The outlook for the US consumer is at decade-long highs. Both 2018 and 2019 will see nominal US consumer spending register growth exceeding long-term trends, according to Bloomberg forecasters. In the next decade, strong underlying fundamentals will see nominal US consumer spending post annual growth of 4.3 percent. Despite this buoyant macroeconomic backdrop, the US retail sector faces headwinds: ongoing e-commerce penetration, disruption from department store closures and broad restructuring within the mall sector, to cite a few.

Current commentary on the US retail and mall sectors is dominated by these concerns, but by focusing only on the headwinds other forces shaping the industry are often underappreciated.

Strotton: important not to lose sight of the underlying drivers of mall sales growth

The impact of headwinds can be reduced by around 20 percent by allocating capital away from lower quality malls. QIC research suggests the story around A and B grade shopping malls is a more positive one and they are less exposed to e-commerce and the rationalization of department stores. Further, the headwinds confronting inline stores’ sales are only around half those buffeting anchor tenants, with many gaining market share from struggling department stores.

Allowing for a very conservative range of assumptions, including a further 60 percent increase in e-commerce penetration into mall sales, zero allowance for bricks-and -mortar retailers capturing any e-commerce sales from omni-channelling and zero upside from remerchandizing shifts from current unfavorable tenant mixes throughout the forecast horizon (which would be a ‘fail’ grade in our business), A and B malls will continue to record positive sales growth over the coming decade of 2.2 per cent per annum.

In fact, adopting QIC’s base case assumptions, inline sales growth at A and B grade malls is projected to average 3.4 percent per annum over the next decade. This forecasted growth would be achieved even on the basis of a virtual ‘do nothing’ approach in terms of the merchandizing mix and asset management, which is in complete contrast to our approach and that of most mall landlords.

Strong fundamentals

In short, we are optimistic about the future for bricks and mortar. The basis for this positivity versus the current downbeat rhetoric springs partly from the explicit integration of the macroeconomic backdrop into our analysis of the retail and mall sectors.

Quantitatively, the strong outlook for the US consumer provides a strong launching pad for all spending subsectors, including overall retail spending and spending in malls. An upbeat outlook for the US consumer is not just the view of Wall Street economists, but of households. Consumer sentiment indicators are now at levels last seen at the start of the millennium.

Buoyant consumer sentiment is unsurprising given that most people who want a job can get one, with the US unemployment rate falling to an 18-year low of 3.9 per cent, with the outlook receiving a further boost in December 2017 after Congress passed the Tax Cuts and Jobs Act. Based on analysis by the Joint Committee of Taxation, these tax cuts should lift consumption levels by 0.7 percent on average over 2018-27. According to a Bloomberg survey of professional economists, nominal consumer spending is expected to be 4.8 percent in 2018. If achieved, this would be the equal best result since 2006.

With consumer fundamentals so strong and recent tax cuts providing substantial support to disposable income, expectations for retail sales are similarly encouraging. Over the next two years, nominal growth in retail and food services sales (excluding autos and gas) is forecast to average around a 4.8 percent annual rate. This would be a marked improvement from the average 3.8 percent growth experienced over the past two years and the best two-year performance since 2005-06. Taking a longer-term perspective, total retail and food services sales (excluding autos and gas) are forecast to grow by an average of 4.1 percent per annum over the next decade.

While the macroeconomic environment is clearly supportive for the US consumer and retail sector, how will these sales be shared between brick and mortar retailers and e-commerce?

Physical versus online

E-commerce has experienced rapid growth since the 2008-09 recession, having grown at an average annual rate of 15 percent over the past eight years, according to Census Bureau data. The e-commerce share of total retail sales has more than doubled from 4 percent in 2009 to 8.9 percent in 2017. Total e-commerce sales are likely to rise from 8.9 percent of total retail sales in 2017 to around 15 percent by 2027.

We estimate that ongoing strong e-commerce growth in electronics and appliance stores will lift the share of online sales to almost 50 per cent by 2027 in that sector alone. Online sales will also continue to post strong market share gains across sporting goods, hobby, musical instrument and book stores, where the online share will exceed 40 percent, and in furniture and home furnishings stores, where online sales will be a touch higher than 30 percent.

However, when incorporating these further growth assumptions for e-commerce penetration over the next decade, brick-and-mortar retail sales (including food services and excluding autos and gas) are forecast to expand by an average 3.4 percent per annum over the coming 10 years; just 70 basis points below the 4.1 percent growth expected for overall retail and food services sales (ex autos and gas) during this period.

Can the same conclusion be reached for super-regional and regional shopping malls that are more exposed to embattled department stores and apparel retailers? In our view, and with no change to the tenant mix, this would be likely.

Aim for the top grade

The mall sector is likely to experience deeper e-commerce penetration than the retail sector as a whole. But in malls, sticking with the status quo is a ‘fail’ grade anyway. It is widely acknowledged that A and B centers remain better positioned than weaker assets and, importantly, landlords that continue to invest in their properties and ensure their merchandizing mix is adapted to changing consumer needs will remain far more productive. Shopping malls must be dynamic parts of communities. ‘Do nothing’ centers will be further impacted by e-commerce, while those that evolve will fare better.

Much of the weakness in sales growth is concentrated in anchor department stores, where sales have been under pressure for the past decade due to the failure of these retailers to evolve to meet shifting consumer demands. Inline tenants have fared much better, benefitting from a nimbler evolution in their product offering. In many instances, inline tenants are attracting market share away from department stores, particularly in fast fashion (H&M for example).

With the performance of inline tenants a much more significant driver of mall operating income, the focus on total mall sales can be misleading as an indicator of mall health. Over the next decade, we expect growth in inline tenant sales to average 3 percent, around 1.2 percentage points above the total (A/B/C/D) mall average, which remains constrained by department stores further reducing their footprints.

A further headwind facing the sector is the oversupply of mall space. The US market is widely considered to have too much overall retail space relative to the size of its population. Reflecting this oversupply and shifting consumer trends, hundreds of lower quality malls and weaker non-mall retail such as power centers and big box retailers will be repurposed or closed over the coming decade.

Mall sector closures will be concentrated in C/D grade malls. These underperforming malls will struggle to maintain consumer relevance, particularly as they are facing a loss of anchors as major department stores reduce their presence. With high exposures to generic apparel and department store offerings, these malls are most susceptible to e-commerce. Underperforming trade areas and inadequate capital investment have also contributed to tired malls that have not kept up with modern consumer demands.

Reposition to succeed

Closures of underperforming malls will reduce supply and provide an opportunity for higher quality malls to gain market share. While some of the sales from the closed malls will be lost to e-commerce, a large portion will be gained by nearby A and B grade malls. Although C and D grade malls represent less than 5 percent of total asset value, they still account for slightly more than 10 percent of mall sales. This means that high-quality A and B grade malls can capture a substantial uplift from likely market consolidation.

3.4%

Forecasted average annual growth of inline sales from A/B malls in the next decade

Higher-quality malls should experience less leakage to e-commerce owing to their more internet-resistant tenant mix. Further repositioning away from department stores and apparel toward food and beverage stores, restaurants, medical services, fitness centres, residential, hotel, other commercial uses and experiential services will help cement these malls’ status as attractive consumer destinations.

Despite the state of transition currently facing the retail sector, the outlook for sales over the next decade is positive. This is supported by the bright macroeconomic environment underpinning a strong outlook for nominal personal consumption. Headwinds from the ongoing growth in e-commerce will continue to weigh on sales growth and mall performance will also be impacted by further department store consolidations. However, the effects will not be evenly shared. Lower-quality malls will bear the brunt of the adjustment, with higher-quality malls more resistant to e-commerce and less affected by the closure of anchor tenants.

In spite of the negative headlines around the sector’s challenges, it is important not to lose sight of the underlying drivers of mall sales growth. These remain positive, with inline sales for A and B malls forecast to grow at a healthy 3.4 percent average annual rate over the coming decade.

This article was sponsored by QIC Global Real Estate. It appeared in the Investing in Retail supplement to the July 2018 edition of PERE magazine.