Retail REIT

OVERVIEW:

Retail Real Estate consists of 3 major subsector property types: 1) shopping centers, 2) free-standing, and 3) regional malls.

Nareit constructed an index that exclusively tracks retail real estate. As of Aug 2022, there are 31 retail REITs in Nareit’s index, comprising 16 Shopping Centers REITS, three Regional Malls REITs, and 12 Free Standing REITs. The total Retail REIT market capitalization as of Aug 31, 2022, was $170 billion.

Overall, the retail REIT has been slightly under pressure since 2008 due to the accelerated adoption of e-commerce. Around 2016, a number of factors contributed to further pressure on retail. Fears of a financial downturn and competition from e-commerce were among the top contributors. Eventually, COVID shutdowns brought everything to a halt. See the chart below for a comparison between Retail, Residential, Office, and Industrial.

The return of four major types of REITs since Dec 1993.
Data Source: Nareit

What impacts retail properties?

The performance of retail properties depends heavily on consumer spending. There are multiple factors influencing consumer spending, including:

The health of the economy
Job growth
Population growth
Saving rates

We can use GDP growth as a measure of the health of the economy, and employment/unemployment data published as a measure of job growth. Note that although the factors mentioned above influence consumer spending, in the short-run, other unexpected factors mostly fueled by psychology can cause a drift from the underlying trend or sometimes accentuate it.

Impact of COVID

As evidenced in the chart above, Retail REITs were impacted by COVID closures around March 2020. But, it was in the aftermath of COVID that asset owners observed an interesting trend. The consumers were still interested in brick-and-mortar establishments. In fact, the retail stores played an important role in the e-commerce distribution chain with the curbside or in-store order pickups. This is known as the “last mile” in the merchandise distribution chain. In the wake of high gasoline prices and environmental concerns, the solution that physical stores offered is specifically appealing.

In addition, local shopping centers are becoming a destination. That is, the consumers are seeking the ‘shopping experience’ as opposed to just a quick purchase. Landlords have identified this trend in recent quarters and started to rebalance their tenant mix. One combination that has been favorable, specifically in suburban areas, is a shopping center with an anchor tenant (a grocer or basic needs) and a mix of merchants, service-oriented, and experiential in-line tenants.

Another concept that has gained traction is mixed-use properties, which represents communities with retail and residential components, and sometimes office buildings. This is also referred to as the ‘work-live-play’ concept. Some of the major REITs are adopting and investing in this concept.

Retail Subsectors:

Regional malls are large shopping malls located in prime urban centers, with two or more big box tenants (for example Walmart) and many in-line tenants (smaller units). The asset owners identified the trends and have already started the transformation with the goal of turning the travel to the mall into an experience.

Shopping centers are smaller than the regional malls and usually located in suburban areas, with one big box tenant and up to two dozen of in-line stores. The tenant that is occupying the big box unit is called the ‘anchor tenant’. In such setting, the anchor tenant draws the traffic to the center since. Therefore, shopping centers are less impacted by the change in consumer taste as compared with regional malls (customers need to buy grocery even in economic downturns). The anchor tenants usually have bargaining power, but it comes with benefits to the landlord such as long-term leases and financial stability of the tenant.

Free-standing properties are usually outparcels located in prime locations, quite frequently adjacent to a shopping center with excellent foot and car traffic. A perfect example is McDonald's restaurant with a drive-through next to a mall. Or, a gas station.

Retail REITs Sources of Return

Rental Income:
Retail REITs charge base rent, expense recovery, and percent rent.
Base rent is a fixed amount that tenants pay. Contracts usually have clauses that allow for periodic rent increases, which are called step-up rent. For example, a tenant that starts with $10 per square foot base rent, can have step-up rent of $1 per square foot each year. This means that in the second year of tenancy, the tenant will pay $11, and so on. Understanding this is important because accounting standards require REITs to record and average rental income annually, a process that is called straight-lining. Therefore, the rental income that you see in the income statement of the REITs is not necessarily the cash rent.
Note that sometime the rental agreement requires the base rent to be increased by the CPI amount each year.
Percent rent is a fixed percentage of the tenant’s revenue. Expanding on the example above, if the contract requires 5% percent rent (neutral rate) with $10 PSF base rent, it means that landlord will earn 5% of the tenant’s revenue that is above $200 per square foot revenue ( $200 = $10 / 5%). This feature is important because as prices rise as a result of inflation, the likelihood of landlords earning percent income is becoming higher.
Recovery income refers to tenants reimbursing their pro-rata share of CAM (Common Area Expenses) and property taxes to the landlords. The reimbursement amount is set at a fixed amount for the year at the beginning of the year and then trued up when the exact amount is known, usually at the end of the year. For this reason, we expect higher income for retail REITs toward the end of the year.
Capital appreciation and capital gains
Quite frequently, REITs sell their assets and realize gains. Assets are usually disposed of when they are not contributing to the REIT’s overall strategy, or when the REIT can sell an asset at an attractive opportunistic transaction.
Over time, property values can increase due to two major factors: 1) increase in NOI (Net Operating Income) or 2) compression of cap rate. See our post for the definition of NOI and cap rate. The formula most frequently used for valuation is: Property Value = NOI / Cap Rate; hence, an increase in NOI and a decrease in the Cap Rate will result in a higher value.
Cap Rates are influenced by a few factors, the most important of which is the Baa Corporate Bond rate, which in turn is impacted by central banks’ policy rates.
As the policy rates rise, so does the yield on Baa Corporate Bonds, which in turn forces the cap rates to expand (as real estate and Baa corporate bonds are in competition with each other).

What is the “Buy Case” for Retail Real Estate?

Public Real Estate is attractive to those investors who like a stable stream of dividends and a gradual appreciation in value.
As the graph above shows, different sectors of real estate are impacted differently by the external factor and hence, they are growing at varying paces. As it relates to retail real estate, there are a few compelling factors indicating that retail real estate has been undervalued:

E-commerce had been portrayed as an existential threat to brick-and-mortar retail spaces for the past decade. Recent developments proved that this is not the case. Not only there were many e-commerce operations that opened physical stores for the first time, but also, many shoppers favored going to the mall over shopping online only because of the ‘experience’. Asset managers have identified this and are making directed investments to enhance the experience. We see growth opportunities because of the reversal of the trend and easing of pressure on the retail sector.
Partially due to the factor mentioned above, there has been long-lasting underinvestment in retail real estate. The latest results show an ongoing positive absorption rate, competition over prime retail space, and an increase in rental rates. The situation is similar to what happened in the energy sector with decade-long underinvestment in oil and gas projects resulting in higher prices.
The recently ratified Inflation Reduction Act allows REITs to take advantage of tax credits earned through investment in sustainability projects. Historically, since REITs are tax-exempt, they were not able to fully utilize such tax credits.
Innovation in retail real estate has increased significantly during the past quarters. These include the use of more advanced technology for managing the properties as well as more efficient ways of collecting shopper preferences and responding to their needs in order to increase foot traffic.

We will introduce companies that in our view have superior growth potential.

Q2-2022 Update

Source: CBRE Research Publication: “Despite Weaker Retail Sales Growth, Real Estate Metrics Remain Solid in Q2”

The information below is as of June 2022 and it does not reflect the changes in the month of July 2022 and afterward, which could be significant.

Consumer sentiment was at its lowest since 2008 despite strong wage growth.
Retail sales growth slowed down to 3.8% which is below the five-year quarterly average of 7%.
Core retail sales, which excludes auto and gasoline sales, grew by 1.2% year-over-year in Q2-2022, while nonStore (e-commerce) retail sales grew 8.6%.
The biggest gainers during Q2 were gasoline stations, followed by miscellaneous store retailers like pet supply and secondhand/thrift stores. Grocery store sales grew 8% year-over-year.
Retail space absorption fell by 40% quarter-over-quarter and 20% year-over-year in Q2-2022 to 19.9 million SF, slightly below the 10-year average. The continued positive absorption is encouraging, given the muted levels of new development.
Malls and lifestyle centers were the only retail center category with negative absorption in Q2 (-251,000 SF).

The retail availability hit a new low of 5.1% in Q2.
The neighborhood, community and strip center segment has seen the biggest reduction in availability, down by 2.4% over the past five years and 5.3% over the past 10 years.
High costs, competition for labor keep construction pipeline lean
- Retail completions totaled a record quarterly low of 3.6 million SF in Q2-2022, down by 56% from a year ago.
- The drop in new development is largely attributable to rising cost of construction materials and fierce competition for construction workers from other property sectors.
Rent growth is robust and illustrated market tightness. Average retail rent increased 2.4% year-over-year in Q2 to $22.39 PSF. This was the highest annual growth since Q1-2017. The trend suggests that the growth will continue. The rental growth in some markets were as high as 4% (for prime locations).