Retail REITs feeling shopping mall pain, except for Simon

In many cases, retailers' pain is spreading to their landlords.

Macy's, Nordstrom, J.C. Penney and other department stores last week reported another quarter of crummy earnings. They warned a consumer-spending slump (in their stores, at least) shows no signs of abating and that declines in shopper traffic are getting worse. Chains such as Nordstrom said they were re-thinking plans to open new stores, and others are likely to follow suit.

Meanwhile, bankruptcy filings by Sports Authority, Pacific Sunwear and a rash of other retailers in the past year—coupled with planned store closures by Macy's, Walmart, and other chains—has already led to the highest number of store closures since 2010, according to commercial real estate firm Cushman & Wakefield.

The damage is weighing on the publicly traded real estate investment trusts with heavy exposure to America's retail real estate, including beleaguered mall owners—and all signs point to things getting worse for this group of companies. Shares in North American REITs with a large portion of their investment concentrated in malls are now down 10 percent in the past year, compared with a 6 percent rise across all REITs, according to Bloomberg data.

The pain isn't spread evenly, though. REITs with more exposure to higher-end malls and outlet centers—such as upscale-mall REIT Simon Property Group, whose shares are up 8 percent this year—are faring better than REITs more exposed to older, poorly performing malls. The latter class includes CBL & Associates and WP Glimcher, whose shares are down 40 percent and 30 percent this year, respectively.

Unlike some of its peers, Indianapolis-based Simon continues to attract star tenants such as Nike and Apple, command higher rents, and get attractive financing terms, according to Bloomberg Intelligence analyst Jeffrey Langbaum.

While the pain might be more evident at mall owners, a broad slowdown in sales at brick-and-mortar stores is ultimately a threat to all retail landlords. Retail traffic across all types of retail real estate—including malls, strip centers, and other shopping areas—has been posting monthly declines of as much as 18 percent in the U.S. and Canada from the year before, according to analysis firm Prodco. Traffic to luxury retailers has fared even worse.

Retail REITs in general have had some trends in their favor, up until recently. Developers (thankfully) stopped building new malls and pulled back on other kinds of retail developments such as strip centers. That limited the supply of high-quality locations for retailers looking for more space. New retail property supply as a percentage of existing properties was 0.4 percent in the past five years, compared to a pre-recession high in 2005 of 1.8 percent, according to Langbaum.

That low supply, coupled with demand from better-performing retailers for quality space, helped push rents across all types of retail real estate higher and vacancy rates down to about 10 percent at the end of 2015 from 11.1 percent in 2011—as retailers slowly shrugged off the recession's vacancy spike.

But that supply-demand dynamic is starting to run its course. Rental growth is starting to flatten: Though rents are still increasing by about 2.2 percent every quarter from the year before, that growth rate hasn't budged in the past three quarters, according to data from Bloomberg and REIS, a real estate data provider.

Previously pent-up real estate demand from retailers will eventually fizzle. More store closures are expected in the coming months as troubled retailers work through bankruptcy proceedings. Even relatively healthy retailers are re-assessing the need for more brick-and-mortar stores as more sales shift online. With North American department-store sales per square foot dropping to $165 last year, from $200 in 2006, it's become more clear that the U.S. and Canada would be better off with 800 fewer department stores, according to research from Green Street Advisors.

For retail landlords, apparel and department-store closures have so far been offset by the store growth of other kinds of chains such as dollar stores and off-price retailers, which have kept vacancy rates low. But that's unlikely to last for long, according to Cushman & Wakefield retail research VP Garrick Brown. Brown equates today's retail real-estate market to a long train driving over a cliff: The cars in the rear can keep moving higher as the front cars plunge, but it's clear that all the cars will eventually end up at the bottom.