The entire real estate investment trust (REIT) sector is out of favor today thanks to rising interest rates. Mall REITs like Simon Property Group (SPG -1.03%) have been out of favor for even longer thanks to the pandemic and fears about the growth in online retail. This is why Simon's dividend yield has reached a lofty 6.5% today.
That figure has changed the company's priorities. Simon Property thinks that buying back its own shares is one of the best investments it can make now. That's what it's been doing -- and long-term investors might consider following its example and buy shares, too.
Simon operates like any other REIT
There's nothing particularly special about Simon when it comes to being a REIT. Sure, it is focused on owning enclosed malls and factory outlet centers, but buying, building, and managing properties is pretty similar across the board despite the nuances of individual property types.
Notably, REITs are designed to pass income on to investors in a tax-advantaged way. To avoid corporate-level taxation on earnings, REITs must distribute at least 90% of earnings as dividends. Most pay out even more.
Image source: Getty Images.
That doesn't leave much cash behind for investment in the business. Investments generally take one of two forms: A REIT can grow by either building new properties or buying them. Both options require a significant amount of capital. Since so much money goes out the door as dividends, that leaves REITs like Simon two main choices: sell stock or issue debt. To simplify, the cost to do these things is one of the most important factors in determining the REIT's overall cost of capital.
When issuing debt is involved, investors can get a rough idea of the cost of capital by looking at the prevailing interest rate environment. With rates up notably over the past year or so, issuing debt is substantially more expensive than it was not too long ago. With regard to equity costs, it is a bit more complex, but you can look at the dividend yield as a rough gauge of the cost (since dividends will have to be paid on the newly issued shares).
Today, Simon's yield is around 6.5%, which is fairly lofty given that the average REIT, using the Vanguard Real Estate Index ETF as a proxy, yields around 4.9%.
What's Simon doing in this "high cost" environment?
You can learn a lot about how management is thinking when you listen to earnings conference calls. And there was a very clear message from Simon CEO David Simon during the REIT's third-quarter 2023 call:
So, from our standpoint, you know, our cost of capital is up. So, you know, any investment we make, as I mentioned earlier, is in the -- is -- you know was measured against return we would get from buying our stock back, the return that we would get from redevelopment or development. And given that, that's why we haven't been active on the acquisition front.
Simon added that he doesn't see this environment changing anytime soon. And he hinted that the company was always looking to monetize assets, which suggests that the REIT might even consider selling assets to raise capital. The next question for investors might be how the cash from an asset sale would be used. Given the interest rate environment, debt reduction might be a good option -- or, given the high dividend yield on the stock, more stock buybacks.
Stock buybacks were, by the way, a big issue in the third quarter when the REIT repurchased 1,267,995 shares. There's a caveat here because some of that share repurchase was done to offset the dilution from an issuance of shares. The Taubman family, which still owns a portion of the Taubman mall portfolio Simon acquired several years ago, exercised a put right, or the ability to make Simon buy a portion of the stake the Taubman family still owns.
But it is still notable that Simon Property Group chose to buy stock, and the CEO is emphasizing that every investment has to compete with a stock repurchase right now.
Look for more of the same, for now
David Simon couldn't have been more clear: "If you ask me today, we'll monetize things over time, and we're going to buy our stock back because, you know, it's wildly accretive." Reading into that only a little, the CEO of Simon Property Group thinks the stock is cheap.
Note that the dividend has been increased 8 times after being cut in the face of the coronavirus pandemic. The REIT is investment grade and its operating performance is strong as well. So there is no particular reason to believe the business is struggling. If you have a contrarian streak, David Simon's strong support for stock buybacks should pique your interest as a potential buy signal.
