by Steve Sakwa and Craig Schmidt
Despite the maturing of the market for publicly owned real estate companies over the past eight years, one issue that continues to bedevil investors is the level of capital expenditure required for a company to maintain its cash flow.
This obsession over cap ex stems from the basic flaw in the way property companies (i.e., real estate investment trusts and non-REIT real estate operating companies, or REOCs) measure profitability, through a metric called funds from operations, or FFO (see Glossary, page 78). The major problem with FFO is that it ignores recurring costs that, under conventional accounting, are capitalized and later depreciated, but which are necessary to maintain the company’s earnings stream over the long term. Since depreciation is ignored when computing FFO, companies can manufacture FFO growth simply by increasing cap ex budgets without actually improving their return on invested capital.
In the regional mall sector, recurring capital expenditures fall into two buckets. First, there’s cap ex for mall maintenance, which includes items such as roof and parking lot replacements, mechanical systems (heating, ventilation and air-conditioning systems, elevators, and escalators), parking deck repairs, and “lightening and brightening” programs, which include sprucing up entrances and redoing floors.
Second, there are tenant allowances—capital expenditures provided to tenants to help build-out and remodel their stores inside the mall. The size of these payments varies widely depending on the tenants and on how much space they occupy.
The challenge is determining exactly how much each company spends on these items annually. We have combed through the past two years’ annual reports and 10-K filings with the Securities and Exchange Commission of each company we cover to see if this information is disclosed in a useful format. The answers range from very identifiable at CBL & Associates to nonexistent at General Growth Properties.
The biggest problem we encountered when looking through the public documents was that the bulk of the capital expenditures were lumped into one category called “renovations and expansions,” and specific breakdowns of this number weren’t available. When we asked for breakdowns, we typically were told that renovations were generally conducted simultaneously with mall expansions, and it was impossible to separate the two figures.
We also looked at cash flow statements. Once again, we were disappointed; each company usually provided only one figure for “capital expenditures.” The problem with that figure is it does not separate maintenance cap ex, which is the cap ex required to maintain existing cash flow, from revenue enhancing cap ex, which would include the acquisition or development of a new mall.
In the face of this inadequate disclosure, we devised our own cap ex schedule for each company we cover, based on discussions with private mall operators as well as with the public mall companies. We also made a few assumptions for each company.
First, we assumed that a traditional regional mall needs to be spruced up every 12 years at a cost that ranges from $15 to $22 per square foot, depending on the asset’s size. For malls in smaller metropolitan areas, where competition is limited, we believe the appropriate level of capital to invest is $15 a foot, while the figure rises to $22 for a high-end regional mall portfolio such as the one owned by Taubman Centers, where sales run close to $500 a square foot.
The one exception to this range relates to The Mills Corp., where the projected expenditures are spread out over the entire gross leasable area of the mall and not just the in-line small shop tenants. As a result, our projected maintenance cap ex for The Mills Corp. is closer to $5 per square foot, but it is applied to the company’s total square footage, which includes the so-called anchor tenants.
Second, based on our analysis of what each mall REIT spent over the past two years on tenant allowances and leasing commissions, and applying that figure to the average square footage rolling over in the next few years, we determined that tenant allow-ances ranged from a low of $8 per square foot at Macerich to a high of $17.50 per square foot at General Growth.
Further, for mall REITs with community shopping centers in their portfolios, we believe the appropriate level of community center cap ex is $0.35 a square foot, which covers major items such as roofs, parking lots, lighting fixtures, and facades.
Bottom Line Analysis
As a result of our study, we have determined that our previous cap ex figure was understated by 45 percent (see top table on this page), although the figures ranged from a low of minus 15 percent at Taubman to a high of 112 percent at Macerich.
Based on our new cap ex figures, our 2001 multiple of adjusted funds from operations for the regional malls rises by an average of nearly 5 percent (see middle table on this page), with the biggest jump occurring at JP Realty (up 11 percent). Our adjusted multiples for EBITDA—earnings before interest, taxes, depreciation, and amortization—climb by roughly 3 percent.
In view of these higher-than-expected cap ex figures, the regional mall REITs are more expensive relative to most other real estate sectors (see bottom table on this page), based on adjusted EBITDA multiples and projected growth rates. Given the recent run-up in regional mall stock prices since the beginning of the year, we remain selective in our recommendations within this sector. Our top two picks remain The Mills Corp. and Taubman Centers.
