Headlines about the death of the American shopping mall have become so common that the phrase “retail apocalypse” has its own Wikipedia page. But this is a death wrongly foretold—and that creates investment opportunities.
It’s true that some malls are dying. Foot traffic is down as more Americans shop online, while shifting demographics have made malls in some parts of the country obsolete.
We estimate that a third of the 1,200 malls that were operating at the start of 2017 will close their doors, with most of the casualties in less affluent areas where population growth isn’t keeping up with other parts of the country.
Many investors have tried to profit from the shopping mall’s expected demise by betting against commercial mortgage-backed securities (CMBS) backed by loans to mall operators. Here’s the problem as we see it: not every mall is destined to close. We think plenty are likely to adapt and survive. And those that do fail won’t all do so at once.
We’ll dig into how investors can take advantage of this in due course. But first, let’s look at what the doomsayers get wrong about malls.
The Sears Fallacy
The trouble started for malls when the department stores that once served as anchors—such as Macy’s and J.C. Penney—started to close. Sears Holdings, which operates the Sears department stores that have anchored countless malls over the last 50 years, has closed more than 2,500 Sears and Kmart stores since 2005, leaving fewer than 1,000 in operation.
Some lower-tier malls won’t survive the loss of their anchor stores. But others are getting creative about replacing them—and it’s not taking as long as many people expected. For instance, the Northwoods Mall in North Charleston, South Carolina, replaced Sears with Burlington Coat Factory and Carrabba’s Italian Grill last year and saw its net operating income improve. Common anchor tenants of the future may be T.J. Maxx, Wegmans or even a car dealership.
Retailers are shifting toward online sales. Omni-channel retailers—those with brick-and-mortar stores that also sell online—convert about 5% of online shoppers into buyers, according to the International Council of Shopping Centers (ICSC). Apparel retailers are closing some brick-and-mortar stores and migrating from a sales ratio of 80%/20% in-store/online today to a target of 65%/35%.
But many want to retain a physical presence, too—with good reason. They do better with their in-store shoppers, with a capture rate of about 20% and a basket size that can be as much as seven times that of an online purchase. Those figures can still make a brick-and-mortar store profitable, despite less in-store foot traffic than in previous years. Call it the power of the impulse purchase.
Location Matters
We don’t mean urban versus suburban or proximity to a highway. When we talk about location, we’re talking about the big picture. Malls on the coasts and in the rapidly growing Sunbelt are doing well. Many in the middle of the country aren’t, especially when there are competing malls nearby.
This has everything to do with changes in demographics and the US economy. Sixty years ago, hundreds of malls sprang up in manufacturing cities like Detroit and Cleveland and their middle-class suburbs because that’s where the jobs and much of the country’s wealth were. Today, it’s high-tech metropolitan areas like San Jose, Boston and Austin that have seen big gains in population, wages and wealth.
Experience vs. Convenience
Even so, malls that have figured out how to cater to evolving consumer tastes are thriving, regardless of location. Discretionary income has been constrained by limited wage growth and by rising housing, healthcare and education costs, all of which have materially outpaced inflation in recent years. That means consumers—and millennials in particular—are making choices based on a combination of modern tastes and restricted spending decisions.
Millennial consumers tend to value experiences more than objects. That may mean they’re more likely to come to the mall for high-end dining, free in-store yoga classes or personal fitness training rather than another pair of shoes. In response, mall owners are repositioning malls away from a mix of 60%–70% apparel retailers to only 40%–50% in order to create a town-center atmosphere where consumers will come to be entertained, as well as to shop for the latest concepts in clothes, cosmetics and home goods.
In general, that means more movie theaters, sports bars, restaurants, fitness centers, interactive playgrounds and entertainment. But every mall is different and needs to reflect local demographics. For example, in areas with large Latino populations, one mall operator is replacing department stores with concert spaces, flanked by kiosks run by local importers and retailers that appeal to local consumers.
Easton, an outdoor “experiential” mall in Columbus, Ohio, is doing it all. It’s got experiential retail stores such as the American Girl store where children can design clothes for their dolls and themselves, top-end dining, a comedy club, several hotels and a planned LEGOLAND family theme park.
How Investors Can Capitalize
What does all this mean for investors? Simply put, not all malls are doomed. Some are still generating sufficient cash flow to comfortably cover their debts, making them viable retail assets today and in the future. For investors who can analyze each mall operator’s leasing strategy and credit metrics, that can lead to attractive, high-income opportunities.
Make no mistake: plenty of malls are in trouble and will close. And loss severities—the amount of missed interest and principal payments—on loans in default have been higher for mall loans than for the office building and apartment complex loans that frequently back CMBS.
These default fears have pushed the yield spreads on BBB-rated bonds in the CMBX.6, an index tied to commercial mortgages that originated in 2012, to trade at a record premium to spreads on comparably rated US corporate bonds, creating an attractive relative-value opportunity. Even when adjusted for potential losses due to anticipated defaults over time, the CMBX.6 BBB– tranche yields nearly 8%, while the CMBX.6 BB tranche yields nearly 10% (Display).
