Phillips Edison & Company, Inc. (PECO) Earnings Call Transcript & Summary

My name is Richard Hill. I'm Head of Commercial Real Estate Research at Morgan Stanley. Thanks for joining us today for our Third Annual CRE Symposium. We're starting off the day with our retail real estate panel, obviously, a topic that's at the center of the debate, given the implication from COVID-19. I'm going to turn it over to my colleagues in just a minute to introduce themselves. But I do want to go through a couple of housekeeping items first. Please note that this webcast is for Morgan Stanley clients and appropriate Morgan Stanley employees only. This webcast is not for members of the press. If you are a member of the press, please disconnect, reach out separately. For important disclosures, please see the Morgan Stanley research disclosure website at www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative. So that -- with that, maybe I can turn it over to my colleagues to introduce themselves. Devin, I'll start with you. If you can quickly introduce yourself, that would be great.

Sure. Good morning, everyone. My name is Devin Murphy. I'm the President of Phillips Edison & Company. We're an owner-operator of grocery-anchored retail shopping centers.

Lou?

Hey, everybody. Lou Conforti, Washington -- I work for Washington Prime Group. And we own over 100 open-air and enclosed venues from Hawaii to Florida.

Conor?

Hi, everyone. Conor Flynn, Kimco Realty. We own over 400 assets, primarily concentrated in the top 20 metro markets in the U.S., close to 80% grocery-anchored and some mixed-use as well.

Sure. And Tom, certainly -- last but certainly not least.

Sure. Good morning, everyone. Rich, thanks for having me again. Tom Dobrowski, I'm the Vice Chairman at Newmark Knight Frank. I run the enclosed mall capital markets group nationally for Newmark. And our focus is on asset sales as well as advisory and valuation services across the enclosed mall sector.

So guys, we're going to jump right in. And Lou, maybe I can start with you. There's a lot of media headlines touting the death of retail, malls in particular. But I'm curious from your perspective, if there's a scenario where the industry emerges stronger on the other side of COVID-19 after a long overdue rationalization. So I guess my question is twofold. Do you believe that's true? And then how much retail and how much malls, in particular, do you think could rationalize as a result of COVID-19?

Wow. Well, first and foremost, the -- well, I actually believe that there's 2 pandemics going forward. And I would be remiss in not happening -- we were remiss in not just -- we're making a -- just offering my respect with respect to what's happening. And albeit with respect to coronavirus, I am of the belief that what is happening now in terms of a final purge of over-levered, often equity-sponsored retail and noncurating and none -- and passive landlords is actually a good thing. We need to get rid of s***** merchandisers and rent collectors as opposed to curators, which is what we attempt to do at Washington Prime Group. So of course, there's a scenario whereby we continue where physical retail is vibrant. And I believe that it -- and it has to be symbiotic with e-commerce. And we have to get off our behinds and be proactive and do interesting things and curate accordingly.

Yes. That's a fair point. And so, Devin, maybe I can turn it over to you just to elaborate on that. You obviously own a different property type from malls. But I suspect what makes a good strip center a good strip center and what makes a good mall a good mall is really not that much different. So can you walk us through what's driving differences in quality? Is it tenant type? Is it location? Is it you being an awesome curator? Walk us through what's driving that.

Sure. I mean, Rich, look, I think the first thing to understand is that retail real estate is made up of many different and distinct types of properties, and the dynamics of each are meaningfully different. What drives malls or power centers or lifestyle centers or community centers or grocery-anchored centers are completely different. And we're seeing that play out in the current environment, which is when we look at our portfolio, we're 100% grocery-anchored. We consider ourselves to be in the "necessity retail business" where the goods and services we're providing are everyday necessities for the consumer. And as we've looked at how our portfolio has performed in this environment, number one, 100% of our centers remained open through the pandemic. We did have meaningful closures. 40% of our tenants were closed at the peak. We're now back to 91% of our ABR being back open and operating. And we've seen better rent collections than we've heard from some of our public peers. So in April, we collected high 70s, 78% of our rents. In May, that number moved up to 80%, and we're not through the June rent collection cycle, but my expectation is that June will be better than May. So my view is it's all of the above. It's, a, what the tenant profile of your centers are; b, what markets you're in. Again, our market strategy tends to be more what investors would consider secondary markets. So we don't have meaningful exposure to New York, San Francisco, et cetera, some of the regions that have been more negatively impacted by COVID. We have meaningful concentrations in Georgia, Texas, Florida, which open -- reopened early, and therefore, we were the beneficiaries of that dynamic.

Conor, maybe I can ask you to share your views. Again, what are you seeing makes a better property versus another right now?

Yes. I think it all comes down to supply and demand. I know that each product type has a little bit of a differentiator in it. But at the end of the movie, it's still all about the dirt, and it's about the location and the supply and demand dynamic that you're dealing with because there is a blurring of lines. There's a lot of mall tenants moving one way. There's a lot of shopping center tenants moving another way. And so you just got to continually reevaluate your real estate and understand that retail might not be the highest and best use. I mean, we've had this discussion, Rich, for a while, is that the evolution that's going on, there's a lot of exciting things happening in retail. Many times, just the negative part of it gets covered. But when you look at what like Target has done to really sort of reengineer the model of using the store as a distribution point, they sort of have laid the blueprint for a lot of folks to follow to be successful today. And it's interesting going through this pandemic, I'm sure a lot of people are forced to shop online, but they may not recognize that the majority of the goods that they've been purchasing has been fulfilled by the store base that's closest to them. And so it's interesting to see that, for example, in my family, we started buying more from Target because they can ship it to us faster than Amazon. And that's because they're utilizing their store base better than anybody else. And I think that's what's happening today, is the emergence of e-commerce married with physical retail is here to stay, and it's just been, I think, accelerated by 5, 10 years in some cases.

That's helpful. Hey, Tom, you have a different perspective. And I suspect you're working with a lot of CMBS special servicers at this point. What are you hearing on your end as an adviser? What -- I'll ask you the same question. What makes a good property at this point?

Sure. Well, look, I would say it's still very early days with respect to how malls in particular are going to emerge in a post-pandemic world. Early indications appear that in markets where the virus really wasn't, we'll call it, top of mind, malls that have reopened are reopening much stronger than I think folks originally anticipated. And as Lou alluded to, when we look at malls across the country, now there are so many drivers that dictate the irrelevancy of that mall. But first and foremost, sponsorship seems to really be kind of pulling ahead as one of the most relevant areas of focus with respect to whether or not that particular enclosed mall is going to survive and thrive going into the future. And you need strong sponsorship that's creative, that's looking at these things outside the box, beyond the retail narrative, as Conor mentioned. So it's -- broadly speaking, it's early days in terms of how we think these malls will recover, but it seems to be moving in the right direction, and early indications are very positive. In terms of what makes a successful mall, it's such a broad-based question, and there's so many dynamics that go into answering that question. I know we discussed last week, you're going to have malls in very tertiary markets that on paper may not appear to be strong enough to survive, but the reality is those malls service that community. They provide a lot of services that, that community is going to need for the foreseeable future. And if you're an active and good sponsor and proactive manager, you'll be able to transition them all and make it even stronger for the future. So there's many directions we could take with quality of mall and survivability. But overall, the big takeaways are these malls are here to stay in many instances, and sponsorship is, I think, a big part of it.

Sure. That's helpful. Conor, I want to go back to you for a second. At NAREIT last week, when we had our meeting, we were talking about the cadence of the recovery. And I think you were pretty thoughtful about an a, b and c scenario. And if I'm putting words in your mouth, I think you said the c scenario was off the table because the implications of COVID-19 haven't been as severe, but there were some -- there was still some uncertainty about b versus d. So could you walk us through how you're thinking about, like the cadence of the recovery and what maybe drives you to the bull versus a base case scenario?

Sure. So what we did for our Board was we did 4 scenarios actually: a, b, c and d. And d being a deep depression where it was a very long recovery. And then we tried to handicap each scenario for the Board to give them an idea of where we think the trajectory is going to go for our cash flows. And what we did was we tried to highlight different categories of retailers, ones that necessarily were on our watch list coming into this in a position of weakness. Those ones obviously have been exposed pretty significantly and have -- less likely have a chance to make it through. So we took those out of the playbook for all of the scenarios. And then what we did was we did sort of a sensitivity analysis on small shops. We looked back at the financial crisis that we went through and looked to see what impact the small shops had during that time. They were the ones that were the most impacted during the last downturn. And so what we tried to do is take that as a scenario and even pressure it even further to get a d scenario and then have like a little bit of a sensitivity on a, b, c to see what that playbook would look like. And so even though we're very early on in the stages here, we're tracking closer to the a, b scenario where we sit today. But that's obviously -- I think we're in the first or second inning of this thing. So we have to be mindful of that. And every day, we go through our collections and our strategy and figuring out how to handle who do we help to bridge to the other side. Our focus has been on helping the small shops as much as possible because they're the ones that don't have the balance sheet, the cash on hand to bridge. And so that's where our Tenant Assistance Program has been focused, to navigate the PPP program. We've gotten over $20 million of government funding for our small shops. Over 600-plus tenants are enrolled in it. So we've got all sorts of different programs focused on where we see the most need and then identify, hopefully, the upside of the portfolio, recognizing that we're only 77% grocery-anchored. And we did have our virtual ICSC yesterday because we're not going to be in Vegas, so we decided to just do it on Zoom. And the amount of demand coming from grocery stores is just phenomenal. It's one that I think we're going to crest 80% and hopefully even higher in a very short period because the demand from Albertsons, to Kroger, to Target, to Sprouts, to Lidl, to ALDI, to Whole Foods, you name it, Trader Joe's, it's pretty significant. Obviously, they're riding high right now as a beneficiary of this. And we think there's going to be a whole bunch of opportunities for Kimco to add grocery to where we don't have it currently.

Yes. That's very good color. Lou, I want to go back to you. You mentioned some pretty interesting comments at the outset about merchandising and making sure you have the right tenant mix. So instead of focusing on what the recovery looks like for malls, Washington Prime Group in particular, I'm curious if you can just talk about what you think the mall looks like, not 1 year or 2 years or 3 years from now, but maybe even 5 to 10 years from now. How are you envisioning the redevelopment, the remerchandising of a mall? And what do you think it really becomes?

I think you're going to continue to have a mainstay, a foundational grouping of national tenancy -- regional and national tenancy. I am also unequivocal in the fact that we are going to have a lot more kinetic, and by that, I mean installations. And we've been a department with respect to common area activations. A lot more shorter-term tenancy which I know, which, quite frankly, will translate into, I don't think it will be meaningful, but shorter leases, hence, magnifying the need or emphasizing the need for more of an operational approach to this business. There's almost this -- when I first came here when David -- when I came here about a little over 3 years ago, and I started walking every asset. And I can put on a blindfold, and I would say I got about 8 out of 10 right. I can just tell what asset or what tenant was going to be next, whether it be sniffing the old factory of an Abercrombie & Fitch or -- and so on and so forth. And it's unacceptable. We did a multi-variant -- we did a lot of analytics. And then just to -- heaven forbid, it played a little bit of common sense. The industry was -- and I don't use mall because I don't think it represents what we own. One, 40% of our NOI is open air, which you take a look is as good as anybody's in operating metrics, evidence that as such. But 3/4 of our malls or our enclosed assets are -- have a lifestyle and open-air component. But back on point, when you -- we were long. This industry was long 43% junior fashion and accessory. Now I know 2 of my colleagues are probably running some Victoria's Secret as we speak, maybe 3, actually. But there is no need that we needed 4 out of our 10 tenants to focus on junior fashion. One other thing I got to mention with respect to -- one, Conor, I love that little Kimco thing right over there. I don't have that. But his comment with respect to small business and local entrepreneurs was so on point and so extraordinarily important that we -- and it's on our website, and it's -- we received a fair amount of national press. We collaborated with the University of Chicago, buddy of mine, Steve Levitt, who wrote for Economics; and Richard Thaler, in terms of just providing assistance for local entrepreneurs and small business. I have my little sheet open for small business here. And I will tell you, small businesses, from a qualitative standpoint, add the texture and flavor to assets. And when you add them up, they are a pretty major component pursuant to revenue. So lots of movement, lots of activity. We're going to have our mainstays in terms of nationals and regionals. And for us, it's incumbent that we act like a town center.

Yes. That's helpful. Devin, I want to go back to you. You mentioned that you own a different type of property type. Are you seeing any different trends than Tom, Conor or Lou mentioned?

No. I echo what Conor and Lou had said. I mean, if the worst case -- I mean, in our portfolio, at one point in time, we had 25% of our tenants not paying rent. And if that's the worst case, that is definitely behind us. I mean I know there are green streets out there saying that they think 2020 NOIs in the community center segment will be down 24%. I think that number is way too pessimistic. I think based on what we're seeing today, I think NOIs will be down in 2020, but they're not going to be down anywhere near that number. And my expectation is they'll be down in the mid-single digits, at least for our portfolio. I do think what COVID has done is accelerated the demise of certain types of retail that were weak pre-COVID, and all COVID has done is accelerated their obsolescence. And I think that the more resilient types of retail, which I would put grocery-anchored necessity retail in that column, are going to benefit from that fallout because there is tenancy in those centers that are going to no longer exist that are going to migrate to centers that are still vibrant. And I believe that those are centers like ours that have a grocery-anchored component. I mean the whole benefit of grocery is that the average American goes to the grocery store a little under 2 times a week. And so they're constantly going to that center, and that enables the other retailers to benefit from that foot traffic. And so in terms of a draw, there's no better draw out there in the retail segment than grocery. And so I think that the open-air grocery concept will be the beneficiary of the demise of certain types of retail that has been accelerated by COVID.

Tom, I want to change subjects a little bit. We've obviously seen some pretty sharp spikes in delinquencies in the CMBS market. Do you expect distress selling to emerge in the coming months?

Well, look, I think it's still early days with respect to the outcome that we're going to see with a lot of these malls that have transferred into servicing or have even gone back to some of the balance sheet lenders, with sponsors asking for some type of forbearance. So look, if 3 to 6 months from now, we don't see the meaningful pickup in terms of the fundamentals at each of these respective malls and those forbearance periods burn off, then yes, I think we'll -- that's when the rubber will meet the road in terms of what are the sponsors going to do if they're still unable to service their debt or if they start breaching debt covenants. So I think we're still -- we've got 3 to 6 months out before we see what the potential outcome will be there. It seems the servicers, in particular, have been very willing to work with sponsors to provide some type of short-term relief, which, in our opinion, is the right tack. Because, again, we just -- hopefully, this is short-term in nature. Most of the restructurings or short-term abatements or forbearances we're seeing with tenants at malls are on a short-term basis. And if things recover and we get to the fall holiday season, things get back to normal, then I can see a lot of these malls transitioning out of servicing and becoming performing loans. But if that's not the case, then certainly, we're going to see a distress there. And whether or not it leads to a quicker liquidation or not remains to be seen. It's very tough to obviously predict what special servicers are going to do in these situations, but that is obviously a distinct possibility. One thing, I just wanted to circle back to Lou's point. He's right. I mean, if we look at over the last several years, traditionally, the focus when you look at malls has been on the anchor tenants and the risk associated with anchor tenants. Now that risk is still there, obviously, but it's much easier for owners to quantify that risk, to understand what the lease-up possibilities are with respect to those large vacancies. The shift that we've seen really over the last, call it, 12 months has been more on the inline side. And in all honestly, that's where the headlines have been focused over the last couple of weeks, in particular. And we've seen all the names that have come out that are potential bankruptcy risks, names that have come out that are going to be closing large amounts of store locations. These are on the inline side of enclosed malls, and that is a big focus that we look at, is what is the mall sponsor going to do when they pick up another 15,000 to 30,000 square feet of potential inline vacancy. Again, that goes back to having a good sponsorship, a creative on-site ownership, management, et cetera. But that's the focus that a lot of investors are looking at. It's not necessarily the box exposure anymore. It's more, am I going to lose critical mass on my inline side? And if that's the case, what are my options there? How do I re-tenant and close inline space at the mall? So that's one of the top of mind focuses that we're seeing people really hone in on.

I know this is idiosyncratic to WPG, but I would -- 2 comments. I'm sorry, I just kind of interject.

Please, please.

There was such decorum until this. So we were at 93 spots -- 93.7% occupied 5 years ago. And today, we're at about 93%. So 70, 80 basis point delta. Given the tumult and this entire sector has lost 10% of its inline to -- has been subject, and I should let you qualify, to bankruptcies, there are plenty -- and this, I -- so that minimal variance between occupancies and we can -- it's about 60 basis points with respect to same-store NOI, and quite frankly, it's healthy. And I -- to purge and clean up. And anybody who didn't realize, and I'll let you guys fill in the blanks, that or was just insipid from a remerchandising standpoint, kind of -- and then they weren't going away and they've -- some dude out of Greenwich, Connecticut, thought that he was going to buy a retailer and -- listen, this is healthy. And one other comment. I talk a lot about binary paths. And I think it was Conor or something -- we've kind of portrayed retail as binary. There's e-commerce and physical and one or the other. And at zero-sum, that's absolutely absurd. There's also a binary path, excuse me, that is just completely wrong as it relates to kind of strict demarcations on what type of real estate. It's not a mall. It's not a strip center. It's not lifestyle. It's not -- and that's one of the things we got to get over. And one other thing is that it's a bunch of direct, the stuff that is going to be -- the vast majority that Tom is going to see and try -- we do a lot of work with Mr. Dobrowski and is -- the kind of stuff that is going to fall into special servicing, nobody wants to own the vast majority anyway, unless there's a nittiest -- a kind of a company-specific screw-up, and we could take advantage of that. But the -- we need to get rid -- it's like we need to get rid of retailers. We need to get rid of crummy assets with crummy landlords who aren't doing anything interesting. And I don't know if it was Devin or whomever, said that they're subject to functional obsolescence. That's exactly right. And when Green Street talks about 24%, it's f****** absurd for the very simple -- well, if you include -- you tell me what your denominator is. Everybody's denominated around here. I mean I think you got to realize what's an investable asset and who's an investable company. So hence, I'm with you. It's not 24% by no stretch, unless you include some real, real garbage.

Tom and Lou, who do you guys -- in terms of your dream scenario that drive the best valuation, the lowest cap rate for your open -- for your enclosed asset, who are they -- who's the pick of the litter these days to drive cap rate compression on the enclosed side?

Landlord. And it's not -- we shouldn't be -- and I hate the word landlord just like I hate the word mall. And I kind of -- I think -- I hate kiosk, the installation. And my colleagues roll their eyes and say, you're such a weirdo. It's -- we can't be over-reliant when we -- think about it as a coefficient weighting. When you're coefficient -- when you're too long something, that's when you get in trouble.

Sure. Right. No, I'm just saying -- I just wonder who's like the -- who's the sexiest? Who's the new -- who's the Trader Joe's of the enclosed mall?

Yes. I'll just chime in there. With the assets we work on that garner the most amount of interest and price the strongest, it's assets where you're able to introduce nonretail uses. Those are the pick of the litter, whether it's medical office, educational, you name it, any type of institutional quality, nonretail use that could add to the retail that you want to keep at that property. But you -- again, a lot of these malls, there is a justifiable use for a portion of the retail space there, but not all of it's necessary, obviously.

And Tom, do you value those different uses on a stand-alone basis? Like do you ascribe a cap rate to each individual use and then blend it? Or is there a mixed-use cap rate that's used on those types of assets that…

Sure. Look -- yes, we always -- if a mall does have different income components from different uses, we'll bifurcate it or break it up and understand potentially what a breakup valuation would look like. And then we'll roll the components together and, obviously, try to come up with a blended going-in cap rate, if you're looking at it from that standpoint.

The problem is there's been very little -- for -- kind of think about it in a normal distribution. For the stuff that is institutional quality, the stuff that we've turned around, there's very little evidencing of price discovery. So the idea of blending cap rates, I mean, it's -- right now, it's a kind of sort of a theoretical exercise. But I mean, yes, we just introduced something called Fulventory, which is last-mile fulfillment which can toggle into clearance. And the reception has been amazing, has been absolutely amazing. It's imperative that we provide goods and services and interesting goods and services and activities and entertainment. Our focus is to be the dominant town center in a robust secondary marketplace, where -- we did a white paper 3 or 4 years ago. We continually updated it. It's called in defense of secondary trade areas or -- where we did cost of living adjustment. We looked at using second -- primary versus secondary. We used top 10 or 15 markets, largest MSAs as proxy. And we were -- everybody is over-retailed. But we were under-retailed or we have less than 1/2 of that of primary. And we have loyal, loyal customers that come from -- as Tom will tell you, they come from large distances to come to our assets. So it's really -- there shouldn't be one tenant concentration. And that's been the problem. We were so long junior fashion. It was laziness. It was laziness on the part of landlords.

So guys, look, this is amazing. I'd love you to moderate all of my panels rather than me moderating my own panel [ back and forth ]. I have a couple of questions coming in. We only have a couple more minutes in the interest of our virtual panels. But Devin, a question for you, could you just elaborate on what you meant by sort of how much NOI would be down? Is that a '20 number? Or is that…

That's a '20 number relative to '19. '20 number relative to '19.

Okay. And what do you think a stabilized NOI looks like? Is it above '19? Is it at '19? Is it below '19? And when does that occur?

Well, again, I'm basing that judgment on what we know today. And what we know today presumes that we don't have a secondary outbreak of COVID that forces additional shutdowns, et cetera. And so I'm basing that judgment on what we know today, which is presuming that the COVID issue is, in essence, behind us in terms of closures. Now where we go forward -- what's not being talked about in the media, because all they focus on is the negative in the media in America today, if there's any good news, they don't want to report it. And in April and May, we continued to see tenants signing leases. I mean we signed over 20 leases in April. We signed over 20 leases in May. And there are retailers like Starbucks and some of the fast food restaurants and -- like Chipotle and Wendy's, Five Below, Athletico, et cetera, that are still looking to grow their businesses and open stores. And so as we thought about fallout, I mean, based on what we know today, we think we're going to see about 3.5% of our NOI not reopened because of COVID. But what we see in terms of new tenancy will more than make up for the tenancy that we're losing. So if we don't get a second leg down here, I think '20 relative to '19, again, in our business -- and it's going to be different in other businesses, but in our business, we think that '20 will be down, as I said, in the single digits from '19. And then I think, if we don't have a second leg down here, we begin to grow from there again. And so I look at this Green Street estimate where they're saying NOI in '20 is down 24%, and they don't have it getting back to '19 levels until like 2026. I mean that's ludicrous. It's just completely -- it's nonsense in our business because there continues to be demand for well-located grocery-anchored retail. And it's a category that I think will outperform on a go forward.

Great, guys. Unfortunately, we're running out of time. So I'm going to cut this short now. But I very much appreciate, number one, your dialogue, your forthrightness, and you're willing to engage in the debate. It's extremely valuable right now, and I think we need more of it. For those that dialed into the retail real estate panel, thank you. The next panel will be on a separate link, so make sure to log back into that separate link. But Lou, Devin, Conor and Tom, thank you for your time this morning, and I look forward to engage -- continuing our dialogue in the future. Thanks guys.

Thanks, Rich.

Thank you. Appreciate it.

Bye, guys.