SPECIAL REPORT: Hedgies sound the death knell

Numerous hedge funds have been betting on the ongoing deterioration of the US mall sector in recent months by short-selling the stocks of listed real estate investment trusts.

Short-selling is the sale of borrowed securities or other financial instruments and subsequently repurchasing them. If the price of the security declines between the sale and repurchase period, the short-seller profits, since the cost of repurchase is less than the proceeds from the short sale.

Their wagers against the future profitability of the US mall REITs sounds the death knell for many malls hit hard by the rise of e-commerce and changing shopping habits. Some hedge funds, such as London-based Horseman Capital Management, predict the slumping share prices of certain mall tenants will in turn signal weakness for the share prices of mall REITs. Others, like New York’s Alder Hill Management, are betting that some mall owners will default on the debt on their properties.

Even the largest and arguably strongest REIT, Simon Properties Group, has seen its price tumble from $201.6 a share on June 9, 2016 to $155.6 a share a year later, according to London-based data provider IHS Markit. During that period, the percentage of shares on loan has risen from 0.6 percent to 2.1 percent. That amounts to a bet totaling more than $1 billion, making Simon Properties the mall REIT with the most short selling activity at press time.

The hedge funds’ pessimistic view of US malls has both its proponents and dissenters. One firm siding with the hedge funds is private equity real estate giant Blackstone, which has not invested in the US mall space since 2011 because of the deceleration in the sector.

“It’s hard to invest in a space where there are continued macro headwinds and secular headwinds,” says Nadeem Meghji, the firm’s head of Americas real estate. “One can certainly make money on individual opportunities, but to do it in scale, and in a sector that is so heavily exposed, it’s challenging.”

Steven Marks, managing director and head of the REITs group at Fitch Ratings, takes a different view. “At a 30,000-foot level, fundamentals are pretty good,” he notes. Occupancies for both Class A and B malls “are at or near cycle highs,” while same-store net operating income remains positive for A malls but slightly negative for B malls, and sales per square foot for inline, or non-anchor tenants stay flat for both A malls and B malls. “The risk is that there may be mass anchor vacancies, or another wave of tenant bankruptcies, both inline and anchor, and to what extent does that begin to squeeze the cashflows to re-tenant those spaces for both the A- and B-malls?”

Meanwhile, Phillip Owens, managing director at Green Street Advisors, asserts that the bet of some hedge funds that the mall industry is dead “might be a bit of an extreme view.” But he adds: “There are some really interesting ways to bet against the retail space beyond simply betting against the retailers themselves. Not all retail is in dire straits the way that some news headlines suggest. There are at the very least some large pockets of retail that are significantly exposed and others that aren’t. If you can identify them, you may have an informational advantage that enables you to make money.” 

One such area of significant exposure is US malls with CMBS debt. “About 400 US malls have debt in CMBS tranches, and if you can unwind all of that, you can find quite a few nuggets of gold from which to formulate and choose investment strategies, like taking something short or potentially even being long on something that might be over penalized because of the negative perception around retail,” he says.

Different from hedge funds

That said, generally it is more difficult for private equity firms to capitalize on the challenges in the US mall industry than it is for hedge funds. “Hedge funds can make money when things get soft, and can also make money when things are on an upward trend; they can make money no matter what happens,” Owens explains. “Private equity firms have a harder time making money when they’re invested in a sector that’s having challenges more broadly. Private equity might be able to take advantage, though, of some unique, property-specific strategies by being very tactical.”

Some of these strategies stem from the perceived gap in the public and private market values of mall properties. Mall REITs were trading at an average discount to net asset value of 36 percent as of March 31, according to a first-quarter report from mutual fund manager Liberty Street Advisors. “This discount is particularly unwarranted for Class A mall REITs, who are also benefiting from an environment of growing retail sales, which should result in strong same store cashflow growth and attractive reinvestment opportunities for them. If discounts continue, it may also attract the interest of real estate private equity and buyout funds, who are sitting on record amounts of dry cash.”

An outright takeover of a mall REIT by a private equity firm is difficult however, says Owens. The last privatization by a private equity firm was Brookfield Asset Management’s acquisition of Rouse Properties, completed last year. But such a deal is “anomalous,” given that buyers of Brookfield’s scale and sophistication are rare.

High quality or A-mall REITs have little incentive to sell their companies because they are fundamentally sound and still boast strong real estate values in the private market relative to their public market valuations, according to Owens.

As for lower-quality or B-mall REITs, the difficulty of obtaining secured financing of such properties may be an impediment, says Marks: “If those assets are not leverageable or not leverageable to the extent that the PE shops would want them to be to make their investments, then it’s more challenging for them to meet their IRR targets.”

Meghji, however, disagrees with the private market valuation of mall properties by research analysts, in light of the dearth of recent trades in the space, and questions the existence of actual discounts with US mall REITs: “Sometimes the public markets are right, and sometimes they are wrong and overreact. In this context, the public markets seem right.”

He believes the private markets over time will start to reflect the new reality of the US mall sector. Although malls were once “mini-monopolies” within their respective submarkets, “retail sales are now occurring as much through warehouses as they do through malls, so that monopoly is gone. The attractiveness of malls is dramatically lower today,” he says.

Buying a piece of malls

Instead, private equity real estate firms that are investing in US malls are pursuing other types of strategies. Madison International Realty, for example, has been buying shares of A-mall REITs such as General Growth Properties and Taubman Properties. Last September, Madison acquired a 1.6 percent interest in Hudson’s Bay Company, following a previous investment of $200 million in HBS Global Properties, a joint venture between Hudson’s Bay and SPG the previous year.

“We think there is asymmetrical pricing between public and private markets,” says Ronald Dickerman, the firm’s president and founder. “GGP is trading at a 25 percent discount – that’s a six cap, and those are four cap malls. The private market values of those malls is 200 basis points below what the trading value is. The difference between a 4 and 6 cap is extraordinary.” Madison, however, has steered clear of lower-quality malls: “B and C malls are going to die. You’d be crazy to invest in a B or C mall unless there’s an alternative use plan.”

Private equity firms could also do joint ventures with mall REITs, where the former may buy a stake in a certain subset of assets. However, in terms of pure dollar volume, mall investments are more likely to be on the asset level, and in fact, may be more appealing than investments in other property types.

“If you’re a private equity fund with a billion dollars of dry powder and you’re going to buy one of these assets to rehabilitate, you’re putting hundreds of millions dollars into a property to do that,” says Owens.

“It’s not like buying other types of one-off real estate where it’s $20 million here, $40 million there and you have to do a whole bunch of them. In this case, you can do two or three, because the capital commitment is so large. But you better be really, really good at assessing your risk as you’re putting a lot of eggs into a few baskets.”

For Blackstone, a mall investment opportunity would become more attractive if an asset could be acquired cheaply enough to justify investing tens of millions of dollars to backfill vacancies and reinvigorate the property through the addition of new experiential, food and beverage and fitness tenants. “Remerchandising and spending capital is one way to generate returns, but it’s not without risk,” says Meghji. “That’s why we’re cautious on the space.” For Marks, what would increase the risk of investing in malls is if lenders and insurance companies in particular pull back on financing such properties. “We’re not seeing it yet, but that would be the canary in the coal mine if we begin to see a pullback,” he says. “You can’t predict the timing, but that would be an early warning system for us that the sector is becoming less financeable, which would begin to differentiate it from a lot of other REIT asset classes that are investment grade and that are able to get fairly consistent financing from the mortgage market.”

If a lending pullback were indeed to happen, malls would not only need to issue more unsecured debt to repay their mortgage maturities, but also see their contingent liquidity diminish. Meanwhile, Owens notes that mall owners can rely less on the evolution of the retail tenant base than they had in the past: “The question mark today is who replaces a vacating tenant? You’ve seen very few retailers expanding; the vast majority are contracting … if the tenant base is actually shrinking, then you are increasingly reliant on the health of your current tenants.”

Such factors mean that the US mall industry will continue to be an ongoing focus for certain private equity real estate firms. “It’s going to take a couple of years for this whole thing to stabilize, there was 3,000 store closures this year, maybe 1,700 last year,” says Madison’s Dickerman. “Our country is over-retailed, rents are too high. All markets have an equilibrium and for retail, we have not reached it yet.”