PEI — Market News — The Closing Table

Management Meetings Highlight Improved Portfolio and Further Portfolio/Balance Sheet Improvements Ahead

We recently hosted a series of management meetings with PREIT CEO Joe Coradino and Head of Investor Relations, Heather Crowell. PEI’s transformed portfolio is well-positioned to thrive in the uncertain retail environment, in our view. The disposition of 14 lower productivity malls has been the biggest component PEI’s transformation. The dispositions along with occupancy gains and significant re-tenanting activity have improved PEI’s portfolio metrics and strengthened PEI’s long-term growth profile. PEI has used the disposition proceeds to reduce leverage and grow its unencumbered asset pool. PEI is focused on reducing leverage further through additional asset sales and growing cash flow through the stabilization of Springfield Town Center and redevelopment completions. We maintain our Buy rating and $27 target price based on a 7% discount to our $29 NAV estimate at a 6.25% cap rate.

Portfolio fundamentals are healthy and PEI sees a clear path to achieving its goal of sales psf above $500. Sales increased to $460 psf from $458 psf at quarter-end following the sale of Washington Crown Center in 3Q. Further asset sales (Beaver Valley Mall) and the stabilization of Springfield Town Center and Fashion Outlets of Philadelphia (estimated sales psf $600+) should allow PEI to achieve its sales psf goal.

PEI expects a mix of outlet, traditional retail, and entertainment at The Fashion Outlets of Philadelphia. Nearly 50% of the GLA is in various stages of lease documentation and PEI is seeing healthy retailer demand for space. The large-scale redevelopment is a 50/50 JV with Macerich (MAC, $82.65, Hold). PEI estimates redevelopment cost of $160-$190 million (at share) and has received $128.5 million of public financing and could receive an additional $30 million that will help determine the scope of the redevelopment. PEI could have a response by Labor Day on the additional $30 million. The project will open in the spring of 2018 with projected stabilization in 2020. The project entails significant execution risk and we expect PEI will provide numerous updates as the project moves forward to allay investor concerns.

PEI has used disposition proceeds to reduce debt, but debt-to-EBITDA is 7.8x, above the mall REIT average. PEI is targeting a debt-to-EBITDA below 7.0x and plans to get there through a combination of asset sales and higher cash flow from improved operations and redevelopment completions, but it will take time for PEI to achieve its leverage goals. PEI has six redevelopments in-process for roughly $250 million with a shadow pipeline of identified potential projects.

PEI is marketing Beaver Valley Mall for sale, its 50% interest in one power center under LOI, and is under contract to sell the office space at Voorhees Town Center. PEI is marketing its 50% interest in two remaining power centers. PEI expects to complete the sales in late 4Q and/or early 2017.

PEI is also continuing to evaluate whether to sell ownership stakes (20%-40%) in a few centers. The JV sales will help PEI reduce leverage while providing some price discovery for their improved portfolio. While there has been sales of “C” and lower tier “B” malls, there has not been any recent sales of high quality “B”/lower productivity “A” malls. PEI believes the sale of an ownership stake in a few malls, a lower-end Premier Mall and one or two higher-end Core Growth malls could provide a positive valuation for the portfolio, demonstrating the value created by the portfolio transformation.

PEI generated same store NOI of 4% in 2Q as growth was positively affected by 200-250 bps by the inclusion of Springfield Town Center. PEI will continue to receive an outsized benefit from Springfield Town Center in 2016 and into 2017 as signed leases come online and growth annualizes. Physical occupancy is 82.3%, but will increase throughout 2H16 and 2017. A new Saks Fifth Avenue Off 5th will open in a few weeks.

PEI did not have any closures in its portfolio from Aeropostale or Pacific Sunwear. The 300 bp gap between its leased (94.3%) and physical occupancy (91.3%) should close in 2H16 with the opening of six new H&M stores. Retailer demand and PEI’s leasing leverage have improved as the portfolio has transformed. PEI expects to generate 3%+ same store NOI growth following the transformation. PEI’s 2016 same store NOI guidance is 2.8%-3.2%, but quarterly same store NOI guidance which includes Springfield Town Center is 4%-4.4%.

The REIT does expect a handful of Macy’s to close in its portfolio following Macy’s announcement to close 100 full-line stores (out of 675). PEI has 21 Macy’s locations in its portfolio and views the closures as a positive. The REIT has redevelopment plans “on the shelf” for a couple of the locations they expect to be on the closure list. The closures are also a positive for the remaining Macy’s locations in PEI’s portfolio since Macy’s plans to invest in its full-line locations to improve the shopping experience, strengthening their malls. These malls will also take market share from lower productivity malls in the market where Macy's closes. PEI has one vacant anchor in its portfolio.

The Macy’s store closure announcement will not be the last among the traditional department store anchors, in our view. The department store model is struggling in the competitive retail environment as changing shopping habits and large store footprints are weighing on growth and creating some uncertainty. In the last 10 years, PEI has converted 10 former department store anchors into new uses, including large format retailers, small shops, a grocer, and office space. PEI currently has four anchor redevelopments in-process. PEI is re-tenanting the former JC Penney at Cumberland Mall with Dick’s Sporting Goods, the JC Penney and K-Mart at Exton Square with Round 1 and Whole Foods, and the former Sears at Viewmont Mall with Dick’s Sporting Goods and Field & Stream. These redevelopments begin to come online in 4Q16 and continue throughout 2017.

The execution on the redevelopment of the former Gallery in Philadelphia into Fashion Outlets of Philadelphia, anchor redevelopments, and other redevelopment projects are significant for PEI. Successful execution on the pipeline will continue to move PEI's productivity toward its higher productivity mall REIT peers by enhancing PEI's long-term internal growth profile and improving sales productivity.

PEI has been reducing its exposure to struggling anchors through asset sales and the proactively recapturing space when possible. PEI’s Sears exposure is down to 16 from 29 four years ago and PEI sees the number falling into the single digits over the next few years through asset sales and proactively recapturing locations when a new user is identified and a lease is signed.

Target Price Methodology/Risks

Our $27 target price is based on a 7% discount to our $29 NAV estimate at a 6.25% cap rate. Risks to our target price include a broad-based economic downturn or recession, interest rate movements, and general market risk. Company-specific risks include a weakening of commercial real estate fundamentals and balance sheet risk.