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Top Mall REITs Diverge

Interest costs have wilted General Growth Properties, while rival Simon Property remains strong.

General Growth Properties (GGP) , the country's second-largest mall owner, has heavily rewarded investors over the past several years with impressive yearly earnings and dividend growth.

This year, though, the real estate investment trust has seen its shares fall 5%, compared with a 7% rise at

Simon Property Group

(SPG) - Get Simon Property Group Inc. Report

, the nation's largest mall owner in terms of market cap and properties.

Fund managers say the discrepancy between the companies isn't because of any significant difference in their core property fundamentals, but stems from General Growth's higher exposure to variable-rate debt in a rising interest rate environment, which is hurting short-term earnings growth.

In past years, General Growth was one of the best-performing REIT stocks. Last year, it posted a total return of 35%, compared with 23% at Simon and the 10% average of other mall REITs.

"They're good operators with a good set of assets," but "2006 will probably not be such a great year for General Growth," says Jeung Hyun, a principal with Adelante Capital Management, which owns shares of the company and Simon Property Group.

"I think because earnings are affected by the floating-rate exposure, they're going to have slower earnings growth on a year-over-year comparison because the cost of their interest is going up," Hyun says.

General Growth owns or manages more than 200 regional shopping malls, mostly Class A top-tier properties in prime locations. A large base of its tenants are apparel retailers like

Limited Brands



Ann Taylor


, and

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, which

all beat analysts' forecasts Thursday for May same-store sales. While worries about the health of the consumer amid rising gas prices, increased interest rates and a weakened housing market have been prevalent, higher-end retailers are still going strong.

This retailer growth has helped spur demand for quality mall space. In the first quarter, General Growth posted same-store net operating income growth of 8.5%, a healthy level for the mall sector.

Looking back, General Growth's track record is rather impressive.

From 1996 to today, General Growth's quarterly dividend has risen at a 12.4% compound annual growth rate. Simon's rate during the same period was 4.9%.

If you look at core funds from operations, a proxy for REIT earnings, going back to 1998 and use consensus analyst estimates for 2006, Simon Property has posted an 8.1% compound annual growth rate in core FFO. General Growth has seen 14.7% growth.

"I'm guessing that would beat anyone (in the REIT sector)," says Dean Frankel, portfolio manager with Urdang Securities Management, who ran these historical numbers for


"No way they will have that disparity going forward," says Frankel, whose firm owns significant stakes in General Growth and Simon. One major reason: General Growth has gotten much bigger and now boasts an $11 billion market cap, compared with $18 billion at Simon. There's also the interest expense issue, which will affect General Growth's ability to increase short-term earnings and raise its dividend.

General Growth didn't return calls seeking comment.

The REIT's outsized gains in recent years were helped by its numerous acquisitions and redevelopments. With all this growth came a heavy reliance on variable-rate debt.

After General Growth completed its $12.6 billion purchase of mall developer Rouse Co. at the end of 2004, the company was saddled with $10.8 billion of variable-rate debt. The level has since dropped to just under $5.8 billion at the end of its most recent quarter, or about 25% of total debt. The company is aiming to reduce the variable number to as low as $4 billion by the end of the year, through a number of refinancings.

But all the while, short-term interest rates continue to rise. General Growth's current 2006 guidance assumes a fed funds rate of 5% (the current level), and the company has said it may need to revise it if the


moves to boost rates further.

General Growth's floating-rate debt comes at a spread above LIBOR (London Interbank Offered Rate). Frankel estimates that every 100-basis-point increase in LIBOR results in a 6.7% decrease in FFO for General Growth. Competitor


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also relies on floating-rate debt, but the effect of the interest expense is less dramatic at the mall owner -- just a 3.8% decrease for every 100-basis-point move in LIBOR, Frankel says.

Simon uses much less floating-rate debt, and also has a lower overall debt load than General Growth. Simon's debt-to-market cap is 42%, compared with 64% at General Growth.

The other issue complicating the story at General Growth is its community development business. The company originally planned to sell off this piece after it purchased it in the Rouse transaction. This segment, which builds master-planned communities in Las Vegas, Maryland and Houston, has a book value of $1.65 billion. The company has estimated the current market value at $3.86 billion, which is about 10% of General Growth's enterprise value.

It's not an easy business for investors to get a handle on, because there are significant tax issues involved with land sales at the developments, along with contingency payments due to the heirs of Howard Hughes (which sold some of the land to Rouse).

Frankel says the division really doesn't contribute much in the way of earnings but does produce a lot of cash, which the company uses to pay down debt and reinvest in mall redevelopment projects.

The mall sector continues to perform well and is considered a good place for people interested in REITs to place some money. Frankel notes that both Simon and General Growth have excellent operating metrics, and both are run by well-respected management teams.

But on an implied cap-rate basis, Simon actually looks cheaper right now, he adds. (Cap rates measure initial rates of returns on real estate portfolios. The lower the cap rate, the higher the asset is valued. Simon and General Growth are considered to have similar high-quality mall portfolios.)

He estimates Simon is trading at a 6.3% cap rate based on its net operating income, whereas General Growth is at 5.9%. Most buy-siders believe Simon is undervalued, he says, and that's why it is one of the most overweighted stocks among dedicated REIT funds.

Currently, General Growth trades at about $45.50, or 12 times its estimated 2007 FFO, with a 3.7% dividend yield. Simon trades around $82, or 14 times FFO, with a 3.8% yield.

"Simon looks very reasonable, almost too reasonable," Frankel says. "It's a lower-risk story going forward, too."