(By Todd Lukasik, CFA) Tanger Factory Outlet Centers
) has entered a multiyear period of outstanding growth. This sustainable growth trajectory differentiates it from other real estate investment trusts, as does its reasonable valuation in an environment where the majority of the REITs we cover trade at a premium to our fair value estimates.
The attractiveness of the outlet format--to both Tanger's tenants as well as the end consumer--drives our view of Tanger's ability to achieve inflation-plus growth from its existing portfolio as well as through new development opportunities. Embedded in-place rents that we estimate to be 10%-15% below market rates will drive internal growth, while new development opportunities and opportunistic acquisitions contribute to external growth. Overall, our average annual revenue growth rate expectation for 2012-16 is 8.2%, about 40% of which is organic, 40% from developments, and 20% from 2011 acquisitions.
Although Tanger trades right around our $34 fair value estimate, it is a relative value among mall REITs (peers Taubman Centers (TCO
) and Simon Property Group (SPG
) trade at 16%-18% premiums to our fair value estimates), and its dividend growth prospects are excellent, at inflation-plus rates for the foreseeable future. For these reasons, we think Tanger should be on the radar of investors wanting to keep an allocation to REITs or interested in a sustainable dividend with great growth prospects.
We Foresee Outlet Industry Expansion
The U.S. outlet industry is small, representing just 1% of all retail space and less than 1% of U.S. retail spending, excluding autos. It is dominated by Simon and Tanger, which benefit from scale. We estimate that Simon (63 outlet malls) and Tanger (40) own roughly 55% of the 185 outlet malls in the United States. Tanger estimates that the two firms own 80% of the quality U.S. outlet mall space.
We estimate the outlet industry can expand to 122 million square feet of gross leasable area in the coming decades, up from 72 million square feet today, providing a long runway of growth. Incremental demand will come from both longstanding outlet tenants and newer entrants to the outlet channel, attracted by the relatively high sales productivity, profitability, and returns on investment from the outlet channel versus mainline stores, fueling demand for both existing space and new developments.
The structure of the outlet distribution channel supports higher profitability for retailers; average cost of occupancy for retail tenants is as much as 500 basis points lower at outlet versus traditional malls. Also, retailers' views on outlets have changed since the 1970s. Outlets are no longer just about liquidating excess or damaged inventory. At many successful retailers, outlets have become strategic--a separate profit center, sometimes with a separate product, and a means to reach a broader customer base.
The attractiveness of the outlet channel is not new or fleeting. Tanger's historical record of high occupancy, high profitability, steady increases in both tenants' sales and Tanger's rents, and 19-year record of dividend increases attest to the sustainability of Tanger's outlet model.
Tanger Has a Big Pipeline; Stay Tuned for More Announcements
Tanger is pursuing its fair share of the outlet industry's development projects, and we expect it to maintain its relative standing and scale in the industry. We estimate that Tanger's recently opened and under-development projects in the U.S. can contribute roughly $45 million-$55 million in incremental net operating income by 2017, fueling 3.5% average increases in NOI growth over the next five years, and contributing roughly 40% of the 8.2% average annual growth we expect from the firm over this time frame. (We expect internal growth to also contribute roughly 40% of the 8.2% average annual growth rate, with the remaining 20% from 2011 acquisitions.)
In addition to the completed developments, current developments, and predevelopments in the U.S. that we include in our base-case forecasts, Tanger has a shadow pipeline of potentially 11 or more projects. With a potential incremental capacity of 50-100 outlets in the U.S., Tanger could build 11-22 new outlets to maintain its current market share. We include 6-8 of these in our base-case forecasts, so there is potential upside to our development growth horizon for Tanger beyond 2017.
Despite its robust pipeline, we are confident that Tanger will remain a disciplined developer. The firm requires at least 50% of space to be preleased with visibility on another 25% of leasing before breaking ground on a project. (It aims to have new projects at least 95% leased within a year of opening.) Historically, it has been willing to shelve projects that don't meet these requirements, as it did with two sites in 2008. Also, it has more recently shown its ability to work with its largest competitor, Simon, to enter joint ventures in markets where two malls don't make sense. Although it is ramping up development spending, it is keeping its balance sheet in good shape. While it development pipeline has grown significantly recently, we have seen no change in Tanger's historically disciplined approach, so we have confidence that its projects will be successful.
Acquisitions Are Excluded From Our Forecasts, but Could Provide Upside
Another external growth opportunity for Tanger is acquisitions. We do not forecast unannounced acquisitions, as they are highly unpredictable. (We do, however, include Tanger's already-completed late 2011 acquisitions in our forecast, which boost 2012's expected results and contribute roughly 20% of our 8.2% average five-year growth forecast.) We do expect to see the industry consolidate further, given its highly fragmented nature beyond Simon and Tanger and the high percentage of the industry in private hands. When outlets do come up for sale, we expect Tanger to be on the short list of potential buyers the sellers call.
Furthermore, Tanger operates with a conservative balance sheet, so it should be both willing and able to consider acquisitions as they become available. Tanger completed five acquisitions in 2011, which contribute about 20% of our average annual growth forecast through 2016 although the benefit comes mainly in 2012, and it announced the acquisition of two centers in Canada in 2012. We don't expect that kind of acquisition pace to continue, but incremental acquisition opportunities would provide incremental growth to our forecast.
We expect Tanger's organic growth to be driven in general by the positive impact of favorable industry dynamics and specifically by in-place rents we estimate to be 10%-15% below current market rents.
Our preferred metric for assessing a landlord's organic growth is the change in same-store net operating income. The three main variables contributing to changes in same-store NOI are occupancy, margin, and rent growth.
Tenant demand for outlet space has driven Tanger's occupancy rate to its highest third-quarter level ever, at 98.6%. While this is great for current results, it suggests that future internal growth must come from margin improvement or rental rate increases, as opposed to further occupancy gains.
In fact, potential loss of occupancy represents risk to same-store NOI growth. If vacancy were to rise, Tanger would lose revenue and potentially face margin pressure through lost efficiencies running less-full centers, weighing on NOI. Although occupancy is at all-time highs, we don't expect falling occupancy to be a problem, because of continued strong retailer and consumer demand for the outlet format.
Tanger's NOI margin is also at historically high levels. At 68.0% through the first nine months of 2012, the NOI margin is the highest it's been since 2004, the only time in the past 10 years it exceeded 68%. Average 10-year trailing NOI margin is 66.6%. We think profitability is near its upper bound and expect a normalized NOI margin near 67% across our forecast. We're comfortable with this forecast, because Tanger's historical NOI margin has generally fallen within a reasonably tight range between 65% and 69%, and our forecast falls just above Tanger's average trailing 10-year level, which we think is reasonable given the slightly higher occupancy we expect in the future relative to the past 10 years. However, Tanger is operating north of our assumption thus far for 2012, and it may be able to exceed our expectation, providing upside to our estimates.
With occupancy and profitability hovering near high-water marks, internal growth will have to be driven by increasing rental rates. There are many ways to consider a landlord's potential benefit from future rent growth. All look favorable to Tanger. Re-leasing spreads on expiring leases were between 16.0% and 21.5% through the first three quarters of 2012, with an average of 17.3%. Implied mark-to-market rent increases on Tanger's average in-place rent at year-end 2011 fell between 9.2% and 14.5%, with an average of 12%, which we incorporate into our base-case forecast. The implied mark-to-market on Tanger's rents using a current versus target cost of occupancy analysis is 19.0%.
The distribution of these mark-to-market estimates spans 9.2%- 21.5%, and while our 12% base-case assumption falls at the low end of the range, it still drives average five-year forward re-leasing spreads of 20%.
This re-leasing spread assumption combined with our expectation for continued high levels of both occupancy and margin drives five-year forward average internal growth of 3.3% in our model. Further, based on the range of estimates for portfolio mark-to-market of 9.2%-21.5%, we think the range of potential five-year forward internal growth rates falls between 2.9% and 4.7%, although we think the high end of that range would be difficult for Tanger to hit. For reference, however, Tanger's trailing five-year average same-store NOI growth has been 3.7%, and it logged a 6.5% rate through the first nine months of 2012.
Overall, our base-case assumption for average annual internal growth of 3.3% through 2016 is based on our expectation that demand will remain high for Tanger's centers, supporting high occupancy, high margins, and 20% average re-leasing spreads. This inflation-plus near-term internal growth expectation provides a great base of growth, to which Tanger can add growth attributable to its external growth projects, mainly recent acquisitions and new developments.
Dividend Promises Inflation-Beating Growth
Tanger enjoys some of the best growth prospects among our REIT coverage in general and retail REITs in particular. We expect a combination of embedded internal growth (thanks mainly to in-place rents roughly 10%-15% below current market rates) and external expansion opportunities (fueled by continued retailer and consumer demand for the outlet format) to drive balanced revenue growth averaging 8.2% over the next five years. Over the back half of our 10-year forecast, we expect growth to slow to 3.1% on average, but there is upside to our near- and long-term growth forecasts, particularly if Tanger can drive rent increases faster than we expect or is able to secure incremental sites for longer-term developments or take advantage of opportunistic acquisitions. This strong growth profile bodes well for Tanger's dividend growth prospects over the coming years.
Many variables ultimately affect Tanger's potential dividend payments. But given the firm's historical record of consistently increasing its dividend every year since its initial public offering, its current well-covered payout (just 66% of our 2012 estimate for adjusted funds from operations), and our expectations for future growth, we think the firm's payout can increase at rates that exceed inflation.
In its first full year as a public company, Tanger paid an annual dividend of $0.46 per share. Currently it pays an annual rate of $0.84, representing average annual growth since 1994 of 3.4%. We think an average rate of growth at least on par with these past 18 years is attainable. However, given the firm's external growth opportunities, Tanger may not raise as much incremental capital as we expect and retain cash from operations to fund external growth instead of paying it out as a dividend. Even if it did this for a few years, however, the future income from the developments should allow the dividend to catch up to our inflation-plus growth expectation over time. Given the firm's strong dividend record, we expect annual increases and inflation-beating average growth over the long term, although the actual increases from year to year may be bumpy.
Given its strong record of dividend growth and value creation, combined with its currently robust growth prospects and reasonable valuation, we think Tanger should be on the radar screen of investors with allocations among REITs or interested in a solid dividend with very favorable growth prospects.