BY JOSEPH DOBRIAN
How are investors responding to the evolution of retail real estate? Are they moving away from retail properties, in response to recent vacancies and downsizings in many malls and shopping centers? Or are they still finding ways to reap attractive returns, without abandoning the category?
According to industry executives, increased online sales have indeed reduced demand for brick-and-mortar retail space. Overall, rents have compressed, and the value of many retail assets has dwindled. The cliché “flight to quality” is trumpeted as it invariably is during times of weakness. However, quality assets are available, and a canny investor will find opportunities to reposition underperforming properties. The investment community has not abandoned retail — but the category now wears a warning label: “Needs work.”
Notwithstanding recent cries of doom, freestanding retail REITs were the top-performing segment of the U.S. REIT market in 2018, delivering a 13.93 percent total return for the year compared to 11.43 percent for the next-most-successful REIT segment, manufactured homes. This, in a year when REITs slightly outperformed the S&P 500 and ran well ahead of the Russell 2000. Jim Costello, senior vice president at Real Capital Analytics, reports in a recent article that sales of mall properties shot up in volume in 2018 — more than 800 percent — with great disparity in pricing depending on asset quality.
Online purchases have changed the retail landscape dramatically. The U.S. Department of Commerce reports that e-commerce sales have doubled over the past five years, hitting $513.6 billion for all of 2018: a 14.2 percent ($64 billion) jump from just a year earlier. As a result, shopping malls — where consumers used to buy many of the products they now buy online, such as apparel, bedding, books and home goods — have suffered. Adam Hooper, co-founder and CEO of RealCrowd, a company that specializes in commercial real estate crowdfunding, notes that mall-store sales slowed during the global financial crisis and still have not recovered fully. In the fourth quarter of 2018, he says, sales at mall stores in the United States fell to a seasonally adjusted rate of $159 billion, and department stores, many of which are housed in malls, have fallen 37 percent since their high point in 2001, hitting a new low of $37.1 billion.
Nevertheless, e-commerce still only accounts for 11.2 percent of all retail purchases, and demand remains high for “daily needs” retail centers that include grocery and drugstores and services such as dry cleaners, nail salons, and gyms. E-commerce’s percentage of total retail sales will inevitably increase. But demand for traditional retail will remain, perhaps more commonly in the form of showrooms where customers order product for direct shipping. Retailers whose presence is primarily online will continue to open traditional stores, and the line between the two methods may eventually fade to nothing.
What has changed the most in retail real estate is that as consumers have embraced online shopping to purchase goods they used to buy at malls and regional shopping centers, their expectations of these environments have shifted, Hooper says.
“Instead of visiting malls and regional shopping centers just to purchase products and leave,” he elaborates, “shoppers are now expecting new experiences, fun gathering places, innovative dining and socializing options, entertainment, and programming in the form of classes and seminars. Retail owners need to provide these experiences to keep their centers profitable.”
Consumers also respond positively to backfilling of vacant space, from local strip centers to former big-box stores, with nontraditional uses such as medical office, health/wellness providers, massage therapy studios, and even churches and other religious organizations.
How has this evolution affected investment in retail real estate, and the development of new retail properties? How are investors adjusting their short- and long-term strategies? Given the amount of negative pressure retail has been seeing from the headlines announcing big-box store closings, real estate prices have been depressed across the retail sector. This means opportunity for investors who still believe in the class. However, most retail investments look like contrarian plays for now.
According to Hooper, both short- and long-term investors are achieving better returns by identifying the locations and properties flexible enough to accommodate shifts in the industry. Due to the scarcity of land for development and investors’ wariness regarding the sector, most retail development today consists of repositioning existing properties rather than ground-up construction. Vacant big-box stores have been repurposed as fitness centers, restaurants, movie theaters and grocery stores; converted to last-mile warehouse facilities; or parceled up and leased to several tenants. Mixed-use centers, that combine ground-level retail with residential or office space on upper floors, remain popular.
Value buyers, looking for higher yield and acquisitions at a discount on a price-per-square-foot basis, can find deals in retail assets. Hooper sees a decrease in desire for retail among high-net-worth individuals, and institutional investors have cooled slightly on the category. Both private and institutional buyers are broadening their search into secondary and tertiary markets — Hooper cites Baltimore; Milwaukee; Charlotte, N.C.; and Louisville, Ky. — in hopes of achieving higher cap rates on their investments and breaking into new markets before prices get bid up too high. Several Midwestern markets that hit their price nadirs at the beginning of the global financial crisis have grown significantly in the past decade.
Todd Siegel, vice president of commercial investments at Passco Cos., agrees that brick-and-mortar retail will not disappear, but it will have to evolve. Even before the recession, he notes, regional malls were criticized as dated and inconvenient. With the recession, demand for commodity-type goods fell while demand for food, entertainment and services increased. But because consumers will always desire human interaction as part of their nature, traditional retailers can stay afloat by adjusting their business models for improved convenience and seeking locations in high-traffic shopping centers, close to Internet-resistant stores and services.
“We have seen the major traditional mall operators shed their class B and C assets in favor of putting more capital into the class A centers that have been resilient and successfully adapted to the changing consumer habits,” Siegel says. “We have also recognized that grocery-
anchored centers have morphed into lifestyle centers. Because they offer increased convenience to consumers and lower operating costs to owners, many investors are turning their attention to this category.”
These grocery-anchored lifestyle centers attract a variety of tenants and will be easy to lease up if they are well located. Much of the traffic will come from customers who need to pick up a last-minute item such as milk or paper towels, when even Amazon Prime is not quick enough. Despite the so-called retail apocalypse, Siegel adds, he sees investors shifting from other real estate product types to retail or, in some cases, back to retail. Amid increasingly high competition, compressing cap rates, and little margin for error in sectors such as multifamily and industrial, smart investors are finding opportunity in retail centers, with higher cap rates to adjust for the perceived risk.
Some real estate investors are forming alliances with real estate services firms, taking advantage of the latter’s management skills and research capabilities to find investment possibilities with greater potential, as well as more dependable tenants. Mark Dufton, CEO of real estate at Gordon Bros., an investment and advisory firm, recently teamed up with JLL, a leading tenant rep firm, combining Gordon’s retail restructuring with a firm that takes a consultative approach and offers comprehensive due diligence services. He explains that owners of retail assets have to be more careful than ever about whom they lease to, in view of so many retailers closing stores in recent years. A new store transaction, he says, can take a year, now, whereas it used to take six months on average.
Dufton says Gordon’s usual strategy, faced with a vacant space once occupied by a Sports Authority or a Toys ‘R’ Us, is to accept the fact the space will have to be split up and leased to multiple tenants: credit tenants, usually, but seldom able to pay more than half to two-thirds of what the larger retailers had paid. These tenants might not be traditional retailers — in which case, owners will have to be certain that non-retail tenancy is allowed under the terms of the loan documents. In some cases, a residential play might be possible.
He notes that Dollar Stores have begun leasing bigger boxes, nowadays, but Family Dollar has been closing stores. Restaurants and fitness centers are back-filling much of this space. Most class A and A-plus assets in good locations will do fine in the long run, he concludes, but strip centers in secondary and tertiary markets might require some close attention and clever brokerage. He suspects that retail in general has more vacancy than is currently reported, since retail data in particular suffer from a chronic time lag.
Indeed, he predicts that some retail real estate will either be repurposed or will go away entirely. Even some class A centers that used to be considered bulletproof are showing wear and are converting to outward-facing lifestyle centers. In general, he advises investors to be wary of malls and outlet centers.
“There are buying opportunities, and still a lot of money to be made,” he says, “but those opportunities are not for the faint of heart. You have to have detailed knowledge of the retail landscape, and how to redevelop that property, and what the new retail rental terms are. If you have the knowledge and the capital, I would advise you to go all in on some of these deals. You cannot buy on a price-per-pound basis and hope that retail recovers. Retail real estate is a get-rich-slow business.”
Dufton says he is surprised that mall REITs in general are holding up well — but he notes that some REITs are taking extraordinary measures to try to keep their properties tenanted, such as suing tenants to prevent their closing stores (as Simon Property Group did in 2018 with Starbucks and Wolverine World Wide).
Are we likely to see much change in the type of investor that favors retail real estate? Some non-traditional speculators have been drawn to retail by the pricing and lack of bidding, but they will not get far without thorough market knowledge and the resources to manage the property day to day. Dufton says he has noticed a few players who used to work for REITs now raising money on a deal-by-deal basis and lining up leases while still in the due diligence process. But, he warns, these people usually have a deep understanding of the local market. The primary goal of retailers today, he says, is to reduce occupancy expense. Thus, owners and investors will have to make some hard value decisions, sometimes involving a large asset.
Conservative investors still like single-tenant net-leased properties, usually triple-net-leased to large credit tenants such as a drug chain, dollar store or bank. These plays, and their returns, tend to be unexciting but safe. Ryan Butler, managing director of Stan Johnson Co., which specializes in engineering these transactions, says that while fewer of these stores are being built than before the Great Recession, plenty of deals are available. Sales are often triggered when the debt falls due, or when a high-net-worth owner dies and the heirs want to create a cash event, so assets with 10 or more years left on the lease sometimes hit the market with little notice.
On the tenant side, Stan Johnson Co. has seen growth in restaurant concepts, expansion of the gym/health club space, and expansion of car repair and body shop chains. Other retail concepts are streamlining and making improvements through “blend and extend,” right-sizing the rent while extending terms.
“Investor activity remains strong,” Butler concludes. “You continue to see plenty of 1031 exchange buyers chasing retail properties, because retail is accessible to them, price-wise. Institutional investors may be more sensitive since they have to answer to Wall Street. But with interest rates likely to stay low, the market looks as strong as it was last year if not stronger.”