1 Reason to Buy Mall REITs (Hint: It's Not the Big Dividend)

By Markets Fool.com

Think malls are dead? You may be right. According to real estate analysts Green Street Advisors, "10% of the nation's 1,000 enclosed malls will fail by 2022."

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But how do you explain how Simon Property Group and Macerich -- two of the largest operators of malls and outlets -- have outperformed Amazon.com over the last three years? Was this the last dying breath of a once great industry? I don't think so.

AMZN Total Return Price Chart

It may sound counterintuitive, but it's my belief that Simon and Macerich benefit from weaker demand for new malls and outlets. This is because it shelters them from the devastating impact of overbuilding.

What is overbuilding?
Overbuilding is when supply for a certain type of real estate outweighs demand.

Think of a gas station at a popular intersection. Not only is it in a good location, but because it's the only station within miles, it can charge higher prices -- that is, until another gas station builds across the street. The increase in competition forces prices lower, and neither gas station is getting as many customers, but let's say both businesses are still creating solid profits. And then a third gas station is built, and a fourth, and a fifth.

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This is an extreme example, but I think you get the point. For real estate properties like hotels, apartments, and office buildings, it's fairly common for developers to build more than there is demand for. As in the gas station scenario, this decreases occupancy, rental rates, and profits.

Why this does not happen with malls
High-quality malls and outlets can cost hundreds of millions to develop. For instance, Mall of America -- the largest mall in the U.S. -- cost more than $650 million to build. This creates an enormous barrier to entry for three reasons:

  1. $100 million is a huge sum of money.
  2. Given the cost of development, getting it wrong would cost a fortune.
  3. Given the low demand for new malls, getting it wrong is more likely.

Ultimately, because malls are expensive to develop and the risk of building an unsuccessful mall tends to outweigh the rewards, malls and outlets are less likely to be overbuilt. This makes successful and well-located malls extremely valuable to retailers.

Here's why
Housing dozens or even hundreds of retailers under one roof is a strategy that still works well. It just doesn't work everywhere. So, because quality mall space is fleeting, retailers are willing to pay a premium -- and agree to consistent rent increases -- for those locations.

Releasing spreads measure the change in rent per square foot between new and expiring leases. For instance, of the lease agreements that expired between the end of the third quarter of 2013 and the third quarter of 2014, Simon released those spaces at an increase of 17.3% per square foot, while Macerich increased its rent by 20.5% over expiring leases.

This metric is one of the best for measuring the demand for Simon's and Macerich's rental space. If mall space is in high demand, then spreads will grow year over year at a steady clip. Although Macerich's data from 2010 was not available, it seems clear that demand and rents have improved substantially since 2010 and 2011.

A reliable income stream
In my opinion, pressure from online retailers like Amazon helps to keep demand for new malls low. Although on the surface this seems like a negative, it deters overbuilding and encourages competition among retailers for the most attractive mall and outlet space. This in turn allows companies like Simon and Macerich to keep their occupancy high, increase rent over time, and create stable and reliable income for investors.

So, for investors looking to build reliable income streams from companies paying big dividends, I think Simon and Macerich make solid long-term buys.

The article 1 Reason to Buy Mall REITs (Hint: It's Not the Big Dividend) originally appeared on Fool.com.

Dave Koppenheffer has no position in any stocks mentioned, but he did see the movie John Wick in a mall owned by Macerich. Dave Koppenhefferrecommends John Wick. The Motley Fool recommendsAmazon.com.The Motley Fool owns shares of Amazon.com. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.