In the past several months, continuing a practice begun with the 2016 acquisition of teen apparel retailer Aeropostale, Simon Property Group acquired a slew of retailers. In a way, bankruptcy courts last year served as shopping centers of a sort themselves. Simon, in partnership with licensing and brand management firm Authentic Brands Group (via their 50/50 joint venture, Sparc), bought Lucky Brand and Brooks Brothers; earlier in the year, with rival Brookfield, they bought Forever 21. At the end of the year, Brookfield and Simon snapped up J.C. Penney for a cash payment of $692 million and new term debt.
It's unusual, but there are reasons why a landlord might want to own its tenant, or even many tenants. Speaking to analysts last year, Simon Property CEO David Simon cited the most fundamental of all — to make money — while minimizing the risk by calling it a "sideline business."
"If Brooks Brothers or Lucky or even Sparc or even ABG were material to our financial situation, then, we would disclose it, but it's not material," he said during a second quarter conference call in August, adding later, "We're doing it because we — for one reason only — we believe in the brand and we think we can make money."
In November, he reiterated this when his company partnered with Brookfield to buy J.C. Penney, a century-old department store that faltered for years before declaring bankruptcy. "We believe in the Penney's brand," he said in a third quarter conference call. "The company did over $9 billion in sales pre-COVID. We believe we can return the company to increasing sales and grow the EBITDA. The company has a loyal, core, diverse and inclusive customer base concentrated in the moderate to higher aspirational category. This customer is important to the community, as is J.C. Penney, and to us, and we expect we will continue to grow this customer over time."
Setting aside the feasibility of a J.C. Penney comeback, which has eluded four CEOs for the past decade, the moves represent a major shift for an investment structure — the real estate investment trust or REIT — that was forged in the mid-20th century to allow ordinary investors to partake of the real estate market in a way that carries relatively low risk.
The other reasons
A mall may have other reasons besides a desire for a side hustle to take over its retail tenants.
One common speculation among many analysts and businesspeople in the industry is that Simon is highly motivated to rescue ailing retailers from bankruptcy because it preserves rent — usually the most important source of revenue for a mall REIT.
As described by the National Association of Real Estate Investment Trusts, in order to function as a REIT, the trust must get 75% of its revenue from real estate-related activities, like rent from tenants or the sale of property. This legal stipulation is what makes REITs, like bonds, an attractive investment for retirees and others who want to put their money into something less risky than the stock market. Mall REITs have been so dependable in part because retail leases, (unless interrupted by bankruptcy or catastrophic events like a pandemic) are long term, with durations of several years or even decades. Going forward, leases may get shorter as landlords get more flexible in the post-pandemic era.
In the case of J.C. Penney, Simon's motivation may be compounded by the fact that an anchor closure triggers clauses in the leases of smaller, specialty stores that allow them to renegotiate their rent, or even leave. The loss of an anchor can therefore spark an exodus that undermines the whole mall and the steadiness of the REIT.
A mall REIT buying up retailers is "a big departure from the normal business but this may be a necessary step to maintain the broader tenant base," Michael Brown, a partner in Kearney's consumer and retail practice, said by email. "Many contracts have requirements regarding co-tenancy and anchor occupancy, so keeping JCP active could be a critical move to maintain broader occupancy."
Simon Property Group didn't respond to questions for this story. But David Simon dismissed this line of thought in August, when he said the acquisitions were made to make money. "I do see the narrative that, and I don't buy into this ... that we're buying into these retailers to pay us rent," he said.
"One of the reasons these retailers are going bankrupt is they can't pay the rent anymore. And the business the malls are in is collecting rent."
In addition to protection against co-tenancy clauses, acquiring a failing retailer may hold an accounting advantage for a REIT, according to Bradley Tisdahl, founder and CEO of commercial real estate advisory firm Tenant Risk Assessment. "If a major retailer has generated significant losses for a period of time, it may also allow the mall operator to take control of the retailer's net operating losses (NOLs), which often have value in offsetting future earnings against tax liability," Tisdahl said by email. "A company like J.C. Penney reported in its latest 10-Q that it held an estimated $2.7 billion in NOLs prior to its Chapter 11 filing."
But value from any of that — rent protection, co-tenancy or occupancy preservation, or tax advantages — "is short term and tactical," according to Nick Egelanian, president of retail real estate firm SiteWorks. The problem is the side hustle itself because the retail industry, already in flux before the pandemic, is under siege.
"This is moving so fast that there isn't much they're going to get out of that strategy," Egelanian said by phone. "One of the reasons these retailers are going bankrupt is they can't pay the rent anymore. And the business the malls are in is collecting rent."
Vertical integration or antitrust?
Vertical integration — apparel retailers that make their own merchandise, farmers that sell their own produce, malls that own their own tenants — can be an efficient way to run a business, with benefits for owners and customers alike. Or it can be harmful, if the setup pushes out rivals, leaving consumers with fewer choices and higher prices.
Whether vertical integration spills into antitrust territory depends on whether it adds up to behavior that stifles competition and harms the consumer, according to Alon Kapen, a partner at law firm Farrell Fritz. There are two potentially problematic scenarios when it comes to mall ownership of retailers.
One would be the mall granting its own retailers leases that are more favorable than what its other tenants must sign. The second would be if the mall shuts down a retailer's stores in rival malls. The latter could be quite harmful to a competing mall, especially if the retailer is an anchor. But to be an antitrust issue, the injured mall would have to show that it was consumers who ultimately suffered.
"In this market, under these circumstances, maybe it's more of a concern from an antitrust standpoint, because you may eliminate a rival, in this case another mall," Kapen said by phone. "If a mall is eliminated, then the surviving mall may raise prices. But antitrust is not in the business of saving competitors."
Then again, malls aren't usually in the business of saving tenants.
Is the mall REIT doomed?
Decades ago, malls were a savvy retail innovation, a perfect way to reach the many Americans who had fallen in love with automobiles and suburbia. Department stores, which still ruled retail, were happy to anchor malls and share their foot traffic with the smaller stores down the hall.
For a long time, that made for a lot of iron-clad leases and steady rent, but the setup is no longer working. Department stores have steadily coughed up market share to specialty players, off-price stores, big boxers and Amazon. People, even when there's not a pandemic, are less inclined to stroll a mall, preferring quicker stops and more convenient parking. Retailers, including apparel stores like Gap and department stores like Macy's and even Bloomingdale's, are following them, opening stores at strip malls and other open-air centers. Last year, Green Street Advisors said it expects just over half of all mall-based department stores to close by the end of 2021 and traditional malls to experience a 20% decline in cash flow compared to 2019.
These pressures recently sent two mall REITs, CBL and Preit, into bankruptcy within 24 hours of each other. Those that are left, even healthier ones like Simon and Brookfield, are under stress, according to a recent report from S&P Global Market Intelligence. Addressing declining footfall, tenant bankruptcies and department store exits may require an overhaul of the traditional model, but the dividend distribution requirements of a REIT leave malls little financial room to maneuver.
"It changes the flow of the mall, it changes the draw of the mall," Egelanian said of the department store flight. "That's a big problem, if you no longer have flow between the anchors. How much renovation is it going to need if a mall that once had six anchors now has two? That is going to happen to every mall out there, it's inevitable. If you have to make investments in your malls, which they do, the REIT form is not suited for that."
Brookfield Property Partners may solve this problem with its proposal, announced a few weeks ago, to ditch the REIT structure by going private. This would be relatively smoother for that company than for most REITs because it is already part-owned by Brookfield Asset Management, the entity that would take it private.
"The privatization will allow us to have greater flexibility in operating the portfolio and realizing the intrinsic value of [Brookfield Property Partners'] high-quality assets," Brookfield Asset Management Chief Financial Officer Nick Goodman said in a statement.
Simon Property Group didn't respond to questions about any similar plans, but David Simon in August said it's not inclined to de-REIT. Rather, he apparently would like to change the REIT structure than abandon it, telling analysts that the company is talking to lawmakers about lifting "certain limitations" regarding "bad income" (related to the percentage of revenue allowed from other sources) that the REIT structure imposes on the ownership deal.
Normally, a REIT's income is untaxed — one of its most appealing features. (Investors pay taxes on their end.) Each year, a REIT must show that its income from non-rent or other property-related sources (defined as "impermissible tenant service income") is "de minimis," or below a small percentage. Otherwise, it's subject to taxes, which lowers its dividends and makes it less attractive to investors.
"Hopefully, they'll see the benefit of it," Simon said about the retail acquisitions. "I mean, we are literally saving jobs."
It's a familiar appeal, notes Kapen."People made the same community argument against malls," he said. "Years ago it was that independent shops can't really compete on price and don't have the efficiencies, but we need to keep them alive to keep people employed and have a vibrant downtown."
More, it's another sign of how getting into the retail business could disrupt the nature of a REIT, according to Egelanian. "The REIT rules are designed to have 'passive investments,'" he said. "If you're operating something that's not that stable, they start to penalize you. If the mall has to pay tax, it could cost them billions in stock valuation."
Considering their bankruptcy filings and years of decline, the retailers bought by Simon Property were arguably in need of saving, and Simon can point to Aeropostale as a turnaround success. That was made possible in no small part by Authentic Brand Group's prowess in managing brands, much touted by many observers and David Simon himself. Simon Property Group no longer directly co-owns that retailer, having traded its "entire interest in the licensing venture in exchange for additional interests in ABG" in April 2018, according to a filing with the Securities and Exchange Commission. Sparc now operates it.
"These REITs and partnerships are evolving, and proof positive that solutions can be developed," Matthew Katz, managing partner at SSA & Company, which advises companies on strategic execution, said by email. "In this situation, not only can these REITs and partnerships see upside in the business, but they also have a way to protect rental income. In the transactions I've seen where the REITs now own such retailers, they made the acquisition on the basis that the underlying business had value and could be further improved."
That evolution, and the project of saving retailers, departs from what a mall REIT was designed to do (own and manage property), and be (a somewhat safe investment for regular folk). Moreover, Simon is not taking on sturdy retailers, but shaky ones, which sell mostly, if not exclusively, apparel, at a time when apparel sales growth is ebbing and e-commerce is rising. As David Simon told analysts in November, "obviously it's more volatile than the rent aspects of our business," though he has emphasized that the retail investment was minimal.
At any size or level of success, retail can be tricky. A mall willing to take that on is by definition scrambling to keep revenue flowing, according to Egelanian.
"It is no longer a stable asset, therefore it's a much riskier business," he said. "The story isn't whether it's a good investment, the story is that they're investing in retailers at all. The very fact that they're investing in retailers is a statement that their rent is more at risk."