Mall real estate investment trust Macerich (MAC) currently trades roughly 15% below our $59 fair value estimate. We believe the company benefits from a narrow economic moat derived from the network effects and efficient scale found in its portfolio of high-quality malls. Macerich has successfully transitioned its portfolio through asset sales of lower-quality malls and redevelopment of higher-quality properties into a true Class A mall portfolio.
While we recognize that e-commerce will continue to apply significant pressure to brick-and-mortar retail, we believe there will be a continued bifurcation of physical retail performance, with the highest-quality assets continuing to produce strong sales growth while the lower-quality product sees foot traffic and sales decline. Macerich has demonstrated this thesis in 2018 with sales per square foot over the prior 12 months up 7.3% for the total portfolio and re-leasing spreads of 10.9% in the third quarter. While we expect that sales growth and re-leasing spreads will slow from these levels over the next decade, we don’t project either going negative in our forecast. Given that the company underperformed the broader market after interest rates increased in September, and we think short-term negative performance for REITs from rising rates generally reverses itself within four to eight months, we think this is a good opportunity to invest in a narrow-moat company that we believe will be one of the winners in retail.
In addition to our narrow moat rating and long-term outlook for Macerich, we believe there are some short- and medium-term catalysts for the stock. Black Friday saw sales increase 9% and Cyber Monday saw sales surge 19% over the same dates in 2017. While most of that increase is due to increased online sales, omnichannel players drove most of the online sales this year. Customers looking to return merchandise they purchased over the weekend will often return it to the store, and frequently shoppers who return products will buy replacements or do other shopping in the store. We think the fourth quarter could be strong for physical retailers in addition to e-commerce players. Either way, the strength of omnichannel companies this holiday season reinforces our thesis that physical stores in high-quality locations will remain essential to any retail strategy. This should play out over the medium term as well, as Macerich looks to fill the recently announced Sears closures in its portfolio. While the closure of these anchors reduces rents in the short term, in the longer term the closures should drive significantly higher sales and rents to Macerich as management can fill the vacancies with more-attractive tenants more capable of driving foot traffic to the malls than Sears.
Finally, Macerich is expanding its program to introduce online-only retailers to physical retail. It is creating a space that will be filled with customizable, smaller storefronts on short-term leases for e-tailers looking to experiment with physical stores before they consider rolling out to a larger footprint and more stores. If this experiment goes well, Macerich will be able to convert its competition into tenants and will have built relationships with these rapidly growing companies as they look to expand into more high-quality locations. We think Macerich has several significant opportunities to create value over the next year that should serve shareholders well.
Retail Holds Risks, but Macerich Is Financially Sound
The growth of e-commerce has caused e-tailers to take market share away from physical retail sales. Additionally, many traditional retailers are moving more of their business online to compete with the prices and convenience offered by e-commerce. The United States is significantly overretailed on a square foot per capita basis, so shrinking market share for physical space will worsen the situation and makes store closures more likely over time.
Several of Macerich’s major in-line tenants have experienced declining sales and expect to close stores. Macerich will have to release vacant space to new tenants, which may be at lower rents in a negative sales environment. Similarly, several major anchors face uncertain futures. Anchors do not typically pay significant base rent (single-digit dollars per square foot versus over $50 per square foot on average for in-line tenants), but they still contribute to a mall’s overall health and can be part of certain co-tenancy clauses with other mall tenants. The closure of an anchor usually means less traffic for a mall and many in-line tenants opting out of their leases, which exacerbates the situation.
Even healthy retailers are likely to become more selective in their physical presence. The number of stores required to enjoy the full benefits of an omnichannel strategy is lower than the actual store count many retailers currently have in many markets. While we believe tenants will prefer to put stores in the highest-quality assets, the competition from lower-quality space will continue to shift pricing power to tenants. Macerich may be forced to offer lower rents, rent concessions, shorter lease terms, higher tenant improvement spending. or lower expense recoveries to attract and retain tenants. Additionally, many retailers are looking to reduce average store square footage to increase efficiency and profitability, increasing the number of tenants Macerich will have to attract to fill its portfolio.
Macerich is in good financial shape from a liquidity and a solvency perspective. The company seeks to maintain a solid but flexible balance sheet, which we believe will serve stakeholders well. Debt maturities in the near term should be manageable through a combination of refinancing and free cash flow. The company should be able to access the capital markets when development opportunities arise.
As a REIT, Macerich is required to pay out 90% of its income as dividends to shareholders, which limits its ability to retain its cash flow. However, the current run-rate dividend is easily covered by cash flow from operating activities, providing Macerich plenty of flexibility to make capital allocation and investment decisions. We expect the company’s credit rating to remain stable through steady net operating income growth in its existing portfolio and the stabilization of its current developments, which should allow Macerich to continue to access the debt market in combination with equity issuance and asset dispositions to fund its debt maturities, acquisitions, and new development activity.
Kevin Brown does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.