The U.S. economic slowdown has resulted in financial firms slashing thousands of jobs and retailers posting disappointing sales.
But so far, the real estate investment trusts that lease these firms office space -- at least in Manhattan -- and retail space -- at least in high-end malls -- have not felt much pain.
"I don't know what's going to happen to the economy, but REITs will hold up OK in a downside scenario," says Dean Frankel, a portfolio manager at Urdang Capital Management, a large investor in the sector.
Frankel says REITs, like office owner
and mall landlord
Simon Property Group
, remain reasonably priced because their portfolios contain substantial embedded growth opportunities, as recent earnings reports have shown.
Both firms sign long-term leases and so far have been able to sign new leases at attractive spreads to the old rates. While vacancies could increase as the economy worsens, it would probably take a significant meltdown in the economy to keep these landlords from increasing rents vs. the previous leases.
SL Green, a large owner of office buildings in Manhattan, reported on Monday that its occupancy rose 40 basis points to 96.7% in the second quarter. Manhattan rents on re-leased space rose to $65.89 per square foot, up 53.5% over the rates on the prior leases.
These solid results come despite the worries about Wall Street investment banks cutting back space as they lay off workers.
"The public market is taking a stance that things will get worse in terms of asset values and fundamentals," says Michael Knott, an analyst with Green Street Advisors, pointing to the fact that SL Green and other office REITs with a heavy Manhattan focus are trading at discounts to the private market value of their assets.
"I think that New York City office is certainly weakening, but to the extent that it doesn't substantially weaken, I think SL Green will be fine," says Jay Rosenberg, portfolio manager with FAF Advisors, which owns SL Green shares.
Manhattan in recent years had "historic occupancy levels, with almost no blocks of space available," Rosenberg says. "This provides a lot of cushion, but we'll see if that's enough."
Along with financial firms, retailers that fill malls have experienced tough operating results this year -- with many reporting declining growth in same-store sales, such as the 2% June decline at
Nonetheless, Simon Property Group, the country's largest mall owner, reported quarterly earnings on Monday that beat analyst estimates. Simon is helped by the fact that mall owners book the bulk of their revenue from long-term leases. Only a small portion of a mall owner's revenue (generally less than 5%) comes from a percentage taken from retailers' sales.
Simon reported funds from operations -- a common REIT performance metric that serves as a proxy for cash flow -- of $1.56 per share, which beat the consensus analyst expectation by 7 cents. The results excluded a bad debt retirement charge. Same-store net operating income at Simon's malls and outlet centers rose 5.4% and 7.3%, respectively.
"Strong malls have good fundamentals and will continue to have good fundamentals," says Frankel of Urdang Capital Management, which owns shares of Simon and other mall REITs.
To show why high-end mall owners are holding up well, Frankel provides the following example.
A retailer's lease that is expiring this year may have been signed seven years ago. Rental rates are a function of a mall's overall sales per square foot. Seven years ago, sales may have been around $300 per sf. Now, the sales may be $400/sf. This may be down from $415/sf last year, but the lease being renewed today still allows for significant rent rate increases.
What Bears Say
The bear case on mall owners is that department stores are getting weaker. What many may not realize is that most department stores pay little to zero rent, because they attract crowds to the mall.
Thus, even if department stores weaken, mall owner results may be fine, so long as overall traffic holds up and sales per square foot remain high at the non-department store retailers.
While the results so far are nice for Simon and SL Green, investors should realize that commercial real estate fundamentals often lag the economy, given the long-term leases in place in the retail and office sectors.
"We worry about 2009, when the mall REITs may begin to feel the full impact of the U.S. consumer slowdown," Stifel Nicolaus analyst David Fick wrote in a research note.
"Absent an unexpected large-scale retailer bankruptcy, we see little risk to 2008 earnings, as retailers signed most 2008 leases well before the full scope of the US consumer slowdown was apparent," he said.
On the New York City office side, the fear is not so much that vacancies will sharply rise over the next year, but that future demand for office space will be stagnant, as Wall Street doesn't replenish its laid-off workers. This could hurt rents and occupancies over a prolonged period.
"One concern is that there might not be growth out of banks for several years to come," Frankel says.