Despite a spate of recent store closure announcements, industry experts say retail real estate isn't broken — but it is being remodeled, possibly furthering a convergence of real estate sectors.
Retail is one of the four pillars of the real estate investible universe, along with office, industrial and apartments. However, some of the once most-prized tenants for retail properties are in the midst of structural changes as consumers go online, leaving shopping center landlords searching for replacement tenants.
Macy's, J.C. Penney, CVS, The Limited, Wal-Mart, Sports Authority, Office Depot and Sears have all have announced store closures in recent months. Neiman Marcus Group Inc. in January withdrew its registration for an initial public offering after closing stores in 2016.
Observers predict more store closures are to come.
Equity real estate investors are not pulling out of retail in light of the store closures because the retail they own is performing well. But the store closures are changing the way investors view the sector, adding more risk to properties such as department store-anchored malls that had been viewed as safe investments, real estate managers say.
“Traditionally, the safer part of the retail universe was department store-anchored malls, now it will be one of the worst,” said Lee Menifee, Madison, N.J.-based managing director and head of Americas research of PGIM Real Estate, the real estate money management arm of Prudential Financial Inc.
“The right tenant used to be the department stores that drove traffic through the rest of your mall,” Mr. Menifee said. “Now the risk is that the weaker department stores are driving traffic away from malls.”
The way real estate managers underwrite or analyze retail investments is changing, too. In the past, investors underwrote retail by looking at the creditworthiness of the tenants.
“That's not the way to assess whether a retail center is a good investment or not,” Mr. Menifee said. “We don't know who the winners will be ... Whoever they are will want to be located in the best conceived, best-located centers.”
Instead, managers are looking at sales, location and traffic, he said.
Adding to the woes, rent growth in the retail sector is expected to remain sluggish in North America through 2019, according to LaSalle Investment Management, Chicago.
Some retail malls are going out of business, being turned into data centers and office parks while others are being transformed into mixed-use centers that offer apartments above a mix of national chains, boutique shops and service-related establishments such as gyms, restaurants and dry cleaners.
“The way to do re-tenanting is less like-for-like but taking an old space and making it good for a couple of restaurants or a movie theater,” Mr. Menifee said “Replacing a department store with an H&M, which is selling the same type of products, is version 1.0. Version 2.0 is converting mall space from just selling goods to providing services.”
The transformation of retail makes it one of the most challenging sectors, said Ronald M. Dickerman, president and founder of New York real estate manager Madison International Realty.
But there is opportunity in the changing retail landscape, he said.
Madison International Realty executives are bullish on grocery-anchored retail shopping centers, malls in main city locations and fortress malls, which have at least four anchors and sales of $600 to $700 per square foot, Mr. Dickerman said.
Grocery-anchored shopping centers have suffered less disruption from the internet and in an economic downturn, people eat out less, making grocery stores more attractive, he said.
These refurbished centers represent a convergence of real estate sectors and real estate returns, said Jacques Gordon, LaSalle's global head of research and strategy.
Property types are converging in two ways. The first is that over the past five years, returns of the property types are more similar — less than 500 basis points of difference across the core four property types, from a typical spread in the past of 500 basis points to 1,000 basis points.
The second way is that some of the largest malls are adding residential, hotels and offices or workplaces, Mr. Gordon said.
“This move to a broader mix of uses may make it a little harder to classify some of the returns in neat categories like "office, retail, residential, warehouse' that we have been using for years,” he said.
Despite these headwinds, retail is one of the highest-performing sectors in the NCREIF National Property index, according to the National Council of Real Estate Investment Fiduciaries, a Chicago-based trade association. Retail real estate earned 2% in the third quarter, the second-highest return of any sector in the NCREIF NPI behind industrial's 2.9% for the quarter. In comparison, apartments returned 1.7%; hotels, 1.4%; and offices, 1.3%.
Lack of new retail
Lack of new retail being built is one of the reasons for the sector's performance. “Much of the new supply has been well-conceived multiuse centers,” Mr. Menifee said.
However, most investors are enjoying only half of retail's positive returns reflected in the NCREIF NPI because the vast majority of the highest-performing retail properties are in REIT portfolios, Mr. Gordon said.
Most asset owners' real estate exposure is in private real estate funds rather than in real estate investment trusts. Investors mainly have exposure to the cream of the retail crop through their managers' joint ventures with REITs, industry executives say.
“Investors do not appear to be shifting out of retail into other sectors,” Mr. Menifee said.
“You would assume with the stories about how bad it is for retail and how great it is for industrial/logistics that (the weightings) would change,” he said. “That may still be to come but we haven't seen the rotational shift in the index that you would expect to see.”
Retail's share of the NCREIF NPI has been unchanged at 23% to 24% over the past two years; industrial/ logistics remained around 13% to 14%.
Meanwhile, while the short-term view for the warehouse/logistics sector has been very, very good, there is no proof that will continue, Mr. Menifee said.
It is not difficult to build warehouses/logistics facilities but it is more difficult to build a new mall. There's a bigger barrier to entry with malls making them a more attractive investment, he said.
However, investors that are aiming at retail real estate are looking to invest in fixer-uppers, to gain from the changes in retail.
New Mexico State Investment Council, Santa Fe, Ohio Police & Fire Pension Fund and Los Angeles City Employees' Retirement System have all invested with value-add manager Asana Partners over the past five months, aiming to take advantage of tactical investment opportunities in the retail sector.
Fund officials either could not be reached for comment or declined comment.
What's more, there is a wide gap between winners and losers in the retail sector.
“Some retailers are stronger than others,” said Lea Overby, managing director of research, structured finance, Morningstar Credit Ratings LLC. “Those retailers managed their debt load more (and are stronger) ... and this applies to property owners too.”
While there has always been a bifurcation in the retail sector, the divide between the top malls and the rest is wider than ever, industry insiders say.
The best performing malls are better able to turn a store closure into a benefit because they will be better able to attract new tenants, Ms. Overby said.
“There's a divergence between assets doing pretty well and assets not doing well,” PGIM Real Estate's Mr. Menifee said. “That's always been true in retail but we're in a time where that contrast between a lot of assets doing perfectly fine or more than fine and some assets really doing poorly is much greater ... and we expect that to continue.”
This article originally appeared in the January 23, 2017 print issue as, "Store closures changing way investors view retail sector".