Description

We believe that Pennsylvania Real Estate Investment Trust (PEI) is an over-levered and overvalued mall REIT for the following reasons:

1)      Brick-and-mortar retail is going to be an increasingly challenged industry over the next several years due to online competition

2)      Malls are deceptively capital-intensive assets yet mall REITs and analysts routinely ignore the capex associated with renovations, redevelopment and tenant-allowances

3)      Malls in highly attractive markets are increasingly valuable as tourist destinations but PEI’s assets in the greater Philadelphia and DC markets are not exactly top tourist hot spots

4)      PEI has one of the most levered balance sheets in the industry, so there is very little room for dividend growth or debt reduction

5)      PEI’s valuation is significantly above its B/C mall peers, largely because of its small institutional investor ownership and a retail ownership based looking only at its dividend yield

PEI is a $1.5 billion mall REIT  with 29 operating properties and 4 development/redevelopment properties, predominantly in the Pennsylvania and mid-Atlantic region.  We won’t spend too much time going through ever property or tenant and lease expiration, but like other mall REITs, the 10k and supplemental disclosures have a lot of data on all of the operating and financial metrics:

https://www.sec.gov/Archives/edgar/data/77281/000007728116000093/a2015q410-k.htm

https://www.sec.gov/Archives/edgar/data/77281/000007728116000091/a2015q4exhibit991supplemen.htm

In addition, the company’s recent analyst day presentation provides a bullish look at the company’s properties and 3-year goals:

http://investors.preit.com/presentations

Our thesis is as follows:

Brick-and-mortar retail is going to be an increasingly challenged industry over the next several years due to online competition

It is no secret that the retail industry is undergoing significant change due to Amazon and other online competitors.  There have been many discussions on this on various threads include the CBL and WPG ideas, as well as BKS, AMZN and others.  We do not believe that retail is dead forever, but it is clear that over time, more dollars are going to shift online versus being spent in brick-and-mortar stores.  There is also a debate about whether being the “only mall in town” in a small secluded area insulates a mall from online competition.  We don’t disagree that some malls do serve as local hang-outs and not only shopping destinations, we think eventually tenants who lease real estate in a mall need revenues to pay their rent, so we are bearish on mall REITs:

http://www.wsj.com/articles/tougher-times-for-mall-owners-1453856400

http://www.wsj.com/articles/malls-reel-as-web-roars-1450917888

Malls are deceptively capital-intensive assets yet mall REITs and analysts routinely ignore the capex associated with renovations, redevelopment and tenant-allowances

While REIT management teams and analysts like to ignore any capex, it is actually very capital intensive to upkeep a mall property, as illustrated by the recent news from Taubman and Westfield:

http://www.wsj.com/articles/upscale-mall-landlords-pay-up-to-stay-chic-1458060062

The retail business requires significant capex to maintain an environment where shoppers will want to come – whether the retailer owns the store (see SHLD) or whether the mall landlord owns the real estate.  Our problem with FFO multiples is that it completely ignores recurring capex and tenant improvements.  PEI often points to their gross re-leasing spreads, illustrating that when a “gone and forgotten” tenant (such as RadioShack or Borders) leaves, it is replaced with a higher paying tenant such as Lululemon or Athleta (see slide 53 of their analyst day presentation).  However, this ignores that fact that PEI often has to spend a significant amount of money to redevelop a store from the condition it was when RadioShack was paying $25/sf ft to where Lululemon will pay $40/sf ft.

We will illustrate the impact on these ignored capitalized costs in the valuation section.

Malls in highly attractive markets are increasingly valuable as tourist destinations but PEI’s assets in the greater Philadelphia and DC markets are not exactly top tourist hot spots

There is no dispute that retail real estate on Lincoln Road in South Beach, Rodeo Drive in Beverly Hills, Fifth Avenue in New York or the Las Vegas Strip are extremely valuable:

http://www.wsj.com/articles/mgm-dubai-world-sell-las-vegas-mall-to-simon-invesco-for-1-1-billion-1458316017

However, we think that the PEI portfolio lacks anything close to the these tourist hot spots with even the “premier” malls being in Cherry Hill, NJ or Lehigh Valley, PA, let alone the “non-core” malls.

PEI has one of the most levered balance sheets in the industry, so there is very little room for dividend growth or debt reduction

With $2.1 billion in debt and $201 million of preferred stock, PEI has over 9.0x debt/NOI on its balance sheet.  With very limited FCF after accounting for capex, tenant allowances and maintaining the common dividend, we believe that there will be very little, if any, debt reduction at PEI.  The very high leverage also reduces the company’s flexibility for buybacks or dividend growth – as the dividend has essentially been keep flat for the past 3 years.

<Q - Floris van Dijkum>: Great. And would you also consider – I know that you've talked about deleveraging and reinvesting, but as these sale proceeds potentially come in quicker, maybe, than the market has expected, including ourselves, would you consider putting some of those proceeds to the side for a potential share buyback with your stock trading where it is today?

<A - Joseph F. Coradino>: Well, it's certainly something we continue to consider Floris, but I think at this point our primary focus is paying down debt and utilization for enhancing some of the redevelopments that we're committed to.  But again something we continue to consider, clearly we're not happy with our share price and we've done significant due diligence on share buybacks and continue to look at the real impact on a medium to long-term basis in terms of increased share price and haven't found at least at this point, significant evidence of that, but having said that it continues to be on the table for us. We are not pleased with our share price, the goal of our strategy that we've outlined in Investor Day and we communicated on this call is to drive our multiple and close the NAV gap and again that's something that we are considering.

PEI’s valuation is significantly above its B/C mall peers, largely because of its small institutional investor ownership and a retail ownership based looking only at its dividend yield

At the heart of the valuation debate for PEI is whether this is an A-mall operator (like SPG or TCO) or a B/C-mall operator (like CBL or WPG).  We believe it is closer to a B/C operator yet the management team has tried to convince Wall Street that it is an A operator and largely succeeded based on its current valuation.

The company’s own 10K classifies themselves more as a B/C mall than than an A operator:

https://www.sec.gov/Archives/edgar/data/77281/000007728116000093/a2015q410-k.htm

Based on these factors, in general, malls that have high average sales per square foot and are in trade areas with large populations and high household incomes and/or growth rates are considered Class A malls, malls with average sales per square foot that are in the middle range of population or household income and/or growth rates are considered Class B malls, and malls with lower average sales and smaller populations and lower household incomes and/or growth rates are considered Class C malls. Although these classifications are defined differently by different market participants, in general, some of our malls are in the Class A range and many might be classified as Class B or Class C properties.

The company tries to portray themselves (from their analyst day presentation) more as a Class A operator but their demographics and metrics are much closer to the B/C levels than A (see Rouse presentation slide 6 http://ir.rouseproperties.com/Cache/1001205665.PDF?Y=&O=PDF&D=&FID=1001205665&T=&IID=4298147) :

Valuation

We think the REIT industry relies too much on “FFO” instead of FCF (similar to the MLP industry’s reliance on aggressive metrics that ignore capex).  However, even on that basis, we believe that PEI is overvalued relative to its closer peers such as WPG and CBL.  

On an absolute basis, we look at the sustainable FCF that PEI generates and the leverage employed to generate that FCF.

One of the reasons, we believe, that PEI trades at such a rich valuation relative to its peers and its absolute value is because of a large retail, index, and passive ownership base.  Mall REITs like CBL and WPG (which have been discussed extensively on this site) have a much larger institutional shareholder base (even with relatively close market caps) so their valuations are almost 50% lower than PEI as these investors are more aware of the issues facing the industry and less focused on just the headline dividend yield:

At a more appropriate level of 8x-9x FFO and 6%-7% dividend yields, PEI would be valued at $12 - $17 per share, down from $21 currently.

Catalyst

Dividend cut - we believe that PEI's dividend may be at risk in a difficult economic/consumer environment and the fundamental value is substantially below where "yield" investors would own the stock

Increased investor awareness of leverage and lack of growth