There’s no reason to sugarcoat anything. The commercial real estate market has been brutally impacted by the coronavirus pandemic, especially in the segments of retail, restaurants, and offices. Despite that the economy has reopened to some extent, consumers remain reticent to shop like they did before the pandemic. This scenario exists because of four distinct reasons:
- The unemployment rate remains at 7.9%, the highest since the Global Financial Crisis, and the labor force participation rate has collapsed to its lowest level since 1976.
- Those who remain employed or have found new jobs are still generally anxious about the economy and continue to save, resulting in a personal savings rate of 14+%, the highest level since 1975.
- Many people remain concerned about the coronavirus.
- Consumer credit remains excessive at $4.1 trillion, only down modestly from $4.2 trillion in February.
These issues contributed to the massive decline of physical B&M retail sales and on-premise restaurant traffic, and none of these adverse factors will dissipate in the immediate future.
Urban office rentals have been upended as many companies that have the capability of working from home have done so. As we have read in news headlines, some companies have recognized that they can shift their entire workforce from the office into a remote capacity. Others have only committed to a partial shift, effectively testing the waters of the impact on productivity, customer service, etc. The firms that somewhat need an office work environment have created a blend offering by making a portion of the week being in the office and the remainder work from home. And then the last segment are companies that absolutely require the office environment in order to be successful. Certainly there’s a lot of variety, but three out of those four scenarios result in less total square footage office space being needed.
Two REITs that are directly exposed to these end markets are VEREIT (VER) (retail, restaurants, and office) and Tanger Factory Outlets (SKT) (retail). Some analysts and investors have argued that the worst, or Q2 2020, is behind us and we’re now on the path to recovery in these real estate markets. However, it’s actually not that simple and it’s very possible that these property types will remain challenged for the next couple of years. Furthermore, there’s a tail risk that conditions worsen before they get better.
Tanger Still Troubled
Back in August, Tanger was described as being among the most troubled retail REITs in the industry, which still seems to be the case. Yes, total occupancy improved to ~94% and rent collection increased to 85%. Those trends are definitely positive news, but it doesn’t consider changes in rent rolls and releasing spreads. For one, there’s about $6 trillion of commercial real estate, consider how much credit exists to keep that market functioning. Well presently there’s a record number of commercial mortgage backed securities in the retail space (which includes restaurants) that are distressed, even worse than the peak of 2012 (or what was the worst period experienced as a result of the Global Financial Crisis). In fact, retail has been consistently among the worst performing categories given all of the companies that are delinquent, defaulting, and filing bankruptcy. Many of these borrowers are malls and outlets, which lends itself to trouble for landlords with exposure to retail.
In the last two quarters, Tanger has committed to rent concessions which have significantly cut revenue, EBITDA, and funds from operations. According to its latest Form 10-Q filing:
Tenants have requested rent deferrals, rent abatement or early termination of their leases and may continue to do so. In addition, tenants have and may continue to be forced to temporarily or permanently close or declare bankruptcy which could reduce our cash flows and negatively affect our ability to pay dividends. Specifically, as a result of COVID-19 and various governmental orders currently in place, a significant number of our tenants either closed their business or operated with limited operations and/or have submitted requests for rent relief or failed to pay rent.“
Tanger’s total revenues and net operating income have collapsed by an astonishing 45% and 55%, respectively, year-over-year. Consequently, TTM FFO and quarterly FFO dropped by a similar amount, which are only slightly above breakeven in the first half of 2020:
We also explained that leverage can become a serious overhang for REIT equity valuations: “An okay business with too much leverage can certainly fall apart and that seems to be the case here.” Not only has book leverage increased, but performance based leverage metrics have deteriorated as well. Net debt to EBITDA had already exceeded 6x at the beginning of 2020 and it has absolutely cratered based on H1 2020 results. Given that retail CMBS has not improved at all throughout September, it would not be surprising either to see more retail properties requesting rent abatements. About one week ago, the Wall Street Journal also broke the story that retail store closures hit a new record, most of which are tied to malls and outlet centers. Keep in mind that monthly rents don’t magically jump overnight, it’s a slow and steady process to recover lost ground.
All things considered, it probably makes sense to steer clear of Tanger as the damage to retail has continued unabated and a recovery appears unlikely, at least in the near-term.
VEREIT Remains Vulnerable
While diversification for REITs is usually a good thing, it doesn’t help if the property types are spread among those most affected by COVID. In fact, a staggering 84% of VEREIT’s portfolio falls within retail, restaurants, and offices while the remaining 17% lands in safer industrial assets. As this net lease operator was negatively impacted by COVID, management had to cut the dividend by nearly half, back to a quarterly distribution not seen since 2013:
Investors have been quick to point out that rent collections have improved to 95%, which again, is good news. In the same vein, a Motley Fool author presented an optimistic viewpoint that the coronavirus pandemic provided management an excuse to cut the dividend so it could return to its growth strategy: “the pandemic gave management the cover it needed to ease the dividend burden so it could self-fund more of its own growth and, at the same time, reduce the cost of issuing new stock. That, in turn, will position VEREIT to start increasing the dividend again as it returns to expanding its portfolio.“
I’m not sure I buy that argument. Dividend distributions are meant to be kept steady unless deemed absolutely necessary to cut and that appears to be the case here. So far, we can see that TTM FFO and quarterly FFO have dropped:
Circling back to the P&L, Q2 2020 revenue and net operating income declined by double digits year-over-year, which resulted in consolidated leverage (gross debt minus cash and short-term investments relative to EBITDA) reaching 6x, which was much higher than its ~5x leverage last year. Oddly enough, this 6x financial leverage level was breached by Tanger in early 2020.
While VEREIT’s tenants do have at least some short-term rent coverage, many of its largest tenants have poor credit quality, which is certainly a challenge during COVID. On the company’s website, the tenant subsection shows that five of ten are currently rated junk by S&P:
So why does this matter? Well, most REIT portfolio credit quality compositions have a reasonable mix of tenants with investment grade and junk ratings. However, VEREIT’s portfolio only has 37% investment grade versus 63% in speculative category, as shown below:
We already know that two of its largest tenants have reasonably high bankruptcy risk, representing about 6% of total revenue. However, the company has more than 600 tenants, and given that 63% on considered speculative junk, that means there could be 375+ that are at above-average risk of default. Some of those will eventually end in bankruptcy, especially if the time horizon spans the next few years.
So despite that Q2 revenue declined by 11% year-over-year, and 6% of the portfolio could be subject to rent reductions and/or location closures, these figures may only be the tip of the iceberg. If additional tenants request rent reductions, debt to EBITDA could potentially approach 7x within the next year.
With a challenging macro environment, EBITDA declining and two-thirds of the tenant base considered poor credit quality, investors should be mindful that VEREIT probably doesn’t land into the category of safe investments. Some investors apparently thought the dividend was actually a positive, but that looks like a stretch given the distribution was cut so significantly. Perhaps a dividend yield of 4.4% is attractive, but there are likely much better alternatives that offer similar, if not better, total return profiles.
COVID has dealt a heavy blow to REITs but definitely to some much more than others. Certainly, highly leveraged landlords have had serious trouble working through the turmoil, but even ones that have somewhat elevated leverage, i.e. 6-7x EBITDA, are not faring too well. Both Tanger and VEREIT cut their dividends and are down 55% and 25%, respectively, year-to-date. Rent rolls could worsen further off of Q2, or at the very least, remain subdued for longer than bulls anticipate. Three things are uncertain: the economy, tenant bankruptcy risks, and rent rates. If you have any thoughts or questions, please comment below.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.
Additional disclosure: I may short VER and/or SKT at anytime over the next 72 hours through common stock and/or put options.