Description

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Summary

Simon Property Group (“Simon” or “SPG”) is a real estate investment trust (“REIT”) that is principally engaged in the ownership, development and management of enclosed shopping centers and outlet malls principally throughout North America. Over the past few years leading up to the COVID-19 pandemic, the higher quality publicly traded REITS (SPG, TCO, MAC and GGP) continuously re-rated lower despite consistent growth in revenue and NOI. As a result of the rapid growth in e-commerce, we believe that investors have written off large portions of commercial retail real estate that, rather than dying, are undergoing a meaningful transformation with a heavier emphasis on mixed uses featuring entertainment, food and beverage as well as multi-family housing. Indeed, for the five years ended December 31, 2019, brick and mortar sales (including food and beverage, but excluding auto and department stores) have grown at a 2.5% annualized rate despite a 14.9% annualized increase in e-commerce sales.

COVID-19 has massively accelerated this trend with high quality public REITs trading off materially in the first half of 2020 and now offering 20+% levered cash flow yields based on the in-place tenant rosters. Since the market peak in February, SPG has traded down 58% to $60 per share and as much as 69% to $44 per share at the lows in March. At a price of $60 per share and assuming the consummation of the pending acquisition of Taubman, Simon trades at a pro forma AFFO yield of 21% and a TEV-implied capitalization rate of 10.6% despite Simon and Taubman owning some of the highest quality retail real estate in the country with a strong history of NOI and sales growth.

While the pandemic is likely to present challenges for landlords more thoroughly described throughout this writeup, Simon is well-positioned to weather the storm with nearly $9.8 billion in cash and availability under its lines of credit before even considering robust operating cash flows which totaled nearly $3.7 billion on an LTM basis after maintenance capital expenditures and tenant allowances. As of this writing, Simon has re-opened nearly all of its retail properties and based on our conversations with the company and anecdotal reporting, traffic is already in excess of 80% of pre-COVID levels. As tenants resume operations, we expect that rent collections will pick up and Simon will be able to return to something resembling a more normal course of operations over the coming months.

With significant headroom under all of the key covenants in its indentures and credit agreements, we do not expect Simon will experience liquidity issues over the next year. Further, Simon has an experienced, best-in-class management team that is experienced in navigating difficult circumstances and market conditions. In a normalized environment, we believe that SPG shares are worth more than double their current trading prices, offering a significant margin of safety to absorb losses realistically likely to materialize as a result of the COVID-19 pandemic. Based on our current expectation for the resolution to the COVID-19 pandemic, we believe shares offer a compelling risk/reward with significant margin of safety to account for uncertainty and potential negative developments that may impact SPG’s portfolio.

Background

Simon is a best-in-class property manager that, as of March 31, 2020, owned interests in 168 properties comprising nearly 143 million in gross leasable area (“GLA”) at its ownership share within its mall segment, which constitutes the vast majority of its NOI. These properties were, on a weighted basis, 94% occupied and Simon has maintained an average occupancy of approximately 95% over the past five years. As of the first quarter, Simon’s portfolio had an aggregate sales productivity of $693 per square foot (“PSF”) and $703 as at the end of February, excluding impact from COVID-19. Simon derives more than 70% of its net operating income (“NOI”) from 91 properties which have sales productivity in excess of $900 PSF, making Simon’s portfolio one of the most productive of all the publicly-traded mall REITs. Over the past five years, Simon has grown adjusted funds from operations (“AFFO”) 29% (5.2% annualized) from $3.2 billion to nearly $4.2 billion exhibiting consistently positive trends in sales productivity and leasing spreads.

On February 10^th, Simon announced that it would acquire an 80% interest in Taubman Realty Group (“TRG” or “Taubman”) the operating partnership through which Taubman Centers owns and manages substantially all of its assets, with the remaining 20% to be held by the Taubman family and their affiliates. Simon agreed to pay $52.50 per share for its 80% stake with a call option to purchase the balance. Taubman owns a considerably smaller portfolio than Simon, though its assets are generally more productive than Simon’s. TRG had ownership interests in 26 properties comprising approximately 13.3 million in GLA at its ownership share with an average sales productivity of $876 PSF across its portfolio. Like Simon, TRG’s properties are demographically well-situated and characterized by high occupancy rates, low occupancy costs and strong historical growth in NOI and sales productivity.

Simon announced in June that it would be terminating its acquisition of TRG as a result of alleged material breaches by Taubman of the purchase agreement. While we will discuss this development in greater detail at the end of this segment, our analysis assumes that the transaction closes at the original price without any concession achieved by SPG. Simon’s decision to acquire Taubman clearly reflected a bid to capitalize on weakness in the mall REIT space and combine two of the highest quality portfolios among the publicly traded players. On a pro-forma basis a $60 per share price for Simon will imply a capitalization rate of 10.6% on the combined enterprise and an AFFO yield of 21% on combined NOI and AFFO of $6.3 billion and $4.3 billion, respectively. Simon will acquire its 80% interest in TRG for approximately $3.7 billion and assume its debt, resulting in a combined enterprise value of $59.3 billion.

The table below shows certain demographic and income characteristics for the Simon and Taubman portfolios as of March 11, 2019:

In terms of population density and income, the Simon and Taubman portfolios are high quality relative to national averages and considerably higher than other publicly traded peers. The most recent data from the U.S. Census Bureau has median and average household income for the United States at $61,937 in 2018, with SPG and TRG reporting median household income in a 15 mile radius of $73,588 and $81,207, considerably higher than the national average and with a large portion of households earnings in excess of $100,000 per annum. SPG and TRG properties are also generally located in areas of high population density on large sites often with dozens of acres of owned land available for development into mixed use projects or pad sites. Over the past several years, SPG has been deploying in excess of $1 billion annually at high single-digit unlevered rates of return into such projects as well as the redevelopment of anchor boxes at many of its properties. While these development projects have been halted in order to manage liquidity during the pandemic, the opportunity remains to deploy capital at attractive rates when conditions stabilize. These income and demographic characteristics mean that SPG and TRG have ownership interests in land that will be valuable for the foreseeable future irrespective of transitory trends in consumer preferences. Because they own land in high-income, dense areas, they will be the owners of places where people will want to congregate.

It is for these reasons that both SPG and TRG have seen strong growth in sales productivity and a consistently high occupancy rate:

SPG and TRG have also managed to maintain healthy re-leasing spreads (the amount by which rent for tenants entering new spaces exceeds the rent paid by the vacating tenant). Over the past 5 years, Simon has reported an average re-leasing spread of 15.6% while Taubman has reported an average re-leasing spread of 12.1%. It is worth highlighting, of course, that the rent a tenant is willing to pay can be influenced by up-front payments from a landlord such as tenant allowances or work conducted by the landlord. Further, re-leasing spreads have declined over the past few quarters in a tough leasing environment. Nonetheless, these spreads are in stark contrast to what we observe at the lower quality mall REITs where we’ve seen significantly negative re-leasing spreads despite significant tenant allowances. Occupancy ratios (a tenant’s rent as a share of its sales) for both SPG and TRG remain healthy, with the most recently reported figures at 13.0% and 12.7%, respectively.

Each of Simon and Taubman were first movers in closing their shopping centers in mid-March, either concurrent with or in advance of guidance from state and local governments requiring closure. As different jurisdictions allowed the re-opening of retail real estate, Simon and Taubman both began re-opening their centers, generally at the beginning of May. Taubman announced that, as of the end of June, all of its centers in the US and Asia had re-opened. Simon similarly announced that, as of the end of June, virtually all of its properties had re-opened with closed properties representing less than 5% of NOI. While certain jurisdictions, most notably California, have temporarily rolled back re-opening efforts as part of a program to manage certain COVID-19 metrics, it is not currently expected that Simon or Taubman will become subject to widespread/total and prolonged closures.

As mentioned previously, Simon filed a complaint in the 6^th Circuit Court for the County of Oakland, Michigan purporting to terminate its planed acquisition of Taubman as a result of material breaches of the purchase agreement. Specifically Simon alleged that (i) Taubman had been disproportionately impacted by COVID-19 resulting in a material adverse effect on its business and (ii) that Taubman had failed to manage its business properly in response to COVID-19. With respect to the former point, Taubman correctly noted in its initial response that the MAE provision in the purchase agreement contains a specific carveout for pandemics. With respect to the second point, Simon’s complaint is somewhat vague with respect to what about Taubman’s management of the business would rise to the level of warranting a termination of the merger. We suspect that, like other companies to have agreed to mergers or acquisitions in the weeks leading up to COVID-19, Simon is posturing to attempt to lower the consideration ultimately payable for its stake in Taubman. Other companies have taken a similar course of action and some have had success, most notably BorgWarner with respect to its pending acquisition of Delphi. From our perspective, the TRG stake would represent just 6% of pro forma net operating income and the portfolio remains one of the best out there from a demographic and sales productivity perspective. Simon has more than enough liquidity to cover the acquisition and the pro-forma valuation at the full acquisition price remains incredibly compelling. While we would welcome any reduction in the purchase price, intrinsic value is not meaningfully impacted if the transaction closes as planned.

Investment Thesis & Valuation

While landlords face considerable uncertainty as a result of the COVID-19 pandemic, indiscriminate selling has left SPG trading at a level that would only be warranted by what we believe to be highly unrealistic assumptions about how the business will perform over the coming years. If you believe, as we do, that SPG is positioned to weather the storm, prevailing prices provide significant margin of safety to prospective investors. Supporting this are what we believe to be three key points: (i) the COVID-19 pandemic does not constitute an event which would absolve tenants from their obligation to pay rent, (ii) SPG has substantial liquidity to navigate the next year even in draconian scenarios and has demonstrated access to capital markets and (iii) SPG is not at risk of breaching any of the key covenants in its unsecured indentures or credit agreements that could cause a default even in the absence of a liquidity shortage.

Additionally, while there are longer-term questions about brick and mortar retail in America and the impact of COVID-19 on retail sales and bankruptcies, Simon continues to manage some of the most attractive properties in the country. While there is no question that certain properties in secondary and tertiary markets may permanently close as a result of the pandemic, Simon’s properties are unlikely to be among them. Despite the challenges of e-commerce, Simon has grown tenant sales and NOI for years and maintained robust property occupancy with healthy occupancy costs and positive re-leasing spreads.

Force Majeure / Act of God

We believe that much of the selling in the commercial real estate space has been a result of uncertainty around the legal liability and the financial wherewithal of tenants to pay rent. These are two separate questions and we begin with the former. Most commercial real estate leases have force majeure or similar “act of god” provisions that allow for delays in performance of specified obligations in the event that the subject property becomes inaccessible or performance of an obligation of the tenant or landlord is precluded by an event that is out of that party’s control. Our conversations with lawyers familiar with commercial retail leases as well as landlords and the public REITs indicate that most leases explicitly exclude the obligation of a tenant to pay rent from any potential delay. This is consistent with public commentary from the REITs, with Simon notably indicating on its first quarter call that north of 95% of its leases to not allow tenants rent relief as a result of a pandemic.

As a consequence, under the terms of any given lease it is almost universally not the case that the COVID-19 pandemic serves as a basis for a tenant’s non-payment of rent. Having said this, the tenant’s legal liability for the payment of rent is separate from their willingness or ability to pay rent. As a result of social distancing guidelines, most shopping centers and other non-essential businesses across the country have closed and tenants do not have the operating cash flow necessary to pay rent. Additionally, evolving guidance from state and local governments has begun to include moratoria on tenant evictions for the non-payment of rent which prevents landlords from enforcing their rights under leases in the immediate term. It is important to highlight that these moratoria only provide for a delay in performance and do not offer a legal basis for tenants to argue for rent forgiveness. This is consistent with what the REITs have been reporting in terms of actual collections. While the guidance varies from REIT to REIT and over time (payment may not be prompt, resulting in collections rates rising depending on the reporting date) we believe that landlords likely collected between 20 and 30% of April and May rents and between 40 and 60% of June and July rents.

Our conversations with tenants, property managers and lawyers advising both tenants and landlords leads us to believe that the most likely outcome is for tenants and landlords to reach mutually agreeable arrangements for the payment of rent for the periods of time during which non-essential businesses remain closed. Generally speaking, these arrangements are likely to take the form of a 2-3 month rent deferral (not abatement) with the back rent payable over a period of time so as to best manage the return to business for tenants and to minimize the likelihood of tenant insolvency. While this is likely to be a common formulation, any agreement will be tenant specific with certain tenants likely to receive outright rent abatement, particularly for those tenants uniquely or disproportionately impacted by COVID-19, such as gyms, movie theaters and other tenants that may not be able to operate their business normally even in malls that have re-opened as a result of social distancing guidelines.

We generally expect that landlords agreeing to forgive rent for any period of time will likely capture value in other ways by, among other things, extending the term of the lease, collecting higher rents in future periods and/or removing unfavorable co-tenancy language which will serve to mitigate the impact from anchor closures. Considerable relief is also available from federal and local governments to smaller tenants that are less likely to be capitalized in a manner that will insulate them from a few months’ business disruption. The CARES Act, for example, provides for more than two months of support in forgivable loans to small businesses where the proceeds are used to pay, among other things, payroll and rent.

The net effect of the foregoing is that landlords are likely to recover much of the value that they are legally entitled to from those tenants that re-open for business when we begin a return to normalcy. For the vast majority of the tenants, though, some of this rent will likely be deferred and collected in later periods. Offsetting this for the landlords is the fact that their premises are generally closed for the periods being deferred, and we believe that before payroll expense it is possible to reduce property operating expenditures by 35-45% in a closure. This is principally the result of lowered utility expenditures, reduced custodial/landscaping services and reduced security services.

Liquidity

Simon has $9.8 billion of cash and availability under committed credit lines. For the 12 month period ended March 31, 2020, Simon generated $3.7 billion in levered free cash flow and, at its roughly 50% margin, would need to lose more than half its revenue before becoming cash flow negative. Simon’s nearly $4.6 billion in credit availability derives from a $6.0 billion commitment due June 30, 2024 and a $3.5 billion commitment due June 30, 2022. Both facilities can be extended up to a year at SPG’s sole election subject only to the payment of a modest extension fee. Simon recently bolstered its cash balances in July by accessing the capital markets and issuing $500 million in 3.500% notes due 2025, $750 million in 2.650% notes due 2030 and $750mm in 3.800% notes due 2050. While roughly $0.9 billion of the proceeds will be used to refinance upcoming maturities, Simon was able to add nearly $1.1 billion to its cash balances, bolstering liquidity and demonstrating its ability to access the capital markets at competitive rates.

The upshot of all of this is that Simon would be able to pay for the entirety of the Taubman purchase (including net corporate debt) out of pocket as well as all property-level mortgage debt maturing at both SPG and TRG through the end of 2021 out of its existing cash and RC availability. Importantly, mortgage debt can simply be discharged by allowing lenders to foreclose on encumbered properties. The most likely outcome is that the Taubman corporate debt and property-level debt is likely to be largely refinanced, given Simon’s demonstrated access to the capital markets, in which case SPG’s excess liquidity through the end of 2021 is nearly $6.1 billion. All of this ignores the nearly $3.7 billion in operating cash flow that Simon had generated over the last 12 months and the more than $0.3 billion in operating cash flow that Taubman generated (at Simon’s share) during the same period.

In order for SPG to exhaust its available liquidity even after funding the TRG acquisition internally, SPG would have to lose more than half of its revenue for a period significantly in excess of a year assuming no cost savings from the reduced operating expenditures. Although there is considerable uncertainty around the resolution of the COVID-19 pandemic, we think a scenario in which SPG’s liquidity is exhausted at any point over the next two years is highly unlikely. We believe that the strength of Simon’s liquidity decision is its decision to continue to pay a cash dividend.

Covenants

As a large portion of SPG’s liquidity is availability under its unsecured credit lines, an evaluation of the financial covenants governing those lines is essential. SPG’s unsecured facilities have four primary covenants listed below along with the most recent test level and discussion regarding the amount of buffer SPG has to a covenant breach:

• EBITDA / Interest Coverage – SPG must maintain sufficient EBITDA to cover its annual debt service by 1.5x. As of 1Q20 SPG’s interest coverage was 5.1x and would be 4.5x pro-forma for the TRG transaction. After giving effect to the TRG transaction, EBITDA would have to decline by approximately 67% to cause a breach of this covenant.
• Total Debt / Total Assets – SPG has three leverage covenants all of which compute its asset base not based on carrying value but by capitalizing EBITDA at a 7.0% capitalization rate. The calculation also allows for certain adjustments for recently acquired assets or portfolios (to be carried based on the acquisition cost for a period of time) as well as new developments (to be counted based on annualized or forecast EBITDA). Simon must maintain a total leverage ratio of no more than 65%. As of 1Q20 SPG’s actual level was 42% and it will be 46% pro-forma for the TRG transaction. EBITDA would have to decline by 32% pro-forma for TRG to cause a breach of this financial covenant.
• Secured Debt / Total Assets – SPG is required to maintain secured debt of no more than 50% of its total assets defined in a manner as described above. As of 1Q20 this ratio was 17% and would be 18% pro-forma for the TRG transaction. EBITDA would have to decline by 69% to breach this covenant.
• Unencumbered Assets / Unsecured Debt – Approximately 43% of Simon’s GLA is encumbered by mortgage debt. Simon is required to maintain unencumbered assets in an amount equal to 125% of the balance of its unsecured debt. Unencumbered assets are determined by multiplying the amount of total assets, as described above, by the percentage of total EBITDA that is unsecured. At 1Q20 the test ratio was 243% and would be 205% pro-forma for the TRG transaction. EBITDA would have to decline (ratably across encumbered and unencumbered assets) by 35% to breach this covenant.

Under the most restrictive covenant, Simon would need to see EBITDA fall by 32% in order to see a breach. Importantly, rent shortfalls from tenants are (i) likely to consist primarily of deferrals and not outright defaults and (ii) deferrals are unlikely to have significant repercussions from a covenant perspective. Because the rents were due and payable in the deferral period, short-term repayments/deferrals are likely to be characterized as revenue in the period in which they were earned and booked as receivables. This is consistent with conversations that we’ve had with several accountants and also consistent on recent guidance from FASB regarding the treatment of interest payment deferrals for financial institutions.

In a Staff Q&A published in April meant to address certain accounting challenges arising as a result of the COVID-19 pandemic, FASB indicated that there are two approaches to handling deferrals under leases:

Some concessions will provide a deferral of payments with no substantive changes to the consideration in the original contract. A deferral affects the timing, but the amount of the consideration is substantially the same as that required by the original contract. The staff expects that there will be multiple ways to account for those deferrals, none of which the staff believes are more preferable than the others. Two of those methods are:

a. Account for the concessions as if no changes to the lease contract were made. Under that accounting, a lessor would increase its lease receivable, and a lessee would increase its accounts payable as receivables/payments accrue. In its income statement, a lessor would continue to recognize income, and a lessee would continue to recognize expense during the deferral period.

b. Account for the deferred payments as variable lease payments.

Under the credit agreements and indentures, Simon’s covenants are calculated using a GAAP framework. As a consequence, we believe that for a majority of SPG’s portfolio for which rent will likely be deferred but not abated, the impact from a covenant perspective will be muted. Again, while we do expect there to be defaults as a result of COVID-19, we do not expect those defaults to ultimately reduce covenant NOI by 30+% as deferred rent will continue to be booked as revenue and count toward financial maintenance covenants.

Valuation

Given the considerable uncertainty regarding the resolution of the COVID-19 pandemic, we prefer to consider a ‘base’ valuation and then look at scenarios that we believe will illustrate the significant margin of safety embedded in SPG shares at a current price of $60. We begin with a discounted cash flow analysis using a 10% discount rate and 2% terminal growth rate (commercial retail real estate leases generally have annual escalators for inflation of at least 2%) in a base case that does not assume an impact from COVID-19. For simplicity we do not consider elective development/redevelopment capital expenditures as Simon has indicated that these are likely to be deferred for the time being in order to manage liquidity.

As a result of the uncertain outcomes associated with the resolution of the response to the pandemic, we look at the impact of a one-time loss/abatement of rent and an associated savings from closing SPG’s properties. We also look at the potential cost to replace defaulted GLA based on prevailing development economics. Generally speaking, delaying the receipts of rents over a period of 12 months or less (the most likely outcome for the majority of all tenants) does not have a significant impact on valuation within the DCF framework. In this base case, we value SPG shares at slightly more than $150 per share:

In a scenario where SPG were to lose 2 months of rent on a one-time basis (either as a result of defaults or negotiated abatements) and its centers were closed for 3 months with an assumed savings of 40% of property operating expenses only (and not savings on general, administrative and other expenses) the implied valuation would decline to just $148 from $151.

Unsurprisingly, a one-time loss of rent over a period of several months does not have a significant impact on the valuation, particularly with some of the loss offset by operating savings. It is likely that a portion of SPG’s tenants will be unable to recover from economic loss associated with COVID-19. Because of the characteristics of Simon’s properties discussed more fulsomely earlier in this memorandum, we think that it is unlikely that a large portion of SPG’s tenants are likely to default. Because SPG’s properties are among the highest in terms of sales productivity, it is generally able to select a higher-quality tenant mix from a credit perspective. Further, those tenants that default but do not liquidate are more likely to have profitable stores that would emerge from a bankruptcy at properties like those owned by SPG and are therefore more likely to continue to operate and pay rent even in bankruptcy. Finally, because the properties are in high demand and exhibit high occupancy, even in the event of default/liquidation, it is likely the case that Simon will be able to find new tenants to fill vacant GLA whereas weaker REIT peers may be forced to leave space vacant and/or settle for inferior lease economics in order to boost occupancy.

Catalyst

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