The residential real estate sector continues its dramatic correction. Defaults have spread beyond subprime mortgages and into Alt-A loans, as well as prime mortgages. Mainstream business commentators are eager to find where the damage will spread next. Increasingly, they are pointing their fingers at commercial real estate. More specifically, because of that old saw “retail follows rooftops,” many are looking squarely at regional malls for problems.

To date, most of the damage to those firms has come from Wall Street, where shares have plummeted precipitously in the past 12 months. As of Friday, Feb. 8, mall stocks were down 31.5 percent compared to the rest of the REIT universe on a trailing 12-month basis, according to Ross Smotrich, REIT analyst with Bear Stearns & Co.

“There is a perception that the consumer is weakening, and mall REITs are trading on that perception versus reality,” Smotrich says. Lackluster same-store sales during the holiday shopping season, as well as in January, have contributed mightily to those views. And observers have also pointed to a rash of announced store closings from a variety of retailers. So far, 2008 is on pace to post the greatest number of closings since 2004.

Add it together — a weakening consumer, slow sales and store closings — and it sure seems like regional malls should be suffering. The trouble with that logic is that public regional mall REITs — which control the majority of the 1,200 or so regional malls in the country — are showing few signs of distress within REIT portfolios.

In mid-February, the firms reported fourth-quarter and year-end figures and there was a lot of reason for cheer. On average, malls REITs grew net operating income (NOI) about 5 percent in 2007, and the average mall REIT portfolio sat 94 percent occupied at the end of the fourth quarter. Mall REIT executives also reported that leasing remained stable through the end of 2007 and into 2008 with no discernable slowdown in demand from retailers. As a result, re-leasing spreads are more than healthy, coming in the mid-teen to low-20 percent range. In fact, Bank of America's REIT analysts say they expect re-leasing spreads in 2008 to remain in the 10 percent to 20 percent range, barring a substantial consumer downturn.

And investors may be soaking all this in and taking the hint. In the 30 days leading up to Feb. 8, regional mall REIT shares rose 12 percent, putting them in line with the rest of the REIT universe year-to-date.

That doesn't mean everything is just hunky-dory, however. Many REIT executives and analysts caution that fundamentals will likely soften this year, particularly for firms with exposure to secondary and tertiary markets. Moreover, store closings could begin piling up at a faster rate, which would be cause for concern.

No slowdown in leasing

As of mid-February, all mall REITs except for Glimcher Realty Trust and Pennsylvania REIT had reported year-end 2007 results. (Feldman Mall Properties has not yet announced when it will disclose its fourth quarter and full-year results.)

For 2007, General Growth Properties, the Macerich Co., Simon Property Group and Taubman Centers grew FFO per share. Only CBL & Associates Properties posted a decrease.

Indianapolis-based Simon — the largest publicly traded REIT in the U.S. — continues to stand tall in operating metrics. It was the first regional mall REIT to report its results. And it did not disappoint. For 2007, Simon posted FFO of $1.69 billion, an increase of 10.1 percent over the $1.54 billion earned in 2006. (See chart for full results.)

Simon pointed to strong re-leasing activity as a prime reason for its results — a refrain that was repeated again and again as subsequent regional mall REITs reported.

Within the firm's 258-million-square-foot portfolio, company executives have said they aren't yet offering concessions and also don't expect to see retailer bankruptcies start piling up, according to Rich Moore, a managing director with RBC Capital Markets' REIT group. However, Simon's top folks do expect retailers to abandon concepts that aren't working, compelling them to sound a cautious note about occupancy. “Simon said that a few stores would be lost, and that worst case scenario, occupancy would be down one percent,” Moore says. “That's a measly amount.”

Based on that forecast, Simon provided 2008 guidance of FFO per share of $6.25 to $6.45 with same-store NOI growth of 3 percent to 4 percent for its malls, occupancy of 92.5 percent to 93.5 percent and re-leasing spreads of 15 percent to 25 percent.

Small-market softness

For REITs with concentrations of properties in smaller markets, however, there was a slightly different story. “We're starting to see a divergence between the haves and have-nots from an operating standpoint,” Marks says. Specifically, Marks points to CBL, PREIT and Glimcher.

CBL ended the year with net income available to common shareholders of $59.4 million, or $0.90 per diluted share, compared with $86.9 million, or $1.33 per diluted share, for 2006. Net income declined by $27.6 million primarily because of an $18.5 million non-cash write-down of marketable securities resulting from a significant decline in their market value during the fourth quarter 2007.

CBL Chairman and CEO Charles Lebovitz said during the earnings call that the REIT signed 6.6 million square feet of leases in 2007 — the most in its 30-year history. However, David Fick, a REIT analyst with Stifel Nicolaus, notes that CBL's rent spreads have been in the 9 percent to 12 percent range for the past several years, far less than the 20 percent plus that Simon has achieved. CBL's 2008 guidance forecasts FFO per share of $3.46 to $3.56 and assumes same-center NOI growth of 2 percent or less.

Glimcher Realty Trust lowered its guidance for 2008 to diluted FFO per share of $2.00 to $2.08 and expects an increase in same-mall NOI of one percent to 2 percent. It also cut its first quarter 2008 dividend on its common shares to $0.32 per share, which equates to $1.28 per share on an annualized basis.

Glimcher has another problem. It's drawn the attention of Newport Beach, Calif.-based ROCA Real Estate Securities Fund L.P., a firm that has a reputation for taking stakes in firms and then pushing aggressively for changes such as mergers, shakeups of boards of directors or sales of non-core assets. ROCA has asked Glimcher's Chairman and CEO Michael Glimcher to seek strategic alternatives to maximize stockholder value, such as paring the company's portfolio and cutting its debt load. ROCA owned approximately 1.3 percent of Glimcher's shares outstanding as of October 25, 2007. (ROCA has also been making noise at Cedar Shopping Centers Inc., a REIT that owns neighborhood centers, and One Liberty Properties Inc., a net lease REIT.)

Balance sheet blemishes

Investors are concerned about General Growth — the second largest regional mall REIT — because of the REIT's debt load. According to stats from Deutsche Bank, the company has $26.9 billion in debt. Of that, about $2.8 billion is expiring in 2008. It has made a series of announcements detailing its debt load and has been able to line up new loans.

However, because of the uncertainty in the credit markets, Fitch has assigned the REIT a credit rating of BB, Marks says, adding that the rating agency is not concerned that General Growth will have any issues refinancing its debt. However, the fact that the company has fewer unencumbered assets — and therefore slightly less liquidity than other mall REITs — is cause for concern.

General Growth expects 2008 core FFO per share to be in the range of $3.58 to $3.61 per share, 20.5 percent to 21.5 percent above the calculated core FFO for 2007. Currently, General Growth boasts a 5.4 percent dividend that will increase 8 percent to 10 percent per year, Fick says.

Even so, Fick isn't recommending General Growth's stock; nor is he recommending the purchase of any other mall REIT stock. “The internal growth profile is better for regional malls than any other commercial real estate sector,” he acknowledges. “But… it will take some time to work through an environment where the consumer is losing spending power.”