Few Bargains in Retail REITs

The disappointments from retailers piled up fast last week, but any possible slowdown in consumer spending won't affect mall REITs as much as some investors might imagine. Extended valuations are a bigger concern.

Wall Street is understandably worried that expensive gas prices and rising interest rates are slowing down consumer spending. Wal-Mart(WMT Quote) added fuel to the fire when it blamed high gas prices for lackluster spending from its low-income shoppers. Other disappointments last week came from The Gap Stores (GPS Quote), The Limited (LTD Quote) and Hot Topic (HOTT Quote).

However, J.C. Penney(JCP Quote) and Nordstrom(JWN Quote) both reported strong sales and earnings that beat Wall Street estimates, showing that consumers are still flocking to certain mall tenants.

With sales strong, high-end retailers over the past few years have continued to pay big bucks to be inside the most desirable malls in the country. As a result, REITs that own luxury shopping malls, such as Simon Property Group (SPG Quote), have been on a tear. Shares of Simon, the largest mall owner in the country, are up 16% this year and 39% in the past 12 months. In the second quarter, Simon increased rents on new leases 18.6% across its portfolio, up from 13.1% the same period a year earlier.

But what if rising credit card rates and high gas prices do end up dampening consumer spending at the mall, and not just at Wal-Mart? In the short term, it doesn't spell much danger for mall owners, although rent spreads could eventually be squeezed.

Mall tenants pay both a base rent and a "percentage rent," which is a portion of their sales. On a quarterly basis, typically only 3% of mall REITs' net operating income comes from percentage rents. Even if spending slows down, percentage rents might drop, but retailers are still on the hook for base rents.

The real danger is if consumer spending slows down for a lengthy period of time; that would force retailers to stop expanding their space needs or even close stores, says UBS analyst Ian Weissman. This could shrink overall tenant demand for space and give landlords less pricing power for new rents, and that would depress REIT earnings. Bankrupt tenants create a much bigger problem for landlords, because landlords are left footing the bill.