The rebirth of shopping mallsJune 13, 2011: 5:00 AM ET
Vacancy rates at U.S. malls are at their highest level in years. So why are investors pouring money into them?
FORTUNE -- For many suburbanites across America, the local mall has been popularly viewed as a landmark of sorts, if not the ultimate teenage hangout. In a way, that reputation – more as a place to meet up than a place to shop – has been part of their demise in recent years, as anchor stores struggle to compete with the rise of standalone big-box retail chains.
The latest economic recession only made things worse. Gravely weak retail sales hit mall anchors, such as Sears (SHLD) and Mervyn's, particularly hard – helping drive up mall vacancies, while sending rents paid by tenants spiraling down. Even though retail sales have improved for the past several months as the U.S. economic recovery slowly carries on, it hasn't exactly spurred more mall occupancies. During the first three months this year, vacancies nationwide struck the highest level in at least 11 years, according to real-estate research firm Reis Inc., which showed the average vacancy rate at 9.1%, up from 8.7% the previous quarter.
But then, not all malls are created equal, say some industry analysts who think a mall comeback is under way.
To be sure, the positive outlook doesn't apply to all properties but rather top-tier locations often owned by big, publicly traded mall owners like Simon Property Group (SPG) and Taubman Centers (TCO). They've seen vacancy rates fall to 7% or lower and better sales have translated to higher rents, a reversal from two years ago when retailers insisted on concessions as they struggled with the recession. What's more, shares of both companies have surged in the past year, and investors are betting business will improve further.
In 2010, investments in regional malls were among sectors that led the overall real estate investment trusts market, which saw total returns at about 28% -- far outperforming the S&P500's returns of about 15%. Total returns for mall REITs were about 35%, besting the overall REITs market, according to the National Association of Real Estate Investment Trusts.
And so far this year, mall REITs have continued to outperform the REITs index.
There has been very little new mall construction since 2006, due to a combination of over-building and changing consumer habits as many turn to online shopping. However, industry analysts say some regional malls still hold promise as big mall operators redevelop existing locations to draw fickle consumers.
Remaking the mall
Retail property giant Macerich (MAC) reopened Santa Monica Place in California, rebuilding it as a three-story outdoor shopping venue with anchored by Nordstrom (JWN), Bloomingdale's (M), high-end restaurants and a food market. Simon, which operates 336 malls across the U.S., expanded Austin's Domain mall in 2010, adding various stores including Target (TGT), which traditionally wouldn't be found at most regional malls but still draws a steady stream of customers.
"The long-term earnings estimate picture for Simon Property is optimistic," according to a May research note by Zacks Equity Research, which maintained its neutral rating of the company. Zacks, however, warned a few factors could dampen demand, including excess retail space in a number of markets and ongoing growth of catalog and online shopping.
Retail consulting and research firm Customer Growth Partners maintains a bullish outlook on large public mall operators, despite the possible headwinds. Efforts to redevelop existing malls helped increase mall productivity for the first time since 2007 to $469 per square foot, an 8% increase over 2009. And even though retail sales since March have slowed, the firm believes companies like Simon and Taubman will continue to do well as reinvestment continue.
Besides, Customer Growth Partners adds, mall anchor stores from Macy's to Nordstrom have seen markedly better earnings following huge cuts amid the latest economic recession. While middle to lower income shoppers remain cautious on spending, Macy's benefits from a higher-end consumer. During the first quarter, it reported net income of $131 million, or 30 cents per share – much higher than the $23 million, or 5 cents per share, during the same period last year.
"Malls have proven to be very good areas for investors to be exposed to," says David Harris, REIT sector equity research analyst with Gleacher & Company. "They have managed to do very well despite the growth in Internet sales that some thought would destroy them."
But regional malls aren't exactly in the clear. Online retailing is growing increasingly mainstream, potentially making retailers wonder why they would ever need to lease big boxes when customers can order whatever they want on their smartphones. But perhaps the more immediate worry is the continually worn-out consumer, who faces a relentlessly difficult job market and rising fuel and food costs.
Nevertheless, those bullish on regional malls would point to a 1998 Time Magazine cover story titled, "Kiss your Mall Goodbye: Online shopping is faster, cheaper and better." The point is malls have seen large headwinds before. And however much they've struggled to reinvent themselves through recessions and the growth of online shopping, they are still very much a part of a slice of suburban America. Now it remains to be seen if they'll be more than just popular hangouts.