While the U.S. stock market has nearly recovered from its 2022 slump, real estate investment trusts (REITs) remain out of favor, largely due to soaring interest rates. But with the Federal Reserve nearing the end of its rate-hike cycle, there are already signs that the valuation pressure on REITs is easing.
This is creating attractive buying opportunities for patient investors. With a yield of 5.5% and plenty of room to grow funds from operations (FFO) over the next several years, mall owner Macerich (MAC -1.85%) looks like a screaming buy today.
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Real estate gets crushed
The Fed's effort to cool off inflation by raising interest rates has hurt REIT stocks in at least three ways.
First, many investors think of REITs (and real estate more broadly) as an income alternative. When interest rates were nearly zero, REITs were among the best options for generating income. But with bonds offering higher interest rates now, real estate valuations have fallen.
Second, companies in the real estate sector tend to carry a lot of debt. As a result, most REITs face rising interest costs, pressuring earnings. While companies with a significant amount of variable-rate debt have been hit hardest, issuers of fixed-rate debt are also getting pinched as low-cost debt matures and needs to be replaced with new borrowings at higher interest rates.
Third, many investors are concerned that the Fed's interest rate increases will eventually tip the economy into a recession. That could reduce leasing demand across most real estate sectors, further weighing on profitability.
Macerich stock has felt these pressures acutely. After rallying from single-digit territory in late 2020 to more than $20 by late 2021, Macerich shares subsequently gave up most of their "reopening" gains, falling back below $10 last year. However, the stock may be starting to regain favor with investors, recently surpassing $12.
Strong underlying trends
Notwithstanding the lingering concerns about a potential recession, demand for high-quality retail space has remained strong. Last year, Macerich's leasing volume reached the highest level recorded since the Great Recession. Leasing activity accelerated further in the first quarter of 2023. And with occupancy approaching pre-pandemic levels again, Macerich's pricing power has started to return.
Due to this strong leasing activity, Macerich has accumulated a pipeline of over $60 million of incremental annualized rent scheduled to come online over the next two years or so. That could drive a roughly 8% increase in net operating income.
Macerich's current guidance calls for adjusted FFO per share to fall from $1.96 in 2022 to between $1.75 and $1.85 this year, largely due to rising interest costs. Fortunately, the headwind from higher interest rates is set to moderate next year, while net operating income growth could accelerate as key new tenants open. And despite the expected FFO decline in 2023, Macerich can still easily cover its annualized dividend payments of $0.68 per share.
Massive long-term opportunities
The vast majority of Macerich's properties are located in attractive, dense markets: primarily in the Northeast, California, and the Phoenix and Denver metro areas. Over time, the REIT intends to capitalize on the considerable value of the excess land attached to its malls.
For example, Macerich is adding new hotel, office, and residential components to three of its top properties in the Phoenix market. It is also pursuing similar projects at several of its malls in the Denver; Los Angeles; Portland, Oregon; and Washington, D.C., suburbs.
These developments won't begin generating income for years, but they offer tremendous long-term upside. Crucially, by forming joint ventures and using the value of its land as its main equity contribution, Macerich can capitalize on these opportunities with a fairly minimal upfront investment.
Huge potential for patient investors
Macerich stock has rallied 28% since the beginning of June, but the stock remains extremely cheap at just 7 times projected 2023 FFO.
As FFO stabilizes and then returns to growth over the next two or three years, Macerich stock should return to a higher valuation. If FFO rebounds to $2 by 2026, the share price could reach $20 even at a fairly modest multiple of 10 times FFO. If interest rates start to moderate, there could be significant upside beyond $20 as investors assign higher valuations to real estate again.
That makes Macerich stock a compelling bargain at its current price. Moreover, shareholders are getting paid handsomely to wait, thanks to Macerich's generous 5.5% dividend yield.
