EUR 850.00 For Business Accounts Only

Morningstar | Upgrading Mall REIT Moats to Narrow as Retail Bifurcation Benefits High-Quality Assets

We are updating our views for mall REITs Simon Property Group and Macerich, and as a result are upgrading both companies' moat rating to narrow from none. We have increased our fair value estimate for Simon to $187 from $146 after changing our view on the company's internal growth and redevelopment opportunities. We increased our fair value estimate for Macerich to $59 from $58 after changing our modeling framework for the company. While we recognize the pressure that the continued growth of e-commerce places on traditional brick-and-mortar retail and that the U.S. is significantly over-retailed, we believe that there will always be demand for high-quality retail locations. Both companies own Class A malls located in many of the best markets with dense populations and high disposable incomes. These companies benefit from an efficient scale moat source as their properties dominate their submarkets, with significant barriers to entry for other mall concepts and shopping experiences that are difficult for other forms of retail to replicate. The high-quality properties in these companies' portfolios attract desirable tenants, which in turn makes their properties more attractive to consumers and future tenants, creating a network effect moat source for the mall REITs. We anticipate continued bifurcation in the mall space between the highest- and lowest-quality malls and believe that the high-quality portfolios for leading mall REITs should continue to see positive net operating income growth over the next decade.

The continued growth of e-commerce is putting significant pressure on traditional brick-and-mortar retail. E-commerce's share of total retail sales has grown from 1% of all retail sales in 2000 to over 9% in 2018, a number that grows to over 20% of retail sales if we exclude categories that e-commerce and malls both traditionally exclude, such as motor vehicles, gasoline, building materials, and groceries. As consumers change their habits from shopping in physical stores to shopping online, demand for retail space will shrink and many existing stores and malls will likely go away. However, we expect the reduction in retail space will occur almost entirely at the lower end of the quality spectrum. Class C and Class D malls are struggling and are either in or on the precipice of the "mall death spiral," where vacancies lead to lower sales for remaining tenants that lead to more vacancies, and so on.

Meanwhile, the 300 Class A malls that make up the majority of the portfolio for these mall REITs should not only survive but thrive in the future retail landscape, and we are changing our moat trend ratings for Simon and Macerich to stable from negative. Brick-and-mortar retailers will want to keep their stores located in the top malls, as they have strong demographic trends and high foot traffic, and they generate high sales. Store closures will mostly be in lower-quality assets and the handful of stores that close in Class A properties could represent a positive development, as the landlord can replace the struggling tenant with one or more popular offerings that could collectively draw more traffic to the mall. Additionally, many previously exclusive e-retailers are seeing the benefit of opening physical locations. More than 50 online retailers have opened physical stores, and the REITs are experimenting with offering micro-storefronts to new entrants to let them test the possibility of opening physical stores. These retailers are looking to put their new stores in the top retail locations, providing additional demand for space in the top malls in the U.S. Finally, Class A malls are being redeveloped to provide more food and recreation options to present themselves as destinations for entertainment to consumers, rather than simply being the place that consumers shop. These trends should all lead to the Class A mall continuing to play a vital role for both the retailer and the consumer.