Managers still sold on retail and hope they pick winners

Real estate managers are still investing in retail as the sector goes through massive changes, hoping they have correctly predicted where the sector will be in the future.

Among recent developments:

• Alternative investment firm Rhone Capital LLC, together with office-sharing firm WeWork Co. and global retailer Hudson's Bay Co., on Oct. 24 announced an $850 million deal to buy Lord & Taylor's flagship store in New York, reducing the retail space to about a quarter of its current size and turning the rest into WeWork's New York headquarters and office space;
• Brisbane-based money manager QIC on Oct. 2 acquired the approximately 50% interest it didn't already own in a $3.2 billion portfolio of 10 U.S. malls from its joint venture partner Forest City Realty Trust Inc., a real estate investment trust; and
• TH Real Estate, Nuveen's real estate investment management affiliate, in 2016 closed a $1.25 billion fund to invest in super-regional malls in the U.S.

Retail's woes were aggravated by the advent of e-commerce, which is forcing managers to redesign their malls and add sought-after tenants to make up for falling rents and returns for some retail properties.

"Part of being successful is that you are counterintuitive from the pack and invest when everyone else is singing from the rooftops to get out of retail," said Damien Frawley, CEO of QIC. Mr. Frawley said the deal with QIC's existing joint venture partner is a "great opportunity" to expand its investment in U.S. regional malls.

"E-commerce won't kill retail," Mr. Frawley said. "Retail today is an omni-channel that blends brick and mortar with an online presence."

But retail won't be the same as it was for the past 50 years. Regional malls now need a mix of tenants, such as restaurants and specialty stores. Instead, traffic-drawing stores from Apple Inc. and Tesla Inc. are more highly prized. Even traditional retailers, such as department stores, are drastically reducing the size of their stores.

Like other managers investing today in retail, QIC executives are selective.

QIC's strategy is to stick with regional malls; it does not invest in strip or inner-city retail, Mr. Frawley said.

Some managers see retail as an opportunistic investment.

Soma Capital Partners, a San Francisco special situations real estate manager, in June acquired Blue Oaks Marketplace in Rocklin, Calif., for $19.2 million in partnership with Timbercreek Asset Management, Toronto. The 100,000-square-foot, Class A shopping center sits in a prominent Sacramento retail node with surrounding median incomes of more than $120,000. Soma Capital Partners bought the property from its developer, Sacramento-based Diamond Creek Properties.

The shopping center was built in 2004 for roughly $32 million for a large grocer. But over time, the grocer has trimmed its space by roughly half, said Jordan Caspari, partner at Soma Capital Partners. That ​ empty space is now being filled by smaller boutiques and restaurants.

Grocery-anchored malls used to be the gold standard in retail properties, but no more. "It's a function of online retail, and across the industry retail space has been shrinking," Mr. Caspari said. Larger, traditional grocers will be challenged, he added.

Smaller specialty grocers such as Aldi, Sprouts, Farmers Market Inc. and New Seasons Market are faring better because of consumer demand for prepared foods, Mr. Caspari said.

Amazon.com Inc.'s acquisition of specialty grocer Whole Foods Market Inc. "will change things quite a bit," he said. "Amazon is a marketing juggernaut. People will still go the store to buy their own produce and prepared foods as well. Nobody knows how Amazon will integrate Whole Foods … we won't see for six to 12 months."

Anton Pil, managing partner of J.P. Morgan Asset Management's global alternatives business, said he will be among those watching what Amazon will do. "It's not so obvious that online only is the road to success," Mr. Pil said. "The grocery space is still evolving. It's not just Amazon. There are new players from Europe. I don't think that story has been quite written."

Mr. Pil is more worried about other sectors of real estate, such as self-storage and hotels. "In many ways, we could disrupt self-storage using online technology that is not far-fetched," Mr. Pil said. And hotels are being disrupted by Airbnb and other temporary-stay places cutting into their business, he added.

Real estate credit managers are still lending to retail properties, despite the massive changes in the sector, but they are being selective.

"We are still lending as long as the tenants' businesses are performing," said Felix M. Gutnikov, executive vice president of origination at lender Thorofare Capital Inc. The firm specializes in short-term bridge loans.

"Two or three years ago, grocery-anchored was the darling of CMBS lenders. Everybody needed to shop for groceries," Mr. Gutnikov said. "I first heard of the change not from mall owners or mortgage brokers but from B-piece buyers specializing in CMBS pools."

The change was due to the consolidation among grocers and the impact of European grocers such as Aldi, which have smaller stores than traditional U.S. grocers.

Mr. Gutnikov does not think Amazon's purchase of Whole Foods on its own is a game changer. "For the majority of the U.S., it will not drive the business," he said. "Whole Foods' market share is approximately less than 1.2%, Amazon's share (of grocery business) is 0.2% but Walmart's market share is 15%."

Overall, the retail sector is here to stay "if it is managed well," Mr. Gutnikov added. "We're still very actively lending."

Indeed, retail still makes up a sizable portion of managers and investors' portfolios. The retail sector accounts for the third-largest share of real estate managers' assets, some 18% as of June 30, according to the results of Pensions & Investments' latest real estate money manager survey.

News of mall closures — including a Credit Suisse Group AG report in June predicting up to 25% of malls will be shuttered by 2022 — are prompting investors to ask their managers and consultants to quantify their portfolio exposure to retail, said Bradley Baker, managing director and chairman of the real asset research committee in the Pittsburgh office of Wilshire Consulting, the investment consulting and outsourced CIO business of Wilshire Associates.

Some 20% of investors' real estate portfolios are invested in retail, he said. Some investors are spending additional capital in the industrial sector to take advantage of the swing toward e-commerce; Wilshire is recommending investors retain their long-term diversification among the various real estate sectors.

Some 22% of the California Public Employees' Retirement System's $31.8 billion real estate portfolio was invested in the retail sector as of March 31, the highest percentage in any one sector. (CalPERS plans to release its latest numbers Nov. 6.)

Executives at the $340.6 billion Sacramento-based fund are continuing to invest in retail, said Megan White, spokeswoman, in an email. "Generally speaking, we invest in existing, leased-up shopping centers," she said.

About 9% of the Santa Fe-based New Mexico State Investment Council's $22.7 billion in assets is invested in real estate, and 17.4% of that is in retail, said Robert "Vince'' Smith, chief investment officer.

Much of New Mexico State Investment Council's retail exposure is part of core real estate funds, said Paul Chapman, the council's director of real estate.

The council is continuing to invest in retail investments that could be protected from weakness in the retail sector, he said. For example, council executives invested with Asana Partners, which invests in retail in residential areas where people can walk to shop, eat and get a hair cut, Mr. Chapman said.

The council would consider investing in similar walkable retail strategies in Europe and the Western U.S., he added.