Business certainly has been good for regional mall REITs, and fundamentals are such that it is not expected to change any time soon. Indeed, by possessing some of the highest-quality properties in any sector, regional mall REITs appear positioned for another year of solid performance. Current supply trends indicate there is little new space under construction, while space demand is expected to remain vigorous as retailers continue to seek new locations. Few vexing problems are on the short-term horizon for mall owners, though concerns over the health and direction of consumer spending are always at the forefront of industry executives’ minds.

Barriers to Entry

In any business, high barriers to entry give established players a tremendous advantage. That is certainly the case with regional malls. Perhaps to a greater extent than other property types, regional mall REITs face less competition from new properties.

“If you own a dominant mall with four or five anchors, there is little chance that someone is going to build a competing asset in that market,” says David Fick, an analyst with Stifel, Nicolaus & Co. “The vast majority of U.S. markets already have all the regional malls that they’re ever going to have, and there are virtually none planned for most markets.”

Indeed, few regional malls have been built recently, and only a small number are planned. Most recent development of retail properties has been concentrated in other space concepts such as community centers and lifestyle centers (see sidebar). Over the short and long term, a convergence of factors makes it unlikely that the supply of regional malls is going to appreciably expand.

There are several obstacles confronting potential mall developments, not the least of which is the simple lack of available space, according Linda Phelps, an analyst with Standard & Poor’s.

It is easier for developers to obtain entitlements for projects measuring from 250,000 square feet to 500,000 square feet than projects of 1 million square feet and more (typically needed for regional malls), adds John Bucksbaum, CEO of General Growth Properties, Inc. (NYSE: GGP). Additionally, development times often extend as long as 10 years, limiting development to a few firms that have the financial wherewithal to endure a lengthy construction cycle.

Phelps’ colleague, Lisa Sarajian, says there are many other barriers to new regional mall development.

“Developers have got to have commitments from a good group of retailers to entice a lender, and that lender is going to require a greater equity commitment than was the case 20 years ago when most malls were built,” Sarajian says. Environmental and engineering considerations are also complicating construction.

“These considerations are going to require savvier developers,” Sarajian adds. “And, to get communities to buy into projects, just building the same old vanilla four or five-anchor regional mall may not be sufficient to gain approval for a project.”

Besides the current and expected long-term slowdown in new mall development, many older malls around the country continue to be taken out of service. “Roughly half of the malls that were built from the mid 1950s until the past couple of years have either closed, been torn down, or have been converted to some other use,” Fick estimates.

This combination of limited new supply and either the demolition or recycling of old supply enhances the value of existing regional mall properties in REIT portfolios.

While regional mall REITs’ portfolios appear to be well insulated from the introduction of new supply in most markets, other barriers to entry exist that limit the field of mall owners to only a few companies.

“It is not surprising that the regional mall sector is one of the most consolidated among the public companies,” says Richard S. Sokolov, president and chief operating officer of Simon Property Group (NYSE: SPG). “There are real strategic and operating advantages to having a large and national portfolio and platform.”

Bucksbaum agrees. “The barrier to entry is that we have great relationships with retail chains, and we have the locations to give them productive spaces all around the country,” he says. In contrast, owners of smaller, less geographically diverse mall portfolios may have difficulty building and maintaining the sort of relationships that regional mall REITs possess.

Supply Limited, Demand High

With large portfolios providing plenty of leasing opportunities, it is not surprising that demand for space in REIT-owned regional malls remains robust. As a consequence, mall owners have been able to raise rents substantially during the past several quarters.

With consumer spending increasing at a healthy clip and greater retailer profits fueling demand for new space, new leases are being written at rents much greater than rents paid on expiring leases. Fick estimates the leasing spread to be 20 percent to 22 percent for mall portfolios that do more than $400 per square foot in sales, and 12 percent to 14 percent for portfolios where sales average less than $400 per square foot.

“We think the pace will continue for the next two years to three years while the scarcity of space exists and while there are very few retailer bankruptcies,” Fick predicts. Others agree, but there remain a few issues to consider that could affect the performance of regional mall properties. Take consumer spending, for example.

Many retailers have fattened up on sustained growth in consumer spending during the past few years, and have been encouraged to open new locations. But 2006 is likely to be a transition year from above-trend growth to a more normal rate of increase. Mike Niemira, vice president and chief economist of the International Council of Shopping Centers (ICSC), predicts consumer spending will expand approximately 4 percent this year, compared with a 7 percent year-over-year rate posted in late 2005. Among the several leading indicators Niemira consults to forecast changes in spending, interest-rate sensitive housing demand began to cool in late 2005.

“Home demand has historically been, and still seems to be, the best leading indicator of durable and non-durable consumer spending,” he explains. “Any slowdown has about a nine month lead time before a similar trend is observed in other areas of retail spending.”

Considerably higher interest rates would have to occur to have a devastating affect on consumer spending, however. “Although we are likely to see a rise in rates this year, we don’t expect it to be detrimental to the consumer,” Niemira cautions.

Despite the importance of consumer spending growth as a rationale for retailer expansion, it may take a few quarters after the initial signs of a slowdown emerge for retailers to revise expansion plans, assuming those plans are revised at all. “In short, there is no hard and fast rule regarding when a slowdown in space demand resulting from a slowdown in consumer spending will occur,” Bucksbaum notes. “It is very particular to the individual retailer. One of the things that enter into the decision-making process is the retailer’s balance sheet; some are clearly better positioned to expand than others.”

Rents and occupancy have historically continued to expand at Simon’s malls through wide fluctuations in consumer spending and various economic cycles, Sokolov points out. “The bigger issue in leasing vitality is the strength of our retail tenants,” he says. “Today the balance sheets of our roster of retail tenants have never been stronger. This is encouraging them to create a significant number of brand extensions and new concepts, which is keeping demand for our space robust.”

Publicly traded retailers must continue to deliver top-line results for stakeholders, and those results are typically attained by opening new locations. “From an equity market perspective, retailers are definitely driven to grow,” S&P’s Phelps stresses. While the push for new stores virtually ensures a steady level of demand for mall owners, retailers can occasionally miscalculate.

“That occurred in the late 1990s, when consumer spending was reasonably robust, but there were concepts that were dinosaurs,” Sarajian says. “There were failures. That’s just an ongoing part of the business that may be tied more closely to the product cycle than to consumer spending.”

Satisfied Shareholders

Just as consumers continue to flock to the malls, investors remain drawn to the strong returns posted by regional mall REITs. After posting a REIT industry best 45 percent total return in 2004, regional mall REITs were again among the top-performing sub-sectors in 2005, according to NAREIT data. The sector’s 16.5 percent total return was only exceeded by the 26.6 percent total return from the self-storage sector.

Analysts say that there are still plenty of opportunities for investors to cash in on that outstanding performance.

“The sector is undervalued,” claims Richard C. Moore, an analyst with KeyBanc Capital Markets. “Property performance has been astounding, and will continue to be astounding for the next one year to five years. There is no new supply, but tremendous demand for space.”

“It’s the cheapest of all sectors,” adds Louis Taylor of Deutsche Bank. REIT funds have generally overweighted the sector, Taylor explains, and do not have much incremental capital to put in. “As a result, there is little money to push the stocks up. That would have to come from general equity investors, and they still equate regional malls with the consumer.” That is, the stocks tend to trade upon changes in consumer sentiment rather than property fundamentals, he explains.

Citing strong demand for space, Taylor expects re-leasing spreads to range from 15 percent to 25 percent this year, and occupancy to remain stable. “We’re looking for FFO to grow 7 percent to 10 percent.”

In 2006, regional mall REITs will continue to put money back into their properties through re-development or renovation initiatives, according to company executives and industry analysts. Rather than taxing liquidity or placing a strain on a credit profile, such initiatives are looked upon favorably. “It is one of the best ways they can reinvest capital,” Phelps says of redeveloping existing assets. “There is less leasing risk than in ground-up development, and it involves smaller capital outlays.”

Sarajian agrees, noting that mall owners must protect the competitive position of their properties. “If consumers are increasingly looking for a shopping experience, then it is the mall owner’s job to provide that,” she says.

According to Bucksbaum, the most exciting part of the business is redevelopment. “The key is a willingness to reinvest and to recognize that it’s critical no matter how good your shopping center is,” he explains. “If you are not continually making it better and bringing in the merchants and the uses that people want, you will not be as good as you might have once been.”

Art Gering is a freelance writer and a senior market analyst with Marcus & Millichap Research Services in Phoenix.