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) - Get Report

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) - Get Report

,

The Limited

(LTD)

and

Hot Topic

( HOTT).

However,

J.C. Penney

(JCP) - Get Report

and

Nordstrom

(JWN) - Get Report

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) - Get Report

, 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.

But right now, store closures and bankruptcy filings are running at historical lows. In the second quarter, both were down about 50% year over year, according to research by UBS.

"I don't think I've ever seen fundamentals

for mall REITs this good," Weissman says, noting that rent growth is strong and that occupancies are pushing near historical highs.

Mall REIT fundamentals are expected to remain strong, but investors should be scratching their heads about whether there is any money left to be made in the high-priced sector. "At some level you have to start separating fundamentals from valuations," says Weissman, who is currently skeptical on the retail REIT sector because of high valuations.

Mall REITs are expected on average to increase funds from operations (FFO), a common REIT performance metric, anywhere from 10% to 12% this year, according to analyst estimates, better than the 7% to 8% growth expected from all REITs. That growth, however, is already priced into the stocks, skeptics say.

As a group, mall REITs are trading at 13.5 times 2005 FFO, according to KeyBanc Capital Markets. This is higher than the range of 6.7 times to 13.3 times over the past 10 years, KeyBanc says. The higher multiples have spiked concerns about whether now is a good time to buy mall REITs.

Jeung Hyun, a principal with Adelante Capital Management, which runs the

( LLUKX)Adelante U.S. Real Estate Securities fund, remains a fan of the sector. He says investors should focus on mall REITs with strong sales-per-square-foot numbers, such as Simon Property,

Macerich

(MAC) - Get Report

and

Taubman Centers

(TCO) - Get Report

.

Adelante sold off mall REITs with lesser-quality assets because such companies' valuations were too close to those of their luxury peers. Investors "are not being rewarded for owning lesser quality," Hyun says. Simon is the fund's largest holding. The Adelante fund is up over 15% this year.

Simon remains the industry stalwart. But the REIT has had an extraordinary run over the past few years and now trades at a price-to-FFO of more than 16 times, based on 2005 estimated FFO. With analysts expecting Simon's FFO growth to be anywhere from 7% to 10% in 2006, the stock could still have some upside.

One of the biggest bulls on the stock is David Fick, an analyst with Legg Mason, which provides investment-banking services for Simon. Fick rates Simon a buy, with a price target of $88, which represents a 16.5 times multiple based on his estimate of 2006 FFO. Simon is currently trading around $75. Fick thinks Simon deserves a premium to its peers because of its top-tier portfolio, strong balance sheet and ability to create growth through rent increases and new mall developments.

One downside for Simon is that the company's dividend yield is now below the 10-year Treasury yield. Even though Simon has increased its dividend over the years, the yield is now just 3.97%. Meanwhile, the 10-year could yield 5% by year-end, according to UBS.

As interest rates rise, that provides more competition for dividend-yielding stocks, and more investors are likely to grow cautious about REITs.

Companies with top-tier portfolios, such as Simon, should continue to stand out, but those with older portfolios in secondary markets, such as

Pennsylvania REIT

(PEI) - Get Report

and

Glimcher Realty Trust

( GRE), will likely continue to lag and remain risky plays.