Shopaholic

Urban Edge Properties
February 9, 2017

It is likely that shopping malls are here to stay. But not at their current valuation

Much has been said about the ominous outlook for the shopping mall industry. Rents are volatile, cyclical and overdependent on the overall health of the economy. And as anyone with an Amazon Prime account would most likely attest, our visits to shopping malls have become fewer and fewer. For over three decades, Malthusian predictions of the eventual demise of shopping malls have been foretold. So, you can imagine how surprising it is to find a shopping mall REIT trading at over 5 times its book value.

Let me walk you through the math. In its recent annual report, Urban Edge Properties (NYSE:UE) showed $5 in equity book value per share, $1.29 per share in funds from operations and $1.99 per share in net operating income. And so, with a share price of $28, we are left with a hefty valuation of over 5 times the book value, 22 times the funds from operations, and an implied capitalization rate of 7%. It is an extravagant valuation, especially when looking at the market valuation of peer companies such as Equity One, Retail Properties of America, Kite Realty Group, Retail Opportunity Investment Corporation and Saul Centers.       

The peer companies did not trade above 17 times the funds from operations or two times the book value. I came up with three reasons for the difference in value between Urban Edge and the peer companies. First, capital markets estimate that Urban Edge management is superior to other management teams. Second, capital markets find the shopping mall portfolio to be superior compared to peer holdings. And third, capital markets estimate the divestiture (read: spin off, in investing lingo) from Vornado Realty Trust was a great opportunity yet to unfold.

But management has yet to demonstrate stellar performance. Take general and administration expense for example. It increased to $28 million from $21 million five years prior (while the number of properties did not change). And for a real estate company that earns $76 million annually, the G&A represents about 10% in lost earnings. Besides, there is only so much management can do. Urban Edge’s top ten tenants, Home Depot. Loew’s, Kohl’s, Best Buy and Sears, all saw erosion in brick and mortar sales compared to online sales.

And the real estate portfolio is risky. Out of a portfolio of 84 properties, 40 properties are cross- collateralized. What the term means is that should property ABC experience financial difficulty, the lender may use property XYZ as collateral. From the standpoint of an investor in Urban Edge, it is an unfavorable situation. And over half of its $1.2 billion in outstanding liabilities mature in the next 5 years. Should interest rates increase, earnings will contract.     

Yet shopping malls are unlikely to disappear from our urban landscape. Shopping in brick and mortar malls still holds favorable characteristics compared to internet shopping. First, walking in shopping malls is a form of exercise. Second, purchasing hefty movie tickets and overpriced popcorn is an activity that the family may share as a whole. And third, let us not forget, the land under shopping malls can be converted to hold internet data centers.