No bargains:
As stores close and rents collapse, shopping centre landlords face a slow recovery
For a long time, it has been evident that retail shopping giants Unibail-Rodamco-Westfield (URW) and Scentre Group were facing growing online competition. More recently, it became apparent the pair had bigger problems than just e-commerce.
URW had taken on too much debt to finance the purchase of Westfield, and Scentre’s management made the dubious decision to remove disclosure on key operating metrics. Then the corona-crisis hit and the already weak share prices were trashed.
If one takes the historical numbers at face value, Scentre is trading at about half its net tangible asset backing with a backwards-looking 10% yield, while Unibail is priced at just a quarter of net assets, offering a 20% trailing yield.
Of course, no one is taking those numbers at face value, attractive as they seem. With venues closed and rent moratoriums in force, retail landlords have been hit hard by the pandemic restrictions and the market is pricing in some carnage. The question is whether it’s overdone.
The first bit of bad news concerns rent revenues. Retailers the world over are rethinking their store footprints, with Flight Centre’s closure of 800 stores worldwide an example.
Shrinking retailers will lead to increasing vacancies while elevated unemployment and a recession-shaken consumer won’t help in-store sales. Landlords will try to entice new tenants to fill the gaps but there may not be much to choose from. It seems inevitable that landlords will have to reduce rents, especially as the accelerated shift to online will drag sales growth down.
While lower interest rates will ease interest expenses, other fixed costs like utilities and wages are unlikely to change much. That entails lots of operating leverage; any decline in rent will be magnified at the bottom line, especially as smaller, specialty retailers will be hardest hit, which is typically where shopping centres make their highest margins.
Lower rents also mean properties will be revalued lower. Each year, independent valuers take into account current rents, growth expectations, interest rates and transactions for similar properties to come up with a theoretical value.
These valuations sit on the balance sheet, feeding into the trusts’ gearing ratios (a measure of their net debt to total tangible assets). If gearing ratios get too high, debt covenants may be triggered; in dire circumstances, worried lenders can liquidate the trust.
Most management teams aim for gearing to be well below covenant limits, selling assets or raising capital whenever the relevant ratios get uncomfortably high. This is likely to become a major headache for Scentre and Unibail. Valuations were already under pressure before the pandemic; now they’re far worse.
With gearing ratios likely to rise across the industry, there may be a wave of distressed selling, adding to oversupply and placing more pressure on valuations. In worst-case distressed selling scenarios, prices could plummet.
The survivors will be those able to garner enough support from lenders. With the best assets in the industry, Scentre and Unibail should be able to raise money and debt as needed, but their elevated gearing leading into the crisis (especially Unibail) won’t do them any favours.
Of the two, Scentre should emerge in better shape. Its balance sheet was more conservative before the crisis and Australia has fared relatively well compared with Europe and the US, where malls have been shut for extended periods.
But with increasing online competition and a souring global economy, both face a painful period of deleveraging and a future of sluggish growth.
What about those trailing yields? To us, the market has it about right. The current level is too high given the double whammy of lower rents and forced asset sales or capital raisings.
The sensitivity is also a concern. Assuming 35% gearing and that any decline in rents leads to a proportional decline in property valuations while fixed overheads remain steady, if rents were to fall by 30%, cash flow would fall by around 40%.
All of this makes the historical yield deeply misleading. With plenty of time to watch this story unfold, steer clear.
Mickey Mordech is an analyst at Intelligent Investor.