We were a tiny bit surprised by the dividend announcement on August 2 that Washington Prime Group (WPG) would be paying a $0.25 dividend – in line with previous quarters. The company’s stock has been under considerable pressure and while business seems to be turning around, we wouldn’t have been surprised if the dividend was cut in order to speed up the process. It did miss the latest FFO and revenue estimates but provided positive guidance. We take a look at the whopping 30% dividend yield and the alternative of investing in the preferreds.
Positive Economic Conditions Bode Well for the U.S. Retail Sector
Key data points for the overall US economy such as consumer confidence and unemployment rates are showing green shoots of economic recovery especially for the retail sector, which is driven by the consumer – which happens to be almost 70% of US GDP.
The University of Michigan’s June consumer sentiment for the US came in unchanged from the same period last year at 98.2 while the index of consumer expectations rose by 3.5% YoY at 89.3. As per the University of Michigan, negative trade news will make consumers cautious over spending. However, the persistent overall strength in consumer confidence is still consistent with expected growth of real personal consumption expenditures by 2.5% during the next twelve months.
Source: University of Michigan 2019
Similarly, the unemployment rate clocked in at 3.6% in May 2019, at a 49-year low. Rising wages among the American workers is another factor to watch out for as wages are directly proportional to consumer confidence and spending. We can see the results of wage expansion and historically low unemployment rates in the retail sales data. The retail sales growth rate has been slowing but in absolute terms retail sales are still rising. The latest data for May reported by the United States Census Bureau was overall sales rising 0.5% from April 2019. Total sales for the March 2019 through May 2019 period were up 3.6% YoY. These numbers suggest a pick-up in consumer spending, warding off many concerns of an economic slowdown.
Demand Supply Mismatch: A Bane and a Boon
A thriving economy doesn’t necessarily mean that the abundant retail space in the United States will be leased out. The US has some serious mismatches in the demand and supply of retail space when compared to other countries. There are approx 1,200 malls in the U.S. that account for just over 1 billion square feet, or 6% of total retail real estate, according to data from ICSC – Out of which mall REITs have ownership in less than 40%.
Malls can be categorized as per the location and footfall into A, B, C or D categories, with A & B being the prime retail real estate properties and C & D being regional-low quality retail real estate. As the retail industry is witnessing rapid changes in consumer tastes and technological and business model advancements that are driving online sales, many malls are expected to close down or see a drop in occupancy rates and sales per square footage (especially the C & D categories).
However, all is not bad for the high-quality malls (A & B categories). These malls are likely to withstand the downturn, as tenants will switch from low to average quality retail real estate to prime retail real estate and pay a premium for the same. Further, imaginative space solutions and experimental tenancy are essential to keep growth intact and some retail landlords are ahead of the game in that regard.
Quality retail real estate for the long game
Mall REITs have to focus on acquiring high-quality spaces which are located in prime locations and have a high footfall. In order to thrive, consolidation is a must. Most REITs need to liquidate their holdings in low quality real estate, and invest in upcoming/established real-estate areas that have higher demand and command above-average rental rates, as traditional brick-and-mortar players are likely to consolidate/reduce their footprint (retail shop closures) to only a few selected areas (along with e-commerce) in order to reduce their operating costs and compete with pure online sellers.
Further, we witnessed that brick-and-mortar retailers are far from extinct. Prominent and new retailers are re-thinking their business models and are adopting omni-channel retail strategies to enhance the customer shopping experience, but focusing on high quality real estate will be key.
Vacancies and leases of shorter duration, an opportunity in disguise
Traditional mall tenants continue to evolve and are signing leases of lower durations. Over the last 5 years, the average term lease has been declining along with average lease term renewals. As foot traffic falls, retailers need to cut costs in order to survive, so they are proactively entering shorter lease terms. Additionally, store closings have led to vacancies, which affect the occupancy metrics of mall REITS. However, vacancies and shorter leases might be a blessing in disguise as it gives mall REITs the chance to redevelop and raise rents by replacing weaker retailers with higher traffic tenants in an environment where expansion opportunities are extremely limited.
One such REIT is Washington Prime Group (WPG). The company owns 103 core assets consisting of 55 million square feet of managed gross leasable area as of March 31, 2019.
Washington Prime Group’s localized national footprint
WPG owns and operates a national real estate portfolio of enclosed and open air retail venues which captures the essence of the surrounding community allowing for operating efficiency between tenant, sponsor partners and local management who can benefit from the technical-knowhow and expertise of the locals.
Source: WPG Investor Presentation June 2019
Diversification in product, size, geography and tenancy: No tenant owns more than 3.0% of total base minimum rental revenues
WPG leases its properties to a variety of tenants across the retail space including anchor stores, big-box tenants, national inline tenants, sit-down restaurants, movie theaters, and regional and local retailers. Its portfolio comprises Open Air, Tier 1 and Tier 2 properties. The company defines Tier 1 as enclosed retail properties that have a higher occupancy, sales productivity and growth profiles, while Tier 2 enclosed retail properties are viable enclosed retail properties with lower productivity and modest growth profiles. The company generates ~93% of the Net Operating Income (NOI) from Tier 1 and Open Air properties and both receive the majority of capital allocation. WPG’s gross leasable area (GLA) is concentrated with its regional tenants, with national only being 26% as of December 31, 2019. A concentration of regional tenancy is positive because it means active/hands-on asset management.
Source: WPG Investor Presentation June 2019
Source: WPG 8K December 2018
Selected companies include Macy’s, Inc. (NYSE:M), Dillard’s, Inc. (NYSE:DDS), J.C. Penney Co., Inc. (NYSE:JCP), Sears Holdings Corporation (OTCPK:SHLDQ), Target Corporation (NYSE:TGT), Kohl’s Corporation (NYSE:KSS), Dick’s Sporting Goods (NYSE:DKS), Best Buy Co., Inc. (NYSE:BBY), Bed Bath & Beyond Inc. (NASDAQ:BBBY) and TJX Companies, Inc. (NYSE:TJX). Exposure towards giants such as J.C. Penney, Bon-Ton Stores, Inc. (BONT), Sears, and Toys”R”Us remains a concern as these companies have either declared bankruptcy or are on the verge of bankruptcy.
A diversified tenant and revenue base is best demonstrated by the fact that there was no single tenant responsible for more than 3.0% of total base minimum rental revenues and no single property accounted for more than 5.1% of total base minimum rental revenues for the year ended December 31, 2018.
Stable operating metrics
Washington Prime Group has been displaying a steady set of operating metrics. The company has strong cash flow stability which it achieves by tenant diversification, common area activation and redevelopment. Cash flow stability is best illustrated by comparable NOI growth of 90 basis points during a five-year period for Tier One and Open Air assets. The occupancy rates for WPG have been stable at ~94% for Tier One and ~95% for open air, indicative of a proactive attention on tenant diversification. Though the average new lease terms and average renewal lease terms have been exhibiting a decline, that’s on par with the overall trend in the industry.
Source: WPG Investor Presentation June 2019
Healthy leasing activity
WPG added 2.1 million of total square feet in 2Q 2019 representing a 10% YoY growth across 113 new leases. The company is focusing on larger square feet transactions per tenant. Of the 2.1 million square feet, 55% of new leasing volume was attributable to lifestyle tenancy such as food, beverage, entertainment, home furnishings, fitness and professional services – up from 52% last quarter. Combined Tier One and Open Air occupancy was 92.5%, a decrease from the prior quarter due to bankruptcies by several retailers.
Source: WPG Investor Presentation Q2 Earnings Call
Redevelopment initiative and filling vacancies
WPG has a strong focus on profitable redevelopment of hybrid town centers into a combination of open air and enclosed formats. The company is estimating a capex of $300-350 million mainly towards Tier One and Open Air properties over a 3–5-year horizon while estimating a return on invested capital in high single-digits. Redevelopment capital allocation would exclude spaces owned by non-retailers including Seritage Growth Properties.
WPG has identified 29 department stores in its Tier 1 and Open Air portfolio that require redevelopment or repositioning and is proactively working on repositioning 25 of them. This is an attractive opportunity for WPG as it can enrich the customer experience by providing alternatives such as dining, entertainment, dynamic retail offerings etc. As of last quarter, 22 controlled by the company were in various stages of redevelopment and/or replacement out of which WPG has successfully addressed 11 spaces formerly occupied by department stores.
Source: WPG Investor Presentation Q2 Earnings Call
Above-average dividend yields to falter
Washington Prime Group has a dividend yield of over 30%. Such a high yield is not sustainable as either one of two things is bound to happen. One, WPG fires from all fronts and surpasses the analysts’ expectations, resulting in the stock price increasing and the yield coming down, or second, it slashes its dividends due to estimate misses and operating difficulties. Opinions vary widely on these challenges but analyst estimates for 2019 and 2020 are for dividends to remain stable.
Washington Prime Group has maintained 2019 FFO guidance in the range of $1.16 to $1.24 per diluted share and comparable NOI growth forecast of between 2.0% and 3.0%. Management looks fairly confident on achieving the above-mentioned targets. For FY 2019, the dividend policy remains unaltered. Further, by strategic redevelopment and active repositioning of tenancy, the company plans to replace all lost rent and address related cotenancy challenges to deliver comp NOI growth of at least 2% from Tier One and Open Air portfolios by 2020 and 2021.
Why I’d buy now and a couple of other options
It seems management is doing the right things to right the ship and the company’s high-quality assets should be a driver of future growth. Do I expect a dividend yield of 30%? Of course not. The current payout ratio is 100% of FFO and that just isn’t sustainable. If FFO can accelerate, perhaps the company can get out of this situation unscathed. However, even if the dividend is cut to a more manageable $0.50 – the dividend yield is still in the double-digits.
So the question is whether to buy now or wait until after the dividend cut? The announcement of a dividend cut will result in a huge price decline, although if you ask me, a dividend cut should be somewhat priced in already. So it’s a tough call for investors – Buy now and lock in a dividend yield you may not ever see again or wait until the dividend cut – the other option is to do nothing and risk losing upside on the stock price if the turnaround gets traction.
There is another option – or two. That is, the preferred shares – The Series H – 7.5% (WPG.PH) dividend or the Series I (WPG.PI) with a 6.875% dividend rate. Both are trading at well below par but both are also trading beyond the initial call date. Both are also cumulative, which means that any unpaid dividends from prior periods must be paid before any common shareholders receive a dividend.
The current yield on the Series I is 9.35% while the yield on the Series H is 9.39% – a toss up. Since both have initial call dates in the past, the company can still redeem the shares with a 30-day notice. Investors who buy at this price would WANT the shares to be called even though it would require them to find another investment yielding 9%+ because if the shares do get called, investors receive $25 and neither share is trading for more than $20. If I had to choose, I’d choose the Series H for its higher coupon, and the increased likelihood it would be redeemed first.
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Disclosure: I am/we are long WPG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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