Value Investing

Simon Property Group (SPG): A Blue Chip REIT Down Over 20% Since July

Real Estate Investment Trusts, or REITs, are a great way for long-term income investors to gain exposure to real estate without the hassle that comes with actually owning, maintaining, and managing rental properties.

 

In fact, REITs, if carefully chosen, can help you achieve the ultimate form of financial freedom; being able to live off pure dividend income during retirement, including early retirement.

 

Of course with so many REITs out there investors can have a tough time choosing where to invest their hard earned money.

 

Let’s take a look at one of the largest blue chip REITs, Simon Property Group (SPG), and see if now, thanks to the recent REIT correction, this mall owner deserves a core spot in a diversified portfolio such as our Conservative Retirees dividend portfolio.

 

Business Description

Simon Property Group is America’s largest mall owner (and the largest REIT by market cap), with 218 properties across the North America, Europe, and Asia. As seen below, malls account for half of the company’s assets, and premium outlets contribute another 31%. Most of the business is domestic with international assets accounting for just 8% of the total.

 

Simon Property Group SPG Dividend

Source: Simon Property Group Investor Presentation

 

By geography, Florida (14.7% of net operating income), California (12.8%), and Texas (10.4%) are the biggest contributors, but the business is well-diversified.

 

Simon Property Group SPG Dividend

 

The REIT’s historical success has been due to management’s disciplined approach to slow but steady growth. Specifically, Simon Property Group focuses exclusively on high-end and ultra premium luxury properties (such as its “Mills properties”), with good diversification across the U.S. as well as with tenants.

 

As you can see, Simon Property Group’s largest tenant accounts for just 3.4% of its total rent for U.S. properties. The malls the company owns property in are also reasonably diversified by anchor tenants with Macy’s representing the biggest share of square footage (12.8% of the total).

 

This helps protect Simon Property Group from being overly exposed to the fate of any single retailer, which is important because retail is a notoriously tough business with a low survival rate for many companies (consumers are fickle).

 

Simon Property Group SPG Dividend

Source: Simon Property Group Earnings Presentation

 

Business Analysis

While lower quality retailers, such as those found in grade B and C malls have suffered in recent years, Simon Property Group’s exclusive focus on the high end of the market has helped it to continue growing despite the rise of e-commerce giants such as Amazon (AMZN).

 

Even more impressive is the fact that management, led by CEO David Simon (Harvard business review called him one of the world’s greatest CEOs in 2013), has been able to generate improving profitability and returns on invested capital in an environment where low interest rates have sent commercial real estate prices soaring.

 

With 31 years of industry experience, including being with Simon Property Group since its 1993 IPO, Mr. Simon has proven to be one of the industry’s best capital allocators, generating 3,000% total returns over the past 23 years (five times better than the S&P 500).

 

Part of that is the REIT’s ability to locate attractive acquisition opportunities, which prove highly accretive to funds from operation per share (the equivalent of a REIT’s cash flow and what pays the dividend). Since Simon Property Group’s IPO in the early 1990s, the company has made over $40 billion of acquisitions, resulting in tremendous growth.

 

Simon Property Group SPG Dividend

 

But Simon Property’s true competitive advantage lies not just in acquiring top quality malls in fast-growing regions. The key to staying ahead of industry headwinds (e.g. rising online shopping) and generating consistent growth throughout various interest rate and economic growth cycles is to focus on the quality of the customer experience within each mall.

 

For example, Simon Property Group has invested heavily into revitalization efforts of its properties ($3 billion in just the last five years). This helps to attract not just more shoppers, but customers with higher incomes that in turn attract superior anchor tenants such as Neiman Marcus, Bloomingdale’s, Lord & Taylor, and Saks Fifth Avenue. Take a look at the $300 million transformation the company made to its shopping center in Long Island.

 

Simon Property Group SPG Dividend

 

The high end nature of its malls allows Simon Property Group to exert enviable pricing power, as represented by this year’s 4.5% increase in base rent it is charging its tenants in 2016. Yet despite the steep rent hike, occupancy at its properties remains at all-time highs (96.3%).

 

Better still, Simon Property Group’s vast diversification and long-term leases mean that it never faces a steep lease expiration cliff. As seen below, no single calendar year sees more than 8.6% of the company’s gross annual rental revenues expire. This staggering protects Simon Property Group from having to renew a large chunk of its leases or find many new clients in a down market. Occupancy rates and rent prices can remain more stable over time.

 

Simon Property Group SPG Dividend

 

These factors combine to give Simon Property Group strong cash flow predictability ,which allows for some of the strongest and most consistent dividend growth in the REIT industry in recent years. From 2010 through 2015, Simon Property Group’s free cash flow and dividends per share compounded by 10.1% and 18.4%, respectively.

 

Simon Property Group SPG Dividend

 

Key Risks

There are two main risk factors to consider with Simon Property Group. The first is the continuing growth of e-commerce and online retailing. Up until now, management has used its decades long expertise in premium retail to prevent this growing threat from harming its growth capabilities.

 

However, there is no guarantee that the company will be able to continue to do so. After all, at the end of the day if rivals like Amazon can deliver what shoppers want more conveniently, and at a better value than mall-based retailers, even luxury mall stores may end up falling into secular decline.

 

Then there is the risk of rising interest rates, which have risen by about 0.7% since the surprise results of the November 8th election.

 

This has been due to markets pricing in growing inflation from a combination of rising oil prices and a Trump stimulus package of tax cuts and infrastructure spending. While such a package is thought to be likely to spur economic growth (based on the market’s knee-jerk reaction at least), it’s also likely to cause inflation to rise, and long-term interest rates are primarily determined by inflation expectations.

 

Add in the improving economy, and the fact that this will likely keep the Federal Reserve gradually raising short-term interest rates, and Simon Property Group is likely to face rising rollover costs on its large debt load.

 

That will mean higher costs of capital and lower overall profitability, which could make future growth harder to come by.

 

In addition, remember that the REIT business model requires, due to the way REITs are structured for tax purposes, that the company pay out at least 90% of earnings as dividends. While this provides investors with high yields, it also means that REITs must periodically raise external debt and equity capital to grow.

 

If long-term interest rates, such as those on 10- and 30-year Treasuries, rise to 4%, 5%, or even 6%, it’s likely that much of the yield-starved capital that has gravitated into the industry in recent years could depart for less risky alternatives that provide safer income and better capital preservation.

 

Or to put it another way, high interest rates may make REITs less attractive to income investors and (temporarily) result in lower share prices and higher dividend yields (to serve as a risk premium over risk free treasuries).

 

That might mean that REITs, like Simon Property Group, will have a harder time raising equity growth capital, further limiting their ability to keep generating such strong returns.

 

Like almost all things in life, moderation is important. REITs can certainly help a portfolio’s current income generation, but they should be just one part of a well-diversified dividend portfolio. No one knows what could happen with interest rates, the value of real estate, and numerous other factors impacting this sector.

 

My preference is to keep my bets spread out across many different types of businesses (so long as they remain within my admittedly limited circle of competence).

 

Dividend Safety Analysis: Simon Property Group

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

 

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

 

Dividend Safety

 

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their track record has been, and how to use them for your portfolio here.

 

Simon Property Group has a Dividend Safety Score of 64, making its dividend one of the safest in the REIT industry and unlikely to be cut, at least in the short to medium-term. This is primarily thanks to two factors.

 

First, Simon Property Group’s low FFO payout ratio of just 62% means that its cash flows are more than adequate to pay the dividend with plenty of safety buffer.

 

As you can see, Simon Property Group has a good track record of maintaining a low payout ratio, which has stabilized in the low 60% range after moderately rising since 2012. The payout ratio remains at a reasonably healthy level.

 

Simon Property Group SPG Dividend

 

However, just as important as a strong payout ratio is a strong balance sheet. A REIT that is over-leveraged may end up facing pressure from creditors or credit rating agencies to sacrifice the dividend in the name of repaying debts or maintaining its rating to have access to financing.

 

Simon Property Group SPG Dividend

Source: Simply Safe Dividends

 

Now on an absolute basis, Simon Property Group has a lot of debt, as seen by its high debt / equity and net debt / EBIT ratios. However, remember that real estate is a highly capital intensive industry and the business model of the industry requires a REIT to take on debt to grow. Thus we need to look at Simon Property’s credit metrics in context with its industry.

 

REIT Debt / EBITDA EBITDA / Interest Debt / Capital S&P Credit Rating
Simon Property Group 5.44 4.82 77% A
Industry Average 6.55 NA 64% NA

Source: Morningstar

 

When we compare Simon Property Group’s leverage ratios to its peers we see that, though the debt load is high on an absolute basis, relative to its industry the balance sheet is actually quiet strong.

 

In fact, Simon Property’s cash flow is more than sufficient to service its debt obligations.  Combined with the fact that it is nowhere near breaching its debt covenants (which would likely result in a dividend cut), this explains why it has such a strong credit rating.

 

Simon Property Group SPG Dividend

 

Barring a major recession and a secular decline in high-end mall real estate, Simon Property Group’s dividend looks quite safe.

 

Dividend Growth Analysis

Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

Simon Property Group has a Dividend Growth Score of 43, indicating the dividend growth prospects are about average. Now that’s not to say bad, after all, since long-term total returns are driven by yield and income growth. A stock with a highly secure dividend of 3.7% needs only to grow the dividend by just under 6% in order to be a market beater.

 

As you can see, 6% long-term dividend growth is well within Simon Property’s historical track record. Of course you’ll note that this REIT’s dividend payout is more variable than some other dividend stocks. That’s because during times of economic stress management sometimes pulls back on the dividend in order to ensure it can keep growing for the future (due to REITs’ high payout ratios and financial leverage).

 

In other words, while the long-term payout growth record is solid, Simon Property Group is no dividend aristocrat.

 

Simon Property Group SPG Dividend

 

That being said, given that Simon Property Group is currently growing FFO per share by 6.6% per year, has over $1 billion of new investments planned for next year (as well as 2018), and has $6.5 billion in available liquidity, long-term dividend growth investors can continue to expect 6% to 7% dividend growth in the coming years.

 

Valuation

When it comes to valuing REITs you don’t want to use EPS and a P/E ratio. That’s because GAAP earnings require deducting depreciation of assets, and properly maintained real estate properties generally increase in value. In other words, the EPS of a REIT doesn’t signify how well it’s able to protect or grow its dividend.

 

For that you want to look at adjusted funds from operation (i.e. free cash flow), which some REITs call “funds available for distribution”. Simon Property Group currently trades at 18.3 times AFFO (adjusted funds from operation).

 

Metric Current 13-Year Median Value Historic Discount
P/AFFO 18.3 17.9 -2.2%
Yield 3.7% 3.1% 19.4%

Source: FastGraphs, Gurufocus

 

Another key metric to look at is the yield and where it is compared to its historical norm. As you can see from the above table, Simon Property Group is trading at a slight premium to its historical P/AFFO but a significant discount on a yield basis.

 

Thanks to Simon Property Group declining over 20% since the REIT correction began on August 1, the stock could represent reasonable value for long-term income investors seeking exposure to REITs.

 

Just be aware that the REIT correction may not be over and Simon Property may still have further to fall. While that potentially means great future opportunities to add on dips, if you are a short-term horizon investor, such as a retiree who will need to sell shares to cover living expenses, you may want to wait for a better buying opportunity.

 

Most of the REITs I’m watching would get me excited after another 10% correction, but they are certainly starting to get my attention now.

 

Conclusion

I’m not trying to say that Simon Property Group is the perfect sleep well at night, or SWAN, REIT. After all, its business model is tied to the health of the economy, and specifically consumer spending. These factors caused it to reduce its dividend during the last recession.

 

That being said, as far as mall REITs go, Simon Property Group has proven itself more than capable of generating industry leading long-term shareholder wealth and income growth.

 

With the economy showing some signs of a stronger recovery, and rising interest rates having caused a substantial correction in the share price, today probably isn’t the worst time to consider a position in a high-yield dividend growth stock such as Simon Property Group. Just be aware that in the short to medium-term rising rates may continue to push the shares lower, meaning better buying opportunities may yet present themselves.

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