Canadian REITs vulnerable in shift to digital retail

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I do admire much of the work of the accounting profession, but if investors wait for what's called a "going concern opinion," as Sears Holdings Corp. delivered to its shareholders Wednesday, they are entirely too late.

The opinion, attached to the company's new annual report, states that there's now doubt that Sears can continue as a stand-alone company, something many of us have been saying for several years. (My first critique of the company in the pages of The Globe and Mail was in 2011.)

But even as Sears is its own special basket case, the real meaning of the news is to underscore the perilous nature of investing not only in retail, but also in real estate, something the smart money has already figured out. And even though the carnage is concentrated in the United States, Canadians should take note about what it means here.

For evidence, we can turn to the more esoteric corners of the market. Bloomberg News reported earlier this month that Wall Street Has Found Its Next Big Short In U.S. Credit Market, namely U.S. shopping malls. A growing group of hedge funds and other investors are shorting – i.e. betting on a price drop – in securities backed by the commercial loans taken out by the operators of shopping malls and strip centres.

The reference to the "big short" is, of course, invokes the subprime-mortgage collapse of a decade ago, which, of course, was a much bigger market. Even if the scale of the problem is not as large, however, the shorts are looking for a similarly profitable price collapse. Bloomberg says short positions on some of the riskiest securities in this market jumped in February by 50 per cent on a year-over-year basis.

Say the authors of the Bloomberg story: "[M]ore and more, bears are convinced the inevitable death of retail will lead to big losses as defaults start piling up." Said Alder Hill Management, one of the firms making the bet: "These malls are dying, and we see very limited prospect of a turnaround in performance … We expect 2017 to be a tipping point."

Often, there's a continuum of realization, where a downturn first manifests itself in the pricing of the financial instruments held by the richest and (maybe) smartest investors; then it moves into bonds, and finally shakes out in equities.

However, it seems equity investors are warming to the problems, not just by beating down the retailers' shares, but also by whacking the real estate investment trusts who own the properties these retailers are increasingly vacating. The bulk of 42 retail-focused REITs on U.S. and Canadian exchanges are down year-to-date, with many shares posting declines in the double digits.

The share-price decline has accelerated for many REITs this month. This, of course, starts the conversation about whether there's a buying opportunity. In this camp is Michael Bilerman of Citigroup Global Markets, who hosted a conference of REIT CEOs earlier this month just as the retail chiefs were seeing their shares continue to tumble. "We had thought the bear trade was too crowded for meaningfully more downside – apparently not. That said, there was little connection between the seeming free-fall in the shares the last few days and what we heard from retail REIT management teams."

So management is positive. Gee, more unsurprising news. Mr. Bilerman does make some compelling arguments about the sharp discount of many REITs' shares to their net asset values. At the same time, he makes repeated references to "negative media headlines," "growing negative rhetoric among the media" and retailers that "have tried to be proactive in changing the media narrative."

Sorry, but this is not fake news, and it's worth asking whether the shares have corrected enough. Andrew Rosivach of Goldman Sachs downgraded his view on the entire retail REIT sector March 17 to "cautious" and downgraded a handful of specific names – even though he said "we believe the mall is not going away and retail REITs can avoid occupancy declines." Hmmm.

Even as we got the news on Sears Wednesday, Bloomberg also reported that shoe chain Payless Inc., which has 4,000 locations in 30 countries, is preparing a bankruptcy filing and initially plans to close 400 to 500 stores. Add that on top of the retrenchments at Macy's, J.C. Penney and any number of other retail names.

In 2013, I opined that buying the shares of retailers such as Sears for their "hidden real estate value" was a poor idea. I generously included the views of those who disagreed, who argued that health clubs and hot-growing retailers such as Uniqlo would soak up the space vacated by the troubled companies.

I thought they were wrong then, and I'm even more sure now. And Canadians shouldn't be so sure that the phenomenon won't spread here. I'm talking about the holders of RioCan, which exited the U.S. in 2015; any of the REITs that stick to domestic ownership, whether via one retailer like Loblaw's or Canadian Tire; or the REITs that are more diversified across Canada. This is a slow-motion tragedy that could easily head north, and there's no telling right now how much physical retail we'll need in a fully digital world. That's my concern.

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