conjecture among these insiders over how soon it will be before dynamics pick up the pace again, as well as how many transaction opportunities still exist.

In his report on the retail REIT sector, Morgan Stanley analyst Matthew Ostrower points out that there was a very low level of institutional quality mall acquisitions in the first five months of 2005 (about $800 million compared to $20 billion for all of 2004), which he attributed to lack of inventory for sale.

Following its acquisition of Chelsea, David Simon, chief executive officer of Simon Property Group, says he does not anticipate additional major transactions for his company in the near future.

"The acquisition of high-quality regional mall portfolios and individual assets has been a key source of growth for Simon Property Group since our initial public offering in 1993. In the recent past, we have been less active in acquiring regional malls because prices have increased to the point where returns do not meet our requirements," Simon says.

Simon continues by saying further consolidations are not expected, especially as there are no prospective properties selling. "The regional mall industry in the U.S. is pretty well consolidated. The majority of premier regional malls not already owned by the public sector are privately owned by families with no interest in selling," he says.

While Lisa Payne, the vice chairman and chief financial officer of Taubman Centers, Inc. (NYSE: TCO), agrees that "80 percent to 90 percent of the top malls in the country are now in the hands of the public mall companies," she says she anticipates more acquisitions are on the way before the deal activity abates.

"We believe that there are more acquisitions to come. Over time, cap rates for regional malls will continue to decline. They may go up temporarily as interest rates rise, but over the long term, highly productive regional malls continue to gain value," Payne says. "As these public companies continue to look for avenues of growth, it is likely that there will be continued public to public company consolidation as well as increased international activity."

Merrie Frankel, vice president and senior credit officer for Moody's Investors Service, says that a significant reason companies like Simon are not looking into more mergers is, indeed, because size matters.

"A larger company buying one of the smaller companies does not impact their numbers all that much," Frankel says. "However, two equal size companies merging into one really moves the needle."

Despite its expectation of more deals to come, Payne says Taubman is not actively pursuing acquisitions.

"We have consistent, highly productive assets and our primary source of external growth is development," Payne says. "We believe that this strategy will provide competitive growth opportunities for us and create shareholder value. It is a strategy that would not work if our portfolio were significantly larger."

AmREIT (AMEX: AMY), with an equity market capitalization of $47 million, is one of the smaller retail REITs. However, H. Kerr Taylor, chairman and chief executive officer, says the company has yet to be affected in the consolidation phase and that in his opinion, size has not been a key component in the most recent deals.

"I do not believe that size, per se, is the determining factor in whether a company should be a buyer or a seller," Taylor says. "Rather, it's how a management team maximizes long-term value for their shareholders on a per share basis.

"Additionally, we see that mergers and acquisitions generally involve strategies to penetrate geographic markets, gain synergies within geographic markets or gain expertise and knowledge capital. These are some of the critical factors that have and will continue to govern the consolidation arena," Taylor concludes.

Taylor adds that sector fundamentals could possibly indicate future mergers and acquisitions. He believes compressed cap rates and the disintermediation of capital flowing from institutions into real estate will accelerate consolidations and acquisitions over the short term.

"In this environment, management teams have the opportunity to capitalize on these cap rates, selling into a market where they can maximize net asset value for shareholders. REITs are looking to get bigger and institutions are looking to allocate more dollars into real estate," he says.

Blending to Make Better?

Analysts are waiting to see how the effects of mergers such as Sears/Kmart and Federated/May are going to pan out for the sector. David M. Fick, managing director and head of the retail research group for Legg Mason, says he questions the long-term health of Sears and Kmart, likening the combined entities to Montgomery Ward's of about 10 years ago.

"In the long term, Sears doesn't survive. There will be an interim insurgence. Sears' distribution system is certainly better than Kmart's was," Fick says.

If the Sears/Kmart merger doesn't prove profitable and J.C. Penney's remerchandising fails, it would put a lot of department store space on the market in a relatively short period of time, which would put downward pressure on rents, according to Lou Taylor, senior real estate analyst for Deutsche Bank.

There is also the possibility the elimination of some of these stores could bring higher paying tenants into the malls, but the full benefits still remain to be seen, according to Fick. "Big box tenants are looking to take over closed anchor stores at malls. While mall REIT executives say they would love to see space come back to them in the Federated/May and Sears/Kmart mergers, all agree that the effect could be less than investors expect."

Reinventing the Shopping Experience

As the possibilities rising from tenant consolidations have yet to be determined, it is a different innovative turn that could sustain interest in retail REITs. Redevelopment efforts are in position to take center stage over the next year. Available and acquirable property might be no-man's land to some, but expansion and growth can be harvested within. Many retail centers are adding residential properties, office and lodging space, in addition to outdoor features. Morgan Stanley's retail REIT report provides evidence of the lucrative business of revamping, as well-capitalized retail companies are achieving double digit yields due to these efforts.

No longer the purview of active developers like Mills and Regency Centers Corporation (NYSE: REG), these redevelopments are helping companies like General Growth and Simon to enhance their portfolio property. "Our job is to create and maintain the best retail locations. If you do that, then retailers are attracted to it," explains Les Morris, Simon Property spokesman.

As evidence of this, Morris points to Simon's plans to spend $600 million in 2005 on mall redevelopment, which includes adding outdoor amenities and mixed use developments to the properties.

Morris adds that many of the new concepts among the retailers are coming from large, established companies, rather than from smaller, less capitalized entrepreneurs. This offers better credit quality to back up new store types. "The fundamentals are very strong right now," Morris says. "Bankruptcies [among retailers] are not increasing. Fashion retailers are doing very well."

One of these modes of redevelopment the larger companies are trying has been what Frankel from Moody's calls "lifestyle centers." Instead of building a massive million square foot mall, these lifestyle centers are constructed at 400,000 to 500,000 square feet. "You have a certain potpourri of stores that like to be in this lifestyle center concept," Frankel says. "Whereas you might not situate a Bed Bath & Beyond in an enclosed mall, it will work well in a lifestyle center."

Right now it's hard to say how well these centers do in equity return, as they are retail REIT-owned and not reported separately. However, Frankel proposes that they are faring well thus far, as they are rapidly increasing. As some long-standing department store anchors have closed stores, property owners have been able to re-lease that space to high-end tenants at higher rates. It's these higher-end retailers rather than typical department stores that are driving the foot traffic in the malls and shopping centers, says Fick, who points to the redevelopment efforts of some retailers as another factor helping to generate customer traffic.

"Department stores are a dinosaur. There's nothing sold at the mall today that the consumer can't get cheaper and more conveniently somewhere else," Fick explains, adding that the higher-end retailers often subsidize the department store's existence in a mall. "Going to the mall is an experience, a way to spend free time. The primary draw is the lifestyle. The mall is a place to go to Starbucks and read the paper."

Frankel disagrees with Fick's notion that department stores are dinosaurs, but she does concede they need to be more distinguishable from one another. "The department stores need to change to keep up with the times. They have to differentiate themselves more in order to keep the customer returning," she says.

Driving Performance

Regardless of whether more acquisitions and mergers are in the immediate future, the mall and shopping center companies' redevelopment efforts and the new retail concepts by their tenants are contributing to growth, according to Fick. He expects retail REITs to continue to benefit from higher rent spreads, higher dividends and expected solid earnings growth.

Taylor says overall retail REIT performance must be viewed in the context of the industry as a whole. He predicts that REITs will return an average of 10 percent per year for the next three years. About half of that Taylor anticipates will come from appreciation, the other half, dividends.

Fick expects spending to grow in the low single digits this year. "Many of [the retail REITs] are trading at elevated multiples, but they're trading at fair value compared to the underlying real estate, so even if they catch a cold, they should be OK," Fick says. "Earnings growth at the retail REITs reflects the growth in retail spending.

"We believe that all of the retail REITs in our coverage will maintain their current dividends, and most will announce increases at least annually, with several possible in the double-digit area," Fick explains.

That's not to say that there aren't any concerns on Fick's part. He cautions that consumer spending, which averages 130 percent of wages and relies heavily on debt, is at high levels.

Ross Nussbaum, analyst for Banc of America Securities says he does not share the optimism for growth that others have. Nussbaum counters that retail's success of the last few years could work against the sector. He says malls have already increased their occupancy rates and the industry consolidations have about run their course, taking some of the steam out of the retail REIT growth engine.

Nussbaum expects sector returns to stay in the low single digits for 2005. Over the next few years, he expects annual returns of 10 percent to 12 percent, which he says will continue to outperform other REIT sectors.

"Many companies contend that they are either ahead of schedule in leasing new space or releasing space coming up for renewal," Frankel says. "They're discussing many new retail concepts being developed by current retailers or new ones, so either the tenants are renewing the space, or there are new ones coming in to take over the space of the ones departing."

Nussbaum also expects the high-end retail REITs to far outperform those catering more to low-end tenants, adding that some of the latter may have some difficulty in maintaining profitability. He adds that customers of the high-end retailers will spend regardless of the price of oil or steep interest rates.

If the interest rate begins to climb, Frankel says she naturally expects that could influence equity returns for retail REITs in the long run. "Paying more interest on mortgages and having less money to buy merchandise or eat out will naturally impact sales at malls and shopping centers," she says. "However, this decline in disposable income funds must be considered in light of the relatively long term leases that tenants are locked into with their mall and shopping center landlords. Therefore, a decline in shopping would have to be protracted in order to affect anything other than the sales per square foot and year over year sales statistics in the shorter term."