Retail REITs: Apocalypse or Opportunity?

For several months now I have been thinking about the retail landscape, more specifically, landlords who own rental properties occupied by retailers.

The challenges facing retail are well publicized and include the Amazonian “Death Star” obliterating all retailers and a number of high profile retail bankruptcies (recently, Toys R’ Us and Clare’s).  I think the general consensus is that retail focused REITs are cheap, but for good reason.  I may have a different view.

First, I should disclose that I have been skeptical (i.e., wrong) about aspects of Amazon’s business for a long time. Something about charging the same or less for parcel shipped goods than, say Target, can charge for the same goods that are shipped in bulk does not make a ton of sense to me. I mean, when you get a tube of toothpaste in a box with packing materials that seems like it should cost 50% more than the toothpaste, delivered by a unionized driver making $100K a year, one has to wonder. I have also read some estimates that it takes 4 times the space to house e-commerce delivery infrastructure versus traditional retail with pallet shipping.

In addition, this digital grocers scenario seems a little bit like Webvan 4.0.  I actually believe people may trend toward smaller, more local grocers, with mostly local suppliers (like back before Whole Foods rolled up a bunch of regional organic/locavore chains).  That trend probably won’t be so great for the food retailer ROICs but might be pretty ok for the demand they create for landlords (kind of like what has happened in brewing and is rolling out through distilling).

Amazon is already having trouble holding on to the Whole Foods people (WSJ $ article). I a think people are going to want to pop in and grab their produce, meat, cheese, in person, etc… for the foreseeable future.  I could also see Amazon becoming a net tailwind in retail real estate, expanding the brick and mortar presence in a big way over the coming years.  Finally, there are several European grocers, including Aldi (and Trader Joes), and Lidl, who are going to be expanding into the U.S. and looking for real estate.

Some guys from a real estate focused hedge fund, Sorin Capital, were recently on the Invest Like the Best Podcast.  They are certainly more informed than me and have a similar hypothesis.  They asserted that the real problem is that the U.S. has way too much apparel space (as opposed to all retail) and that is where the landlords are really going to face challenges.  I think they would distinguish between suburban malls with department store anchors and a bunch of other apparel retailers versus the neighborhood or local smaller shopping center that might have home improvement, grocery, gym, salon, and some restaurants as tenants. This made sense to me, malls are abominations.

I checked out Sorin’s most recent holdings (per SEC filings) to see what equity longs they have used to express their view.  Looked like the held some Kite Realty Group (“KRG”) and Ramco-Gershenson Trust (“RPT”).  (I also noticed some EQC and VER, which I also own).

I was planning to pick five or so REITs with exposure to non-mall retail centers and rank them on various factors including:  exposure to grocers and smaller retail centers, projected rental growth, attractiveness of markets,etc…and then draw some conclusions.

I was reminded, however, that this would almost certainly serve only to form a narrative fostering false certainty in any conclusions I would draw. See Superforecasting: The Art and Science of Prediction.  Dan Rasmussen recently reminded me of this in a couple of his appearances, including one on the podcast linked to above.

My theories and forecasts about retail and real estate likely have zero or negative value.  Even experts (which, especially when it comes to real estate, I am not) generally cannot perform as well as a simple empirical model. See  The Little Book that Beats the Market and The Acquirer’s Multiple.

Historically, statistically cheap stocks outperformed expensive ones.  See What Works on Wall Street and The Little Book of Value Investing.  This is probably because the predictions of other people also have little value and are usually based largely on projecting current trends into the future, because of their recency bias (overweighting recent experience).  See Thinking, Fast and Slow and Quantitative Value.

So to sum up, all my projections and theories about retail are not worth much.  The challenges faced by retailers have created selling in the shares of their landlords.  Cheap stocks tend to outperform.  I decided to see how cheap a few of these landlords were and maybe buy a few of the cheaper names.  If I buy them cheap, something good might happen.

Retail REITs Table

So below is little table I put together last weekend with some quick calculations/facts about a few retail REITs.  I included short interest as high short interest has been shown to have some correlation with negative outcomes. Quantitative Value.

Dated 03/18/18.  Sources: SEC filings. Short interest from Nasdaq.com

A few notes: I included a line item for alignment of interest, as it is generally important to have the incentives correct, especially when you are dealing with a business/industry that is under stress (empirically, I think this is picked in data on cannibals/shareholder yield/buyback achievers). I always prefer to have someone in the boardroom who isn’t just worried about keeping the lights on and the jets flying.

For FFO, I used NAREIT FFO as reported, with some minor tweaks to try and make sure stock compensation is reflected.

I included Vereit (“VER”), as I already own some of that name and am familiar with it.  It has more broad retail exposure (even some Amazon) and a lot of restaurants.  Store Capital (“STOR”) was a recent purchase of Todd Combs at Berkshire (it was either Ted or Todd).  STOR focuses on middle market tenants.  Kimco (“KIM”) is a big owner of shopping centers. KRG and RPT I learned of via Sorin.

I could not find the RPT credit rating for some reason.  They did, however, note in their most recent quarter that they recently reduced their total exposure to Michigan to 20% of their annual base rents….  I would probably knock them out of consideration just for that concentrated exposure, but I will knock them out for having the highest short interest.

For Brixmore (“BRX”), I credit a poster who goes by Frommi on the Corner of Berkshire and Fairfax.  This is a great message board by the way, where investing is the primary topic of most discussions. A thread over there was discussing how public, liquid REITs, are priced more cheaply than offers people are seeing in private markets.  This matches up with commentary from Green Street Advisors.  Of course, if the real estate market is moving in a downward direction, I would expect the public securities to adjust faster than less liquid private transactions.

Blackstone (the LBO/PE shop with historic real estate focus) took BRX public a few years ago after an apparent roll up of some private RE funds.  They had some accounting issues related to “earnings smoothing” a year or two ago and management got canned.  The new-ish CEO came over from Federal Realty, where he was CFO.  Federal is a really high quality retail REIT that is moving into doing mixed-use “live, work, and play” type developments.  It is not cheap enough to be in the mix for me.

I didn’t see any large BRX shareholders who could protect the owners in the board room.  Blackstone dumped their stake (Schwartzman holds a little token piece), but at much higher prices.  I did see that management has actually bought back some stock (as opposed to just talking about it) and BRX has shown up in the holdings of a mutual fund that behavioral economist Richard Thaler is associated with.  The strategy of the relevant fund is based, partially, on statistically cheap stocks with insider buying and/or buybacks.

Regency (“REG”) is the last REIT in my table.  It owns a lot of grocery anchored centers which I like, but it is more expensive than the rest of the options, so it’s out for now.

I find it interesting that on an enterprise value to FFO ratio these probably aren’t really super cheap, compared to like regulated utilities or consumer staples, for example.  Kraft Heinz is at like a 12 EV/EBITDA (so is CAG).  Dominion Energy trades at around a 12 EV/EBITDA as well.   These aren’t apples to apples comparisons of course, but it isn’t like these REITs are valued at a fraction of other, traditionally stable, cash/yield generating industries.

I also need to remember that I already have exposure to the theme of value created by the forecasted “death of retail” via my holdings of QVAL and RPV.  These two value ETFs don’t really own any REITs, but they do own retailers and other industries which are beaten up because of the fear of the Amazonian warriors. I also own a little VBR. VBR has REITs as its second highest industry group after banks. VBR is a much smaller position for me, but one could just buying more VBR to get some additional exposure.

Thus, as they are not screamingly cheap and I already have some exposure to the broad dislocation,  I do not see any real rush to get into these retail REITs.

I own VER.  I will hold that.   I will also plan to selectively add some KRG and BRX when Mr. Market is eager to sell and needs some liquidity.  This should result in building a little sort of retail-mageddon REIT basket over time.  If and when it becomes a material position for me, I will plan to post an update. Thanks for reading!