This mispricing and arbitrage typically occur due to the amount of and availability of debt and equity capital, interest rate levels and the cost of capital, investor outlook and concerns, regulatory pressures on lending institutions, REIT momentum investors and asset allocation programs from institutional investors. This arbitrage profit is typically available to large institutional investors that have large war chests of capital and can more easily move from one market to the other. Smaller individual investors can also profit by buying or selling the specific REIT stocks.

When this mispricing occurs, astute investors can earn this arbitrage profit in a number of ways as follows:

• If assets owned by REITs are valued higher than private market values, investors can: |
  • sell private market assets to REITs
  • sell REIT stocks and reinvest the proceeds in cheaper private market assets

• If private market values are higher than REIT asset values, the REIT may: |
  • be liquidated and taken private or its assets sold into the private market, or,
  • investors can sell private market assets and reinvest the proceeds into cheaper REIT stocks

As stated above, the current arbitrage play is in the mall and shopping center sector. A number of retail REITs are trading at values substantially less than what the assets are worth in the private market. The stock prices of many retail REITs are down more than 20% during the last year, while their assets are worth more in the private market. The chart below shows the public and private market valuations of three retail REITs that have had significant reductions in their public stock prices. The REITs were valued based on average cap rates from 7% to 8% and their annualized 2017 net operating income excluding general and administrative expenses and impairment charges. The estimated arbitrage profit ranges from $1.7 billion at Brixmor Property Group to $2.8 billion at DDR Corp.

1. All amounts in billions except NOI and stock price data.

As shown in the above chart, there is a huge estimated arbitrage profit of approximately $7 billion in just these three retail REITs. The public market valuation of these three stocks has declined precipitously due to some soft operating numbers and the volume of bad press on the retail industry. Many pundits believe that retail stores and malls are dead, everyone will be shopping on Amazon and the Internet and retail bankruptcies will destroy the brick and mortar shopping experience. There are certainly negative issues in the retail sector including; high level of store closings and bankruptcies, decreased disposable income of the consumer and shrinkage in the footprint of big-box retailers. However, once many of these poor performing retailers are out of business, the retail sector will be stronger from less competition. It is widely expected that Sears/Kmart will file bankruptcy soon and close most or all of their stores. This will have a negative effect on malls that have these retailers as tenants, however, it will make all other retailers financial stronger. The primary benefit from the loss of Sears/Kmart is their $15 billion in annual sales that will be soaked up by other retailers, like JC Penney, Macy's and Kohls.

The decline in retail REIT valuations and the arbitrage profit is definitely a case of the valuation pendulum swinging too far to the negative side. Investment firms with access to large amounts of capital should consider buying these REITs, taking them private and finally liquidating the portfolio. This will capture the arbitrage profits shown above.