Yardi on the stubborn resilience of US retail

This article was sponsored by Yardi. It appeared in PERE’s Retail Report supplement alongside its July/August 2019 issue.

“Online shopping officially overtakes brick-and-mortar retail for the first time ever.” That eyebrow-raising headline appeared briefly on CNBC’s website on April 2, although it was later amended. But the fact that it initially seemed plausible is a sign of the perceptions swirling around the retail sector and retail real estate.

Retail presents the most complex and even contradictory currents of all the major commercial real estate asset categories. In no small part, this complexity stems from the diversity of a sector that encompasses properties ranging in size from 1,000-square-foot quick-service restaurants to million-square-foot regional malls, and everything in between. So attempting to paint the entire asset class with a single broad brush is a perilous exercise, yet one trend is clear – faced with a full menu of challenges and despite the eagerness in some quarters to write an epitaph for brick-and-mortar retail, the asset category is proving to be stubbornly resilient.

Retail operators are investing in bold redevelopment programs and exploring new technology while healthcare providers, co-working spaces and other non-traditional retail tenants are discovering attractive locations at retail centers, backfilling vacant space and helping drive foot traffic to fellow retail tenants.

Certainly, investors started 2019 with a cautious approach to retail property assets. The pool of big-ticket buyers is dwindling and institutional investor acquisitions dipped 7.8 percent during the first quarter, according to JLL estimates in May. One notable exception was the best first quarter for power center deals since 2016, the result of a 30.4 percent year-over-year surge in volume. In another major shift, institutional investors are also turning their attention from large portfolios to deals under $100 million. Despite store closures and competition from online sales, vacancy is holding steady at 3.6 percent for malls and 4.4 percent overall, according to JLL data. While absorption was down 61.9 percent, the decline was offset by a 24 percent drop in new retail space, JLL reported.

Multi-tenant vacancy is also on track to decline in 2019, with net store openings outnumbering store closures, according to Marcus & Millichap. In contrast to the overbuilding characteristic of the period leading up to the Great Recession, developers have kept supply in check by maintaining discipline; just 10 markets will account for half of new product completions this year. Secondary and tertiary markets may be attractive to investors looking for yield as a limited supply of new retail inventory in those locations is fueling demand, creating opportunities to buy assets at a relatively low cost of capital and with higher potential returns, according to Marcus & Millichap. Successful investors, owners and retailers will continue to embrace and understand the “five Fs of retail” that are now thriving: food, fitness, fashion, furniture and fun.

The backdrop to the retail investment picture is an economy that continues to hum along on the strength of low unemployment, consumer confidence and rising wages. The National Retail Federation estimates that US retail sales will rise from $3.68 trillion in 2018 to $3.9 trillion this year. That is helping maintain momentum in the face of events that would have stalled the retail sector in a weaker economy: a 0.08 percent drop in consumer spending last December; the 35-day partial shutdown of the federal government, which took an $11 billion toll on the economy; and extreme weather, particularly in the nation’s heartland, that combined with a soft housing market to hamper sales of home-related products such as furniture, appliances and building materials.

Multichannel trends

No aspect of the retail sector calls for more careful analysis than the interaction of online and brick-and-mortar channels. If you judged the retail sector exclusively by media headlines, one might conclude that online sales account for the majority of consumer retail spending. The convenience of online shopping has undoubtedly contributed to hard times for well-known brick-and-mortar brands specializing in products like apparel and consumer electronics, yet sophisticated retailers, whether native online or brick-and-mortar, are embracing the value of multichannel marketing. Online sales continue to take a growing share of the retail market, yet represent just 10 percent of actual retail sales. And in a consequential trend for property operators, native online retailers continue to expand to brick-and-mortar formats, creating a steady, if relatively modest, demand for space. Nearly all of the top 50 online retailers now maintain physical stores.

The brick-and-mortar ambitions of Amazon, which accounts for almost half of US e-commerce sales, underscore the point. According to a March report in the Wall Street Journal, the company is eyeing plans for an empire of some 2,000 Amazon-branded grocery stores. Presumably those properties would complement, rather than compete with, the 500-store Whole Foods chain acquired by Amazon for $13.7 billion in 2017. The first store would open this fall in Los Angeles, followed by stores in Chicago, Philadelphia, San Francisco, Seattle and Washington, DC, the Journal reported.

Absent details, the impact of Amazon’s rumored intentions to expand its grocery-market footprint are nearly impossible to assess. Nevertheless, a long-term rollout on that scale would likely affect the dynamics of fundamentals of grocery-anchored centers. As the early post-recession years demonstrated, properties anchored by necessity retail, like grocery stores, provide stability and reliable returns through economic fluctuations.

The continued waves of large-scale store closings unquestionably pose challenges to operators and concerns for investors. As of early June, retailers had announced plans to close 7,222 stores and open 2,796, according to Coresight Research. Announced closings could reach 12,000 this year, the firm estimates. By contrast, Coresight tracked 5,864 closures and 3,239 openings for all of 2018. Leading this year’s list of downsized or disappearing brands are Payless Shoes (2,500 store closings), Gymboree (805) and Dress Barn (650). The closings are variously attributable to online competition, excessive debt assumed during leveraged buyouts and the failure of retailers’ leadership to keep up with the times.

What tends to get overlooked is the other side of the equation. The National Retail Federation’s annual survey found 54 percent of retailers plan to open new stores in 2019, while 57 percent expect to end the year with about the same number of stores they started with. Retail saturation is also a consideration for investors, developers and retailers themselves. It is a truism that the US has too many brick-and-mortar stores; Daniel Hurwitz, CEO of Raider Hill Advisors and 2019-20 chairman of the International Council of Shopping Centers, has quipped, “We’re not over-retailed – we’re under-demolished.”

While Hurwitz has a point, distinctions among markets suggest opportunities as well as cautionary notes. To pinpoint the most and least over-retailed metropolitan areas, Reis, the real estate data and analytics company, compared retail employment to population on a market-by-market basis. Topping the over-retailed list: Orlando, Lexington, Jacksonville, Fort Lauderdale and Knoxville. Ranking as the five least over-retailed markets are Tucson, Providence, San Bernardino/Riverside, New Haven and Washington, DC. Rent appreciation appears to track saturation levels, with over-retailed markets demonstrating considerably slower price growth than their less over-retailed counterparts. One perhaps surprising conclusion of Reis’ assessment is that saturation may be less troublesome than expected, in part because unconventional tenants like urgent care facilities and yoga studios often absorb vacant retail space.

Consolidation with a caveat

As property owners grapple to adapt to change at ground level, realignment continues at the corporate level. Last year, Brookfield Asset Management completed a pair of blockbuster deals: the $27.2 billion acquisition of GGP and the $11.4 billion purchase of Forest City Realty Trust. Multiple retail property operators, whether strong or struggling, could well be courted successfully; in its 2019 Real Estate M&A Outlook, Deloitte projects further consolidation, led by the retail and lodging sectors. One caveat, Deloitte adds, is that all real estate categories, including retail, are likely to experience one or more market disruptions that could influence the volume and value of M&A activity.

Retail REITs continue to enjoy record-breaking fundamentals, with REIT-owned retail properties reaching 95.43 percent occupancy, the highest on record since tracking began in the first quarter of 2000, according to NAREIT.

Even as some regional malls have sputtered, and often shuttered space, owners continue experimenting with new combinations of services. At The Mall at Short Hills, an upscale property in Short Hills, New Jersey, Taubman will introduce a co-working space in a 30,000-square-foot outpost previously occupied by Saks Fifth Avenue. Macerich is similarly partnering with Industrious, a New York City-based provider of flexible office space, to open co-working space at the REIT’s properties. Debuting in January 2019 at Scottsdale Fashion Plaza in Scottsdale, Arizona, the program’s forthcoming locations will include Macerich’s Broadway Plaza in Walnut Creek, California. A study by Colliers International cites co-working as a potential driver of foot traffic at retail properties: “More than two-thirds of people say that a co-working space located in a mall would encourage them to visit shops more often; for restaurants, the figure is 73 percent.”

Venerable retailers are freshening up their approaches as well. Since October 2017, Nordstrom has unveiled three small locations in upscale Los Angeles submarkets. Conventional apparel inventory is conspicuously absent from the stores, which are branded as Nordstrom Local. Instead, each store aims to build customer loyalty by offering services such as alterations, styling and pick-up of online orders. The retailer reports Nordstrom Local patrons tend to be younger, shop more often and spend more than customers who do not visit these stores.

This fall, Nordstrom will bring the concept to Manhattan’s Upper East Side and West Village, around the same time as a 320,000 square foot flagship store opens in Midtown Manhattan.

Another retailer defying traditional retail logic is Rent the Runway, which has opened a new 8,300 square foot flagship in San Francisco’s Union Square. Instead of selling product directly, Rent the Runway features a self-service counter, 3,000 curated merchandise items, event space, co-working space, a beauty bar and 20 dressing rooms.

Retail real estate investment in the US presents investors with a constantly changing set of variables. For investors in search of yield, unconventional but promising metros deserve a close look. So do the retailers and operators dedicated to innovative technology, tenant line-ups and property configuration. Some industry veterans speculate that the future of larger retail properties is mixed use. Not all experiments will succeed, but the future favors operators and retailers willing to make bold choices.