The Mighty Penn: How Penn REIT’s New Philly Mall Tests the Future of Retail
In the mid-2000s, an eager developer zeroed in on a plot of land in one of America’s biggest East Coast metropolises. Perched above a mess of train tracks in a central but underused district, the land’s potential — especially as a consumer destination — had floundered for decades under a messy tangle of fractionalized public-private ownership. But after 10 years’ worth of planning and development, the project appears to stand a good chance of living up to its developer’s formidable vision: a flourishing lifestyle center with the potential to transform the entire surrounding neighborhood.
The parallels to Hudson Yards are hard to miss.
But at Philadelphia’s Fashion District Mall, an ambitious, 900,000-square-foot retail development project by Penn REIT and Macerich set to open later this month, the stakes may be even higher. That’s because not only is the more down-to-earth Fashion District crucial to the health of its developers’ balance sheets, it’s also a critical test of whether or not middle-brow urban retail development remains viable — and financeable — under the looming shadow of e-commerce.
The world of development lenders should be watching particularly closely. As a succession of the traditional anchor-worthy department stores like Sears and Bon-Ton have filed for bankruptcy in recent years, few and far between are the developers who have even broached the subject of major new retail developments with their bank lenders. But for Fashion District, Penn and Macerich were able to pull in a $250 million five-year syndicated term loan led by Wells Fargo (WFC) in early 2018 — a financing package that Wells, along with co-lenders US Bank, PNC, J.P. Morgan Chase and Union Bank, extended earlier this year with a balance of up to $350 million. If the deal soars, it’ll say something positive about the troubled retail sector. If it stumbles, it could send retail development lenders back into hiding.
That’s in part because, though it’s less flashy than Hudson Yards, Fashion District might well have more to say about the viability of retail in middle-class markets around the country. At Fashion District, sales are projected at a moderate $700 per square foot (The Shops at Hudson Yards is expected to top $2,000 per foot). Located directly above Philadelphia’s busy 8th Street commuter rail hub, the center’s flow-through entrance will become a routine sight for tens of thousands of suburban commuters and local office workers — and with tenants like Burlington Coat Factory, Century 21 and H&M, the products on offer will be things most Americans can buy without taking a second mortgage. But do everyday Americans still want to buy stuff like that in person, rather than on Amazon?
“The development picture on the mall side is basically zero,” said Haendel St. Juste, a REIT analyst at Mizuho. “I think there’s a lot of excess land in a lot of portfolios, where people are trying to figure out higher and better uses.”
A high-stakes project for two REITs
One month before opening Fashion District’s doors to the public, Joseph Coradino, Penn REIT’s CEO since 2012, was the picture of confidence.
A Philadelphian through and through, the 67-year-old Temple University alumnus beamed with pride as he stood just inside the below-grade atrium that will permit Philly commuters to stream into Fashion District’s food hall directly from the subterranean passage that leads to their trains. (Transit-agency data show that more than 16,000 people use the station on a typical weekday.) The complex’s food hall, with vendors such as Chick-fil-A and Philly-based sports pub Chickie’s & Pete’s, seems like a no-brainer to draw thousands of hungry travelers deeper into the three-and-a-half-story Fashion District, whose other stores will include GameStop, Eddie Bauer, Aeropostale and Hollister. Coradino hopes that many will march all the way through the concourse a third of a mile to the east — the mall stretches for three full city blocks — to visit the AMC movie theater set to open early next year. (Astoundingly, the Philadelphia city center currently has a handful of arthouses but not a single name-brand cinema chain.)
But assured as he may be, Coradino is also keenly aware of what’s at stake for Penn. After all, the analysts that track the REIT won’t let him forget it. On the company’s most recent earnings call in July, Coradino was peppered with questions about Fashion District’s prospects, in part because Penn has made income from the development a prime justification for a dividend level that many analysts worry is too high.
“I know there’s going to be some upside from Fashion District next year, but … from the outside looking in, it [looks like] an easy lever to pull to retain capital,” Ki Bin Kim, a SunTrust bank analyst, said on the call. “What keeps you guys from proactively rightsizing that dividend?”
Investors, too, have betrayed skepticism of Penn REIT’s value. The day Commercial Observer visited Fashion District in late August happened to coincide with the REIT’s lowest share price since the Great Recession — although, in fairness, retail REITs from Macerich to even the well-heeled Simon Property Group have slumped mightily over that period.
In response, Coradino said that the company isn’t putting all its eggs in one basket: Good results at a handful of suburban malls that Penn REIT owns would also help “normalize our dividend payout,” he said. But he also acknowledged that the Fashion District opening — along with the reopening of a big suburban mall in Western Michigan — would “change the face of the company.”
“We think that this project will take its place at the top of our portfolio,” Coradino told CO in the mall’s leasing office. “You know, we’re a Philadelphia-based company. This is almost like a capstone for what we’ve done. When an investor comes to my office, I walk with them a couple blocks over here [to Fashion District] and just say, ‘Yeah, this is it.’ “
Santa Monica, Calif.-based Macerich, Penn’s partner in the project, has a much broader national portfolio than Coradino’s company, so it might have less on the line in downtown Philadelphia. Nonetheless, it’s been an enthusiastic member of a partnership that began when Coradino cold-called Macerich executive Edward Coppola.
“I saw their project in Chicago, Fashion Outlets of Chicago, but I didn’t know anyone at Macerich. So I called up Ed Coppola and said, ‘I think we might be the only two Italian-American CEOs in the REIT space. We have to know one another.’ “ (Coppola, in fact, is Macerich’s president, not its CEO. But, point taken.)
In light of the successful Fashion Outlets of Chicago project in particular, Macerich brought some urban know-how to the initiative. And in general, Macerich is on slightly sounder fiscal footing than Penn. In the second quarter, its higher-value portfolio notched better than 12 percent sales-per-square-foot growth year-over-year, up to $776, according to Morningstar. It’s also worth noting that that sales figure makes Fashion District a relatively low-rent property for Macerich, whereas for Penn REIT, it will be one of the highest yielding.
But Macerich is also working through its own balance sheet issues, as per St. Juste, the Mizuho analyst.
“Macerich had a big outlet under development in California, and they had to bring in Simon [Property Group] as the joint venture partner,” St. Juste said. “They didn’t have the liquidity to do it on their own. The last thing they would have wanted to do is to bring in a partner.”
Still, at $28 per share, Macerich is trading at a market cap more than 10 times Penn REIT’s — but its shares, too, have fallen somewhat out of favor with investors, having lost more than two-thirds of their value since the beginning of 2015.
By press time, Macerich had not responded to multiple inquiries about Fashion District.
Retail development finance at a turning point
Without breaking a sweat, the Shops at Hudson Yards scored an impressive $1.5 billion construction loan from a consortium of banks in 2015 for a similarly-sized shopping center. But much has changed in four years. And any way you slice it, the debt ask at Fashion District was far more mainstream — meaning, in an era of retail hair-pulling, that it was also far more ambitious.
“I think, with the environment for investment in retail being what it is, the fact that we were able to secure [the term loan] speaks to this property’s potential,” Coradino said. “Lenders are skeptical about retail. There’s no question about it.”
Though many lenders don’t have much of an appetite for retail per se, thanks to low benchmark rates and intense financing competition, commercial borrowing writ large has rarely been cheaper. Low interest rates have been a key incentive for small retail-centric REITs aiming to take on major acquisitions or capital-intensive renovation projects like what Penn and Macerich are attempting at Fashion District, according to Kevin Brown, a REIT analyst at Morningstar.
“As an example, if you’re paying for something with 100 percent debt and you get a 6 percent cap rate, today, you still have a 200-basis-point spread between your earnings and your financing costs,” Brown explained. “Essentially, that’s the game [retail owners] are trying to play: They’re trying to get a good spread between what they’re acquiring and what they’re paying. As rates go down, the spread increases.” (Penn and Macerich have also injected an undisclosed sum of equity into the project — tens or hundreds of millions of dollars apiece, based on the financing size and overall budget. But the logic still holds.)
Another key contribution to the project’s financeability came from its legacy association with the city of Philadelphia. Before Penn REIT came on board in 2003, the predecessor mall to Fashion District, Gallery East, was ground-leased to its cadre of owners from the municipal government.
“The city owned the ground that was under it, owned the exterior walls, and owned the mall’s [common] space,” Coradino said. A fractured group of owners, on the other hand — the names included the Rouse Company, the Pennsylvania State Employees’ Retirement System, Vornado and Macy’s — owned the stores themselves.
“Nobody ever wanted to put money in, right?” Coradino said. “Why should I put money in when I’m benefitting a different owner who didn’t want to invest?”
Penn REIT’s successful bid for the project still relies on a city ground lease, but if and when the project opens for business, Penn and Macerich have the right to buy the underlying land for a buck. So, the city is stepping back. But in accord with the location’s longstanding civic ownership, as well as its self-evident role in promoting the city’s downtown, Fashion District got off the ground with four rounds of public finance: $55 million in tax-increment financing, a $25.5 million grant from the state’s Redevelopment Assistance Capital Program, $1.5 million from Pennsylvania’s Infrastructure and Facilities Improvement Program and $1.2 million in transit-oriented financing to help link the mall to the neighboring train station.
“We got all of those funds [to start], right? So it’s almost like we passed a test,” Coradino explained.
Report card in hand, Penn and Macerich’s next phone call was to Bryan Gregory, an executive in Wells Fargo’s REIT finance group. To be sure, the public money they’d amassed amounted to less than a fifth of the planned development costs, but the seed was important to demonstrating strong civic backing. It also helped that Gregory and his team knew both firms well.
“These are long-standing relationships,” Gregory said. “Both of these companies were substantially committed to this asset, [and] they had invested a lot of time and capital in the center.”
The nature of the project also fit with Gregory’s market view. Although the Fashion District project represents an expansive gut renovation from Gallery East — including all new common spaces, storefronts, building systems and pedestrian design — the plan is, at the end of the day, a redevelopment, not ground-up construction. That fits with Wells’ view of how retail is moving forward.
“There’s more focus on redevelopment, and [finding ways to] drive that foot traffic,” the Wells executive said. “Department stores probably aren’t driving traffic to malls as much as they used to, and that’s reflected in REITs’ capital priorities. [But] good centers remain financeable.”
One of the most challenging financial aspects of all, however, was persuading Penn REIT’s investor base to go along for the ride. Gallery East remained open for business until 2015 — but to bring Fashion District to fruition, it would have to be shut down for the better part of a decade, leaving tens of millions of dollars of revenue on the table.
“At our Cherry Hill [N.J.] mall, we spent about $220 million [on a renovation],” Coradino recalled. “We closed it for not a day — not even an hour. But we felt it was necessary for the kind of transformation we wanted to do [at Fashion District]. That was probably the hardest part for me, because we’re measured on our quarterly performance. But we thought long and hard about it and decided that that was best for the project.”
By the time CO visited, Fashion District’s long, bright central hall had taken delivery of electronic directories and public art installations, including a clever mobile, that, depending on where a person stands, looks either like the Liberty Bell or the silhouette of Benjamin Franklin.
But retail stores that had been turned over to tenants were still very much yet to be realized. At the future site of the mall’s City Winery location, workers standing on top of scissor lifts were setting up wiring in the exposed space below.
Unfazed, Coradino was pleased to speak in definites about opening-weekend festivities planned for the spot, which will double as a wine bar and a music venue. And, everywhere we went, he was unfailingly gracious to the site’s workforce, heaping praise on a newly operational escalator and trading a few dollar bills for three packs of Twizzlers from the operator of a freight lift who sold candy as a side gig.
Coradino, of course, has staked a good part of his company’s fortunes, as well as a decade of his life, on the promise that those three bucks will be among the first of many millions that will change hands at Fashion District in the years to come.
“I had a professor at Temple who used to call the old Gallery East defensive architecture,” Coradino said. “It defended itself from the pedestrian, [as if to say,] ‘Don’t come here!’ That was the first thing we’ve tried to change.”