Simon Property: High Stock Price, High Debt

Simon Property (SPG) has become quite the fashionable stock since 2012. For almost all of Simon Property’s history, the real estate investment trust (REIT) traded somewhere between 13 and 17x its annual funds from operations. That’s about what you’d expect from an outlet and regional mall landlord. You could reasonably argue that the difficulties in filling malls with tenants should have brought the valuation down to the 13 range, or you could have argued that the low interest rates and generally rising property values should put Simon Property towards the 17 end of that range.

You wouldn’t think that too many people would argue that Simon Property deserves to trade above the end of its historical 17x funds from operations rates.

But now, Simon Property trades at $220 compared to its expected funds from operations figure of $10.60 per share. That’s a P/FFO ratio of 20.7. The stock, which has advanced $20 per share for the past three years, now trades at a 15% premium to the high end of its historical average and a 35% premium to the low end of its historical average.

And you know what I find crazy? People are valuing this stock as if it’s not leveraged up to the gills. Simon Property carries $23 billion in debt. It generates $3.4 billion in annual funds from operations. The high debt burden hasn’t been an issue in recent years because Simon Property has only needed to pay off between $500 million and $1.5 billion in debt principal plus interest payments per year.

But if you look at page 76 of Simon Property’s annual report, you will see that the debt plus interest payments are starting to climb. Between now and 2020, Simon Property will have to start paying out between $2 billion and $3 billion in debt payments plus interest per year.

If something happens to cause a significant amount of tenant defaults in the next couple of years, Simon Property could be in the position of seeing its debt obligations exceed its funds from operations. The margin of safety that has seemed to exist–as evidenced by the dividend that has more than doubled since 2011–has been the product of low payments on debt and increases in the cost of becoming a commercial tenant (while the economy has been prosperous enough to keep default rates low).

But the bundle of risks that come with this stock are greater than recent experience suggests. The debt is high, the payments on it will soon be rising, and Simon Property needs a strong commercial real estate market to continue in order to avoid issuing a substantial amount of shares to finance its debt obligations.

Somewhat perversely, it is a huge benefit to Simon Property shareholders that the stock trades at such an elevated rate. Simon Property has issued 20 million shares since 2011, meaning each share has experienced a 7% dilution in its claim on the ownership of the REIT over that time. If you’re going to get diluted, you want the price to be high so that you will maintain a higher ownership position and the company will receive a good bang for its buck with the capital raising effort.

If Simon Property continues to trade at this high of a valuation, the company might be able to successfully challenge the title of this article by proving that debt doesn’t matter–it could raise capital at a 20x funds from operation rate and use that to pay down any deficiency that arises from a potential downtick in rental income from commercial tenants.

Since its IPO in 1993, Simon Property has been an excellent stock. It has compounded at almost 17% annually, turning a $10,000 investment into $330,000 today. It is a juggernaut in the outlet mall space, and is one of the few REITs that generates billions of dollars in rental income. It is probably one of the top ten buy and hold REITs that you could ever own. However, it doesn’t need to be leveraged so much. It’s the REIT equivalent of Anheuser-Busch–it has very strong revenue streams, but boy, does it like to leverage a safe stream to the point of being dangerous because even a 10% downtick would have unusually adverse consequences for their investor base.

Although I like Simon Property’s core business, the valuation is at the highest it has ever been since the 1993 IPO (with the exception of 1998-2000) and the leveraged balance sheet means that I would demand a discount on the stock price which is in no way present right now. That’s okay. It happens in the market that people will price things far and away above the price you’d be willing to pay. Even if it didn’t have high debt, the P/FFO operation should make you wait at a minimum for the price to go below $200. Don’t use Simon Property’s rapid stock price increases of the past few years distort your judgment of what ought to be a fair price to purchase the stock.