What Types of Retail Real Estate Assets are in Demand?
There are seismic changes taking place in the realm of commercial real estate. Although individual opinions vary greatly as to how extensive these changes are, no one can debate the fact that the industry is undergoing a significant paradigm shift.
Although the entire commercial real estate sector has experienced a decent bounceback from its dismal performance during the depths of the Great Recession, the sub-sector of retail real estate in particular has struggled to find its footing. Firms that operate retail space such as strip malls and outlet centers have experienced significant demand destruction due to consumer cutbacks as well as stubbornly high unemployment rates.
The years leading up to the 2008 Financial Crisis saw a glut of construction in practically every sector of real estate, and new retail outlet building projects cropped up at a torrid pace right before the onset of the Great Recession. Oceans of debt and equity capital had flooded the commercial market, sending property valuations soaring–and ultimately peaking–right before the 2008 crash.
Unfortunately, many of these retail projects were either delayed indefinitely or abandoned altogether, as new construction financing dried up, and lending for the overall sector slowed to a crawl. In the aftermath of 8.4 million jobs lost across all sectors of the economy, tenant demand diminished rapidly, vacancy rates for retail properties skyrocketed, and rental rates subsequently plummeted. Evidence of these disruptions is even more pronounced when looking at the year-over-year numbers–commercial investment in 2008 had fallen 71.6 percent from the previous year.
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This ultimately led to a scenario where operating income for neighborhood strip malls, regional outlets and power centers began to shrink, and landlords had to resort to offering creative discounts and rent abatements in order to obtain or keep tenants. Percentage rents were also negatively affected as households began to stabilize their balance sheets by spending less at retail stores. Many of the vacancies that appeared early on in the Great Recession were due to several big-box retailers (e.g., Circuit City, Borders, Blockbuster, etc.) going bankrupt and closing stores.
While many of those early vacancies have subsequently been filled, vacancy rates overall are still on the rise, as consumer confidence continues to remain relatively stagnant. One primary “thorn in the flesh” for the retail real estate sector is the elevated unemployment level; job growth has been virtually nonexistent except in very specialized fields, leaving the average consumer with few options except to cut spending on nonessential items. The ripple effect produced by this languishing consumer confidence is dismal retail spending, ultimately producing lower sales figures for retail establishments, which in turn negatively affects the retail property market.
Decreasing rental income due to slow retail sales has pushed many properties into default and foreclosure, which has been a catalyst for legal battles between property owners and lenders. Real Estate Investment Trusts (REITs) have also felt the heat from losing some of their retail properties to lenders, as legal liabilities surrounding management and partnership obligations have been on the rise as well. According to Advisen’s Master Significant Cases and Actions Database (MSCAD), 71 different real estate-related securities cases were filed between the years 2007 and 2010. One of the most prominent examples of this is the 2006 class action lawsuit filed by the Iowa Public Employees’ Retirement System against The Mills Corporation, a retail shopping mall developer.
The plaintiffs had accused The Mills Corporation of a number of financial improprieties including overstating net operating income figures and several other violations of Generally Accepted Accounting Procedures (GAAP). The suit was ultimately concluded in 2008 when a settlement was reached, in which the plaintiffs received a $165 million payment in exchange for a dismissal of all claims. The cessation of new retail property development projects, as well as a slowdown in retail rental income, has spawned several cascading consequences that have turned many risk-averse investors away from the market altogether.
Is there any light at the end of the tunnel for retail real estate?
As in all down economies, there are always several pockets of value to be found, but caution and due diligence must be exercised before committing investment capital to any idea. While the retail real estate industry is still very fragile, it is beginning to build modest momentum in this post-recessionary marketplace. Even in the midst of such a volatile economic environment, savvy investors and developers have been able to capitalize on the fallout of some of the big-box bankruptcies that took place in the wake of the financial crisis by snapping up favorable properties in prime locations after several high-profile companies were forced to close their doors.
Interestingly enough, the sting of the recession prompted several big-box companies to rethink their real estate requirements, and several big names have downshifted in order to try out concepts with smaller footprints. This move towards a more boutique-style approach has reinvigorated several key brands, as they have been able to keep the overall feel of their primary stores while still balancing out profitability. Tracking which companies are changing the look and feel of their brick-and-mortar establishments is one of the definite trends to keep an eye on, as opportunities to land potential anchor tenants will continue in this space.
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Outlet centers are another pocket of growth to keep an eye on during this post-recession period. Early on in the economic recovery, risk-averse lenders became more willing to finance ground-up outlet center projects, as the risks were perceived to be more palatable versus other sectors of retail real estate. Current demand for value-priced goods (e.g., dollar stores and discount retailers) continues to grow, and the resulting boost in sales productivity has prompted retailers to be more receptive to increases in rents. In late 2012 and early 2013, outlet center openings began to surge, as retailers began to make more robust expansion plans in light of the marginal but steady improvements in the overall economy.
This could bode well for developers and investors looking to build outlet center projects, as the demand for quality retail outlet space will continue to increase in the coming months. Current landlords will also begin to benefit more and more from the strengthening of the supply/demand equation in the commercial real estate markets. Retailers that didn’t “lose their head” during the financial crisis are now in a better position to increase store counts and strategically expand their operations. This expansion will lead to a shrinkage of available inventory of retail space, fortifying the supply/demand equation for landlords.
Despite the woes of the greater commercial real estate industry, shopping center REITs have shown solid performance over the past few quarters, leading many analysts to believe that the worst may be over for the beleaguered retail real estate sector. Real Estate Investment Trusts that focus particularly on triple-net lease properties have shown significant promise in recent months. At its core, the triple-net lease requires the tenant to pay not only rent, but also a portion (or sometimes all) of the expenses that would typically be absorbed by the property owner. Investors are finding value in REITs that have amassed a large portfolio of properties falling into the triple-net category, as yields and dividend growth have steadily increased for this particular segment of the REIT market.
The best part of choosing e-commerce
E-commerce has proven to be a strong competitor to brick-and-mortar retail establishments as well, but savvy retailers have absorbed this change in the consumer landscape by adapting a hybrid model that integrates digital and traditional shopping into one process. Many large retailers are experimenting with in-store fulfillment as a way to keep the customer’s appetite for online convenience satisfied, while still providing a means for the customer to visit the store in order to pick up their order, which may possibly lead to additional in-store sales. Aside from providing cost savings to retailers, the real estate impact of “site-to-store” fulfillment could be quite significant. Retailers that develop efficient in-store fulfillment systems could see a need to effectively repurpose portions of their current sales floor space in order to accommodate the fulfillment aspect of their operations, which would help to curb any downside risk of vacancies for landlords.
As mentioned earlier, value-based retailers have come to the fore in the wake of the economic downturn. As consumers are becoming more and more budget-conscious, national dollar store chains are aggressively expanding, occupying an increasing number of freestanding locations. Discount giants Family Dollar and Dollar General are both in the process of opening a minimum of 500 new locations apiece in 2013. In aggregate, dollar stores will account for over 15 million square feet of retail occupancy growth this year. On the other side of the coin, upscale retailers are experiencing significant growth as well, as affluent Americans continue to shop at prominent fortress malls as well as luxury establishments positioned in major urban districts.
While the aggregate net worth of the poor and middle class has effectively decreased, the rich have indeed gotten richer due in part to the meteoric rise of the stock market over the past year. This has prompted many well-off Americans to increase discretionary spending, which in turn has strengthened the sales figures of major high-end retailers. This collective splurging by affluent families has been a boon for high-end retail real estate, as higher sales volume posted by luxury tenants usually translates into increased income for the property owners.
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Many retail real estate investors are becoming more comfortable with properties in secondary markets as well. Although investors intuitively tend to defer to the more “reliable” core markets found in major urban areas, the spotlight has recently turned to non-core markets due to their accelerating improvements in employment and housing in relation to their core counterparts. Traditionally, risk-averse investors have avoided secondary and tertiary markets due to the relative uncertainty of the local economic picture, but as many non-core markets have begun to adopt business-friendly tax policies in order to attract economic development, their local real estate performance has improved dramatically; this has produced a significant positive impact in terms of boosting employment and retail spending. This investor-friendly tradeoff in the risk-to-reward ratio has prompted many investors to take a second look at secondary markets, and develop strategies to deploy capital in order to acquire high-vacancy properties in non-core markets with above-average potential.
Investing in promising foreign markets is another area of value to stay mindful of in the arena of retail real estate. As an example, Canada’s retail sector has experienced modest broad-based retail sales growth over the past three years. Despite the shuttering of a handful of big-box retail stores such as Best Buy/Future Shop and Sears, the Canadian employment market continues to remain strong, and consumers continue to demonstrate confidence in their future spending capacity. Ontario and Quebec continue to remain retail powerhouse regions, claiming well over half of Canada’s $550 billion in total retail sales. Major outlet developers such as Tanger and Simon Property Group have also set their sights on Canada as a potential hotbed for retail expansion, with major outlet mall development projects in the works for Vancouver and Toronto.
Below are some of the primary retail categories that are currently projected to expand in the coming months:
* Fast food and fast casual restaurants
* Dollar stores
* Drug stores
* Off-price or discount apparel shops
* Pet supply stores
* Fitness, health and spa concept stores
* Niche grocery stores (e.g., organic, ethnic, etc.)
* Sporting goods stores
* Automotive service centers
Retail real estate investors looking to capitalize on potential growth trends can use the above list of categories as a guide for their market research.
Even the broader economy continues to make slow but relatively steady forward progress, the retail real estate sector continues to be susceptible to shocks that have the potential to impact both investor and consumer sentiment. The lessons learned from the sharp market decline of 2008 have, if nothing else, sharpened the wits of many investors who are now even more equipped to outperform their competitors in this volatile commercial real estate investment environment. Retailers as well have doubtlessly reevaluated their approach to their overall business operations, as lean and efficient systems are increasingly becoming the order of the day to maintain a competitive edge. The combination of better-equipped investors along with forward-facing retailers holds promise for a significant turnaround in the future of commercial real estate.