Markets & Finance

Chelsea: The REIT Choice


By Raymond Mathis With an uncertain economic environment -- and the equity market's erratic performance -- it's no wonder that investors have shown an appetite for income stocks. (These issues pay out a significant portion of company profits as dividends.) One category that has provided not only high yields but also exhibited earnings growth through the economic downturn, is

real estate investment trusts, or REITs. One of our favorite REITs is Chelsea Property Group (CPG), thanks to its steady earnings and dividend growth. The stock carries S&P's highest investment recommendation of 5 STARS (buy).

It's not just the high yields that turn investors' heads in a difficult market environment. REITs have also become particularly attractive because the shares are backed by hard assets. Year-to-date through May 31, the S&P REIT Composite Index provided a total return of 10.6%, vs. a 5.3% decline for the S&P Super 1500 (the combined S&P 500, S&P MidCap 400 and S&P Small Cap 600). This follows sharp outperformance by REITs in both 2000 and 2001.

One other way that investors benefit from REITs: The trusts are exempt from corporate income taxes, and they're required to pay out 90% of taxable earnings in the form of dividends.

A WIDE VARIETY. The REIT industry comprises trusts that own and operate real estate, or hold mortgages on real estate. This is usually accomplished through various types of operating partnerships. The trusts serve a number of different needs and are typically categorized by the type of real estate operated.

Because of the varying lengths of lease terms, some type of REIT is suitable for nearly every market condition. For example, hotels can adjust their rental rates on a daily basis, and they usually perform best in an economic growth phase. At the opposite end of the scale is office property, where leases for often run as long as 20 years. A lengthy lease term, with a hefty penalty for early termination by lessors, allows earnings growth to continue through economic contractions.

In any event, REITs own hard assets, and share prices are buoyed by the

net asset value (NAV) per share. The NAV is the amount available to distribute to shareholders if a company were to liquidate its properties to private investors and pay back its debt.

PREMIUM FOCUS. Retail REITs occupy the middle ground between hotels and offices, with lease lengths typically 5 to 10 years. Many retail REITs also charge a percentage of tenants' gross revenue as rent. The largest publicly traded retail REITs own and operate either regional malls or community shopping centers.

Chelsea has differentiated itself by focusing on large, strategically located, high-end premium outlet centers serving major metropolitan markets. Outlets are manufacturer-operated retail stores that sell primarily first-quality, branded goods. Outlet stores enable manufacturers to optimize the size of production runs while maintaining control of their distribution channels and brand positioning.

At the end of 2001, Chelsea owned or had an interest in 57 outlet centers in 20 states and overseas, containing an aggregate of 12.6 million square feet of leasable area. Its Premium Outlet portfolio (91% of 2001 revenue) comprised 27 upscale, fashion-oriented manufacturers' outlet centers located near major metropolitan areas.

BUYING PROPERTIES. These areas have populations of at lease 1 million people within a 30-mile radius, with an average annual household income of over $50,000, or is within 20 miles of a major tourist destination. Chelsea has major properties in or near New York, Los Angeles, Boston, Washington, D.C., San Francisco, Sacramento, Cleveland, Atlanta, Dallas, Portland, and Tokyo and Osaka, Japan.

The premium portfolio was 98% leased as of Dec. 31, 2001, and contained approximately 2,000 stores with more than 500 different tenants. Outlet centers in Chelsea's Other Retail segment (5.9% of 2001 revenue), primarily factory stores, were 91%-leased and contained 700 stores with 180 different tenants at yearend 2001.

The company continues to snap up retail properties, and in September, 2001, it purchased a portfolio of 31 retail centers from Konover Property Trust.

GROWTH AVENUE. Chelsea's properties developed in Japan now represent the largest and second-largest outlet centers in that country. The trust is expanding the existing properties, breaking ground on a third, and has plans to add five to seven additional Japan locations in coming years.

At S&P, we believe that Chelsea's strategy of taking its premium outlet concept overseas will provide an excellent avenue for growth in coming periods. It's now analyzing the possibility of developing six outlet centers in Mexico and one in Korea.

Chelsea also has a Web-hosting business -- Chelsea Interactive - that has assembled an impressive roster of outlet-industry clients, including Polo.com Ralph Lauren, Elisabeth by Liz Claiborne, Timberland, ColeHaan, Maidenform, ULTA.com, Liz Lange Maternity, and Via Spiga. The division is likely to post a loss of $11 million in 2002, due to costs involved with the launch of Polo.com. However, the unit should gain critical mass by yearend and turn profitable by 2003.

HEALTHY RENEWALS. Chelsea's revenues climbed 26% in the 2002 first quarter, on acquisitions, development of new outlet centers, expansion of existing facilities, higher rents, and relatively stable occupancy rates. Leases written years ago are usually well below current market rates and provide substantial revenue growth when renewed. In the first quarter, rental rates on renewed leases were raised 12% to 15% on average.

We at S&P see revenue growth trends continuing throughout 2002, aided mainly by a full-year contribution from the 31 properties acquired in September, 2001, and expansion of Chelsea's Japan joint venture. Longer-term, we expect new developments planned for 2003 in Las Vegas, Chicago, Seattle, and a third site in Japan to continue growth.

Solid consumer confidence and strong retail sales should support tenant revenues, a portion of which Chelsea collects as rent. In the first quarter, consumer confidence posted its largest increase in 25 years, though recent releases have indicated a bit of a pullback. Outlet-center sales track employment figures more closely than other retail sales, which include nondiscretionary items. With the employment picture improving, we believe outlet-center sales will exhibit growth in coming quarters.

JUICY DIVIDENDS. We expect Chelsea's earnings and cash flow over the next few years to increase faster than those of most other retail REITs that we cover. While some are suffering through the well-publicized bankruptcies of tenants such as Kmart and Service Merchandise, Chelsea has limited exposure to tenant bankruptcy. It has provided a compound annual cash flow growth rate of nearly 18% over the past five years. We project that growth will continue above 10% over the next several years.

While Chelsea's dividend yield is now lower than the REIT industry average of 6.6%, its rate of growth has accelerated. Chelsea has increased its dividend 12 cents a year in each of the past three years, and it has raised the dividend twice in the past two quarters. At its current rate, the dividend will be $1.86 in 2002, up 19% from 2001.

The trust is conservative in its dividend payments and typically is required to raise its dividend commensurate with earnings growth in order to meet the minimum payout requirement. Although the trust has not raised its 2002 earnings guidance yet, we believe recent dividend increases signal Chelsea's confidence in its earnings growth. We recently raised our 2002 EPS projection to $1.60 per share, from $1.51, adjusted for a late May 2-for-1 stock split.

COMPELLING BUY. Based on our dividend discount valuation, and taking into account accelerating growth rates, we see the shares as trading at a significant discount to their intrinsic value. Chelsea's stock also trades at a discounts relative to price-to-earnings and price-to-cash flow multiples of peers.

We believe that the growth, current income, and net asset value provided by Chelsea's stock make it a compelling buying opportunity, and we're establishing a 6- to 12-month price target of $40 -- a 25% premium to the June 14 closing price of $32. Analyst Mathis covers shares of real estate investment trusts for Standard & Poor's


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