It does not matter how much due diligence is undertaken or how closely managers monitor their funds, sometimes the existing function of an asset needs to be abandoned if attractive returns are to be delivered. Markets change and performances are volatile, so it is up to asset owners to identify the right time to convert existing assets into something new.
In the retail space, the past couple of years have been particularly disruptive, upending previously established risk-return profiles. As such, many asset owners are deciding to convert their retail assets into other forms of real estate.
“Repositioning is moving towards the top of the agenda for many landlords, and as a trend will undoubtedly gather pace over the next decade – over half of investors are expected to utilize an asset repositioning strategy this year, according to the JLL 2021 Investor Survey,” reads JLL’s Unlocking Value report from 2022. “However, repurposing is complex and costly, and there are significant barriers and risks amongst the undoubted opportunities.”
Even if some retail properties appear ripe for conversion, asset owners are still left with the challenge of identifying prime opportunities, and navigating shortages of construction materials and labor. As always, there are no certainties when it comes to investment strategies, which leaves the managers of retail assets facing a dilemma. Which assets should continue serving their original purpose (even if modernized), and which are ready for a complete overhaul?
The covid-19 pandemic has had a truly transformative impact on the retail sector. With high streets shuttered, businesses all over the world were forced to close – in some cases, permanently. Knight Frank research shows that global retail property capital values declined 8.4 percent during the pandemic as shoppers embraced e-commerce or were simply put off making purchases altogether. Then as economies rebounded, rising energy prices and interest rates created further headaches for owners of retail assets.
And yet, despite facing seismic challenges, the retail sector has displayed impressive levels of resilience. The Knight Frank data further reveals that total returns for retail assets were projected to be 3.6 percent across 2022, the only commercial real estate subsector to record a positive return. In addition to large-scale retail investments like the acquisition of The Source, New York’s 262,000-square-foot retail center, other opportunities are being created for retail investors. This includes China’s decision to expand its REITs pilot program to include commercial retail properties. Evidently, this is not a sector that is necessarily facing an apocalyptic reckoning.
“It won’t be that simple – retail sales will not simply collapse, nor will they ride out the downturn totally unscathed,” Stephen Springham, partner and head of retail research at Knight Frank, argues. “They will be erratic, some good months, some bad. Erratic is the only constant in retail.”
As Springham suggests, the inconsistency of the retail market – across different properties and geographies – is presenting owners of retail assets with a quandary. Their assets do promise attractive returns, but perhaps not if they remain in their current form.
Ripe for resurgence
One of the main ways owners of retail properties are looking to add value is by converting their stock. Not only does this enable existing owners of retail assets to avoid being buffeted by headwinds – many of which pre-date the pandemic – but it also allows investors looking to add to their portfolios to acquire assets at discount compared to the price of the converted product. It also lets them avoid competition from investors that are not interested in expending the resources required for a successful conversion – those prioritizing passive returns and speed to market.
For instance, US real estate investment trust Washington Prime Group is in the process of redeveloping WestShore Plaza, in Florida, creating a 1.5 million-square-foot lifestyle destination that will include office, residential and hotel components. A $78 million redevelopment of Upper Arlington’s Golden Bear shopping center is also underway – again to create a mixed-use facility composed of office spaces, hospitality, and retail outlets. These examples, among many others like them, suggest that owners of retail assets should adopt an open mind when it comes to their conversions.
“Much of the recent and current repositioning narrative centers on formulaic ‘retail to residential’ conversions,” JLL’s Unlocking Value report cites. “There is a risk, however, that by taking this relatively blinkered approach, the real value-add opportunity is overlooked, and landlords are potentially closing the door on other fast-emerging markets.”
Convert with care
For landlords to unlock longer-term value from their retail assets, it is essential that they do not adopt a formulaic retail-to-residential approach.
First, they must be clear in their reasons for repurposing. These are likely to vary based on location and other market dynamics. Cost, complexity and regulatory hurdles must all be considered too. A data-driven approach is likely to be the best way of evaluating the many factors that will drive the conversion of retail assets – and determine their returns.
“One notable example of data or analytics being used to drive investment decisions is the data sharing strategies of retailers and banks, fostered by PE funds with advanced analytics, which can create new business models,” says Pablo Beldarrain Santos, head of financial services solutions at augmented data fabric specialist Stratio BD.
There is even an argument that assets should not distance themselves from the retail sector entirely – even if they incorporate other forms of real estate. Large-scale retail deals are still being pursued, such as the recent auction of a 7-Eleven retail property portfolio in Sydney, Australia, with yields around or above the 4 percent mark.
Retail repurposing is certainly something for investors to consider, but adding value to assets also requires a shift in thinking. A longer-term, creative approach to asset conversion will deliver the best returns.
The Source of higher returns
Unusually, retail has been determined as a route to value
Earlier this year, property services giant CBRE brokered the $112 million sale of The Source. The asset, a 262,000-square-foot mixed-use retail center in New York, which was 99 percent occupied at the time of the acquisition, comprises five retail tenants and two office occupiers.
Following the transaction, the new owners of The Source – global real estate investment, development and management firm Hines – spoke of the potential upside to be gained from active management. Ironically, the firm said the “conversion of many older retail properties into residential development sites” had reinforced the demand for well-functioning larger retail sites.