Black Friday is around the corner. Will US shoppers head to the mall? Or are malls out of fashion for good? The debate about the retail apocalypse is playing out in a single bond index.

That index is the CMBX.6, which references 25 US commercial mortgage-backed securities (CMBS) issued in 2012 that have meaningful exposure to retail loans, including loans on regional malls. The narrative of the death of the mall has led many investors to “short” the CMBX.6. But we view that narrative as overly stark and simplistic.

What we see instead is a landscape that’s far more complex and nuanced. Our fundamental research reveals a sector in flux, with many regional shopping malls on the verge of failure while others are reinvesting and evolving to keep pace with changing consumer preferences.

To get a better perspective on the future of the American shopping mall, we need to begin with its history.

A Little History of a Big Industry

The indoor regional shopping mall with its department store anchor dates back to 1956 and the Southdale Center in Edina, Minnesota. With suburbs flourishing across the US, the concept spread like wildfire. Throughout the 1950s and 1960s, malls of all price points sprouted in every location in which strong demographics and household incomes supported them. Highly productive “class A” malls’ higher price points appealed to higher-income households. A middle-market customer base supported a “class B” mall.

Mall development slowed in the soft economy of the 1970s but resumed in earnest in the 1980s and 1990s, spurred by rapid real income growth, the tech boom and the ensuing demand for apparel and lifestyle brands. Private equity firms, which acquired retailers and expanded locations in pursuit of fast profits, added fuel to the fire.

Pressure Builds, Especially for Apparel Retailers

Meanwhile, a new dynamic was brewing that would dramatically change the course of the mall industry.

In the 1950s, when the first enclosed shopping malls were introduced, their core market was suburban homemakers and mothers. These women shopped not only for themselves but for their families. The apparel model was rigorously defined: there was clothing suitable for home, for being seen in town at midday or in school, for work and for social occasions. A high proportion of discretionary income went toward apparel. It made sense that regional malls and department stores of the time focused on soft goods.

In contrast, today’s dress codes are much more relaxed, both at work and socially. A work wardrobe may require one or two suits, compared to four or five just a few years ago. What’s worn in the morning is likely still appropriate for a dinner out. There’s simply less need for multiple wardrobes.

As social conventions relaxed, soft goods sales suffered. To make matters worse for the apparel industry, there is also less time to shop—today, 62% of married couples with children are dual-income earners. Lastly, catalogue and online purchases increase convenience.

Soft goods retailers have also come under pressure because middle-income households have lost ground to stagnant wages. Meanwhile, critical household expenditures such as rent, energy, healthcare, childcare and college tuition have far exceeded overall inflation. For example, from 1996 through 2016, while consumer goods prices collectively rose 55%, the costs of education, childcare and healthcare climbed 200%, 125% and 120%, respectively. That has dramatically shrunk middle-income households’ discretionary income for apparel.

These factors have all contributed to the shuttering of store locations that are no longer productive. From 2017 through 2018, while hard goods retailers netted 18% more store openings, department stores and soft goods retailers saw net store closings of (11)% and (29)%, respectively, according to IHL Group.

These store closures are painful for malls located in mall-crowded trade areas. They’re particularly troubling for malls ranked in classes C and D. These malls fall in the bottom quartile of productivity in the mall industry and therefore aren’t likely to get life-saving, fresh investment.

In the Retail Apocalypse, It’s Survival of the Fittest

While some analysts have concluded that retailers are headed toward an online-only presence or that a store fleet’s footprint is too small to support any but the most productive class A malls, there’s much more to this story.

We see surviving malls adapting to contemporary needs and interests, taking on capital programs that enhance the shopping experience with fresh concepts, and upgrading and redesigning stores. We especially see evidence of this evolution in malls ranked below class A.

Furthermore, malls are reducing their reliance on apparel to reflect today’s demographic and spending patterns. With millennial consumers entering their higher-spending, child-rearing years, many mall owners are making investments that will make malls the preferred forum not only for apparel but also for dining, entertainment and lifestyle, such as health and fitness. Malls that succeed at this shift have an economic future as functional retail assets.

Add to this that most retailers are now embracing omnichannel (online plus brick-and-mortar) rather than online-only shopping and are enjoying positive sales growth as a result. Recognizing the virtuous cycle created by a mix of online and physical stores, retailers are moving toward an optimal distribution strategy of 30%–35% from online and 65%–70% from physical shops. (Today, the online share is 20%–25%.)

Even the latest wave of retailer bankruptcies has involved restructuring and rightsizing instead of liquidation. We’ve seen this with chains like Forever 21, which has closed selected—rather than all—locations. Store closures such as these are adversely impacting weaker (class C and D) malls—but productive malls (many of them class B) continue to enjoy retailer demand for store locations.

As the shopping mall industry works through this current phase, many malls will indeed fail. But others will win the evolutionary race for survival of the fittest.

Controversy over Dying Malls Creates Opportunity

Many investors betting on a retail apocalypse have made headlines by shorting the CMBX.6—a bet that, in order to succeed, depends on the underlying loans experiencing sizable losses, and soon. We think shorting the CMBX.6 is a risky strategy for several reasons:

1) The index holds less than half of one percent of malls in the US. Shorting it to express the macro view that American malls are dying is inefficient.

2) The non-retail assets that dominate the CMBX.6 have enjoyed material growth in net operating income, considerable commercial real estate appreciation since 2012 and more defeased loans than usual. These assets are not expected to suffer meaningful losses.

3) More than half of the CMBX.6’s 44% retail exposure isn’t in malls at all but in power and strip centers. These are typically anchored by community retailers such as grocery stores and discount stores that face far fewer closures than do apparel-oriented regional malls. In many cases, power and strip centers are benefiting from expansions of retail fleets.

4) Most of the mall loans in the CMBX.6 are likely to be fully or at least partially paid off at maturity. We estimate that eight of the 37 malls included in the index are essentially failed malls that will almost certainly default and liquidate close to their land value. But that extreme loss severity is being broadly applied by some investors across all the malls in the CMBX.6. In reality, the other malls in the index are viable assets that have sufficient cash flow to comfortably cover their annual interest and principal payments.

5) Losses will be mostly down the road. The special servicers that work out defaulting loans work with borrowers to maximize recovery value. That frequently means modifying loans. Even in the case of outright liquidation, the process can take many months.

As investors, it’s easy for all of us to get caught up in the hype of a headline. But often the best trades aren’t found in a soundbite. To our mind, the demise of the American mall makes for a good story—but not a sound investment strategy.

Brian Phillips is Director of Commercial Real Estate Credit Research at AllianceBernstein.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

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