Sheer relief. That was the retail real estate industry's collective reaction to Simon Property Group's rosy 2001 earnings announcement last month.

As the largest retail real estate investment trust (REIT) in existence with a total market capitalization of roughly $7 billion, Simon is the Goliath of mall-dom and the REIT that Wall Street analysts most watch as a barometer of the industry's health.

Given the down economy and stock market and the struggles of notable retailers such as Kmart and Gap, many REIT analysts appeared positively giddy when Simon released such strong quarterly and end-of-year numbers. “SPG is our favorite large capitalization REIT,” noted David Kostin, head of global equity research at Goldman Sachs.

“Mall REITs, once considered the Rodney Dangerfield of the REIT industry, continue to ‘deliver the goods,’ proving they have a higher level of stability in these tough economic times than many observers had previously believed possible,” added Jonathan Litt, retail REIT analyst with Salomon Smith Barney.

Despite flat tenant sales, Simon (SPG) reported that its diluted funds from operations (FFO) for 2001 rose 7%, to $3.51 per share from $3.28 per share in 2000. “We were delighted with the results”, says analyst Louis Taylor of Deutsche Banc Alex. Brown. “Our fear was that they were going to be worse.”

Simon also reported that occupancy rates in its portfolio rose slightly, to 91.9% at the end of December compared to 91.8% for the same period in 2000. That's noteworthy, Taylor says, given that many companies in other property sectors expected to lose between 100 and 300 basis points of occupancy.

Simon's results also reflect the roll that REITs in general have been on for the past 12 months. Many investors view REIT stocks as a hedge in tough times for their modest but steady returns and dividend yields. (REITs by law must distribute 90% of their income to shareholders in the form of dividends.)

For his part, Steve Sterrett, Simon's CFO, says the results may have surprised some, but they reflect mall REITs' inherent stability in down cycles.

“Maybe it's just a function of the overall perception of retailing and the mall industry, but I really think our ability to produce positive, predictable earnings growth in the midst of a recession and in the midst of a large wave of bankruptcies in the retailer community in 2001 was a surprise to the less sophisticated investor. People don't understand the stability of the mall cashflows. When they read about retailers filing bankruptcy and the country being in recession and unemployment rising they assume the malls are going to get whacked. They don't really understand that 90% of our revenue comes from lease contracts which are long term in nature,” says Sterrett.

So after months of uncertainty the proof was there for all to see. Retail REITs had pulled a Houdini and escaped the ravages that many Wall Street analysts instead heaped on their hotel and office brethren.

Or had they? The positive news also raises an important question — can retail REITs actually keep the good times rolling through 2002?

Mall owners aren't so worried about bankruptcies as much as they are in driving new revenue growth. Mall REITs like Simon have cut their development pipelines so there aren't many regional malls opening in the next few years. Instead, many have turned to acquisitions to pump up growth. And with percentage occupancy rates stabilized in the low-90s, many argue that significant growth could be hard to come by, either through leases on new space or rents that can be “marked to market.”

Sterrett says Simon's growth will come from the Class-A nature of its assets. “If you own assets where retailers want to be located and shoppers want to shop, those assets will generate incremental sales which will allow us to charge higher rents. We're certainly not building many malls, and not many malls are being built in this country, but one of the things that also means is that as the population grows, the supply/demand characteristics of the mall business get tilted a little bit in the landlord's favor. We've got a little bit more scarcity of space.”

Taubman Centers (TCO), the nation's fifth-largest mall REIT, posted a meager 5.1% FFO growth for 4th-quarter 2001, due primarily to slowed growth in its upper-moderate and luxury retail niche. For 2002, Taubman's guidance is heavily weighted to improvement in the second half of the year, which concerns many analysts. “We will be watching carefully to ensure that TCO is making the appropriate switch to occupancy from a traditionally very aggressive negotiating posture surrounding rental rates,” says Matthew Ostrower, retail REIT analyst at Morgan Stanley.

The notion of using retail REITs as bellwethers has been under fire for years, particularly since retail REITs control only a miniscule piece of the total retail real estate pie. Yet, because they are public companies that dominate many major retail markets, retail REITs are the most scrutinized bunch of real estate owners you'll find on the planet. Given their huge portfolios, they have their fingers on the pulse of virtually every major retailer in existence.

Investors certainly have done their bit to push retail REITs into the limelight. In scrambling to diversify their portfolios to cope with today's unsettled economy, they have made retail REITs a diversification hedge in hard times. And why not? Even in the midst of the economic downturn, most of the top retail REITs posted strong fourth-quarter and end-of-year numbers, a development that surprised more than a few analysts.

Surprise: 2001 wasn't so bad

“In 2001, other sectors suffered from occupancy troubles, while regional malls, which at worst suffered flat occupancy levels, managed to boost income from operations,” notes James Sullivan, managing director and senior real estate analyst for New York-based Prudential Securities.

The strong valuation levels of mall REITs continue to attract new investors. One reason is that many investors just can't resist the clock-work dividends that all REITs pay out to their stockholders. Meanwhile, in 2001, FFO and earnings per share for real estate stocks, including REITs and other publicly traded real estate companies, were strong for the second year in a row. NAREIT's index of 182 such companies climbed 41% during the most recent two-year period. Retail REITs were by far the best performing sector in the index.

The nation's No. 2 mall REIT, Chicago-based General Growth Properties (GGP), is a good example. In February GGP announced a 12.2% increase in FFO for 2001. It was the eighth time the company had reported double-digit growth since going public nine years ago.

As a result of its failed bid last year to acquire the mall portfolio of Rodamco North America, GGP is now sitting on a $350 million cash pile. CEO John Bucksbaum says the money will be funneled into other acquisition opportunities this year. That news, plus the performance results, drew higher ratings and estimates from some analysts.

But mall REITs weren't the only retail companies with a lock on good 2001 numbers. The nation's largest neighborhood center REIT, Kimco Realty Corp., reported in February that its net income rose 14.9% in the fourth quarter and its FFO increased 18.5%. Meanwhile, Kimco's new joint venture with GE Capital also purchased majority interests in 11 shopping centers from the Rouse Co. for an estimated $120 million.

Federal Realty Investment Trust, which posted better-than-expected earnings for 2001, has several major projects in its development pipeline that are making analysts a bit nervous. Morgan Stanley expects the Rockville, Md.-based REIT to post a 6% decline in FFO for 2002 and only 1% FFO growth in 2003.

Leasing at the company's new $475 million Santana Row mixed-use center in San Jose, Calif., is going slower than many expected. About 60% of the project's 400,000 sq. ft. of high-end retail space is leased. The project is slated to open in August 2002. On the other coast, about two-thirds of the 300,000 sq. ft. of retail space in Federal Realty's Pentagon Row development in Arlington, Va., is now open and 95% leased.

Mall REITs appear to face fewer risks than owners of neighborhood and community centers. With their sheer number of storefronts, more than a few tenants would have to go dark to make a huge impact in the regional mall sector. By contrast, in the neighborhood center sector, Kmart's bankruptcy and the struggles of various other retailers, combined with rapid consolidation in the grocery store industry, promise to create vacancies.

Not that all REITs have been immune. Despite signing 58 new leases during the fourth quarter, Kimco reported that retailer bankruptcies caused its overall portfolio to shrink. The company's occupancy rate at the end of 2001 was about 90%. For Kimco, however, the impact of Kmart's bankruptcy looms — Kmart leases account for 13.3% of Kimco rents.

Retail gets the nod for a change

Still, retail REITs have finally clawed back some respect in the past year, despite the sorry state of some retailers. There's one over-arching reason: “The ongoing popularity of REITs, and retail REITs especially, can be attributed to their steady increase in earnings,” says Sullivan of Prudential Securities. “Because of the state of the economy and certain other outside factors, the internal growth rate of some retail REITs is slowing a bit but is still good.”

Taylor and other observers say retail REITs benefited in 2001 from the weak performance of other property types. “On the office side, companies took too much space, and they're now disgorging themselves of it. There's basically little or no incremental demand,” Taylor explains. “You've had the most construction in the office sector of any of the property types. It's really going to be a pretty tough year.”

According to Cushman & Wakefield, the national vacancy rate for Central Business District (CBD) office properties during the fourth quarter was 12%. The vacancy rate for non-CBD properties stood at 17%. Another report by Cold-well Banker Commercial, which examined fourth-quarter vacancy rates throughout the nation's 72 largest markets, placed overall office vacancies at 13.5%, up 8.3% from the previous year.

Meanwhile, SNL Financial notes that office REITs were the only sector in the SNL Equity REIT Index to post negative fourth-quarter returns. The office sector posted a return of -0.5% compared to 29.5% for all retail REITs and 29.8% for enclosed mall REITs.

Occupancy rates at regional malls have generally stayed strong, due in part to the long leases typical of major malls and the solid credit of their top tenants. “When you do have good locations that become available, generally you see demand for that space from another format,” Taylor says. “You can lease it faster than with the other property types.”

Litt of Salomon Smith Barney believes such high occupancy rates will be a plus for companies like Simon, especially in 2002. “The company is now the leading REIT candidate for inclusion in the S&P 500 index.”

Other big mall REITs have seen their investment stars rise. “Most of the significant mall companies' stock prices are doing very well, so people see value there, even at a time when things are a little slower,” says Jeffrey H. Donahue, CFO for The Rouse Co., which owns and/or operates 47 regional retail centers and 14 community centers. “It's a little perverse but it seems to be pervasive.”

A tough road ahead?

Taylor expects retail REITs in particular to perform solidly in 2002. But if other property types are perceived as turnaround plays, rotation out of the retail sector could be a negative. “The risk to the stock is that the other property types start getting really cheap,” he says. “You have a recovery in the apartments and people say, ‘Gee, I've made some nice money in the malls. I'm going to go play in the apartments.’ They sell the stocks off and rotate to another sector.”

Looking forward to the rest of the year, Morgan Stanley's Ostrower also sees a potential threat to the stock price of some retail REITs. “We think fundamentals are going to hold together pretty well for the mall companies,” Ostrower says. “We'll just have to keep an eye on valuations. Stocks have been going up a lot. As they go up, and the other sectors in the REIT world start going down, we'll be biased toward downgrading the malls and upgrading some other sectors.”

For the moment, Ostrower continues to recommend that investors buy mall REIT stocks. But he is less optimistic about REITs with portfolios of neighborhood, community and strip centers. Retailer bankruptcies haven't hurt them yet, but the stock prices of many shopping center REITs appear overvalued and a correction is quite possible, he says.

Kostin of Goldman Sachs expects Simon to generate 7% FFO growth in 2002 (which correlates with management's guidance of $3.72 to $3.82 earnings per share). Its recent $1.55 billion acquisition of 13 Class-A malls from Rodamco North America will help, too (see February SCW, p. 6). “We believe that the Rodamco acquisition will be slightly accretive immediately and will advance SPG's strategy of upgrading the quality of its portfolio,” says Kostin. The 13 malls include several high-quality properties including Copley Place in Boston and The Galleria in Houston.

Writer Mark Battersby and Associate Editor Joel Groover contributed to this story.