Retail is quickly losing its luster among investors

Investors' distaste for retail real estate, heightened by the pandemic, may not be enough to eliminate it as one of real estate's four food groups for institutional investing, but it might become more of a substantial side dish than a main course.

COVID-19 and the ensuing recession are accelerating trends that are changing the makeup of most of the traditional real estate sectors and beefing up niche asset types, such as digital, that now are considered as only appetizers. In retail, grocery-anchored centers are expected to endure, while a greater number of malls are likely to be converted into multiuse properties with department store spaces turned into distribution centers or apartment complexes, industry executives say.

"They say when you are underwriting office, you are underwriting human behavior. It's the same for retail," said Pamela Boneham, Chicago-based managing director and head of capital strategies at Barings. "What will thrive and survive are grocery-anchored retail."

Barings manages $46 billion of real estate debt and equity. It manages retail real estate assets in excess of $1.2 billion.

Retail returns were the second lowest behind hospitality in the first quarter. According to the results of National Council of Real Estate Investment Fiduciaries' Property Index released in April, retail real estate returned -2.06% for the quarter ended March 31, down from 0.05% in the prior quarter. Retail's one-year return ended March 31 was -1.9%.

Institutional investors' actual allocations to retail real estate have been declining while industrial assets have been increasing over the past few years, said Greg MacKinnon, director of research at the Pension Real Estate Association, a global trade organization. The pandemic is accelerating the drop in retail properties in the U.S., he said.

"The retail sector was already facing pretty significant challenges, and those have grown and been exacerbated as a result of COVID," said W. Todd Henderson, head of real estate for the Americas at DWS Group. "Grocery-anchored performance is better but service-orientated tenants without big balance sheets are facing pretty significant challenges and there's a concern over their viability long term."DWS' real estate AUM is $71.3 billion as of March 31.

As of January, retail accounted for 20.8% of all investor portfolios and 16% of North American portfolios, down from 24% and 20.9%, respectively, a year earlier, according to the annual Investment Intentions Survey conducted jointly by PREA; INREV, the European real estate association; and ANREV, the Asia-Pacific real estate association.

Some 10.3% of global and 17.6% of North American real estate portfolios were in industrial in January, compared with 10.3% of global and 13.1% North American at the same time in 2019, survey results show.

Retail was the second-largest sector for global investors and the third-largest for North American investors in January. The largest sector was office, with 35.4% for global investors and 26.6% for North America. Multifamily accounted for 19.1% of all investor portfolios and 21.2% of North American portfolios in January.

"I think you will see that trend (the move away from retail) accelerated somewhat by the pandemic," Mr. MacKinnon said. "But, even with average allocations to retail drifting down, it is still a major sector for institutional investment and shows no signs of disappearing altogether from institutional portfolios going forward even if the cycle is working against it at the moment."

"Retail is out of favor at the moment and the U.S. is highly over-retailed in terms of square feet per capita compared to other countries, so there will be a reckoning of some type" that will include properties being repriced, he said.

Post-COVID, more retail properties such as malls will be transformed into assets in which retail is combined with residential, office, entertainment, social uses and possibly light logistics — places for people to receive packages and for businesses to accept returns in one location, Mr. MacKinnon said.

That process already has begun but will ramp up when the world starts to look normal again from a health perspective, he said.

Retail that remains will be very different than what investors currently think of as retail properties, he said. Investors may once again be interested in the retail sector to take advantage of opportunities, especially in converting malls and other retail properties to other uses. Meanwhile, real estate managers are continuing to underweight retail.

Todd Everett, New York-based CEO for Principal Real Estate Investors, said his firm has underweighted retail "for quite some time" with minimal exposure to malls and power centers, which are large outdoor malls that usually include a few very large department stores.

The majority of the properties in Principal Real Estate Investors' portfolios are grocery-anchored, which have outperformed the rest of the sector over the last few years, Mr. Everett said.

Principal executives would still consider investing in retail, but prices would have to drop first, he said. Principal Real Estate Investors had $78.9 billion in total assets under management as of March 31; retail real estate assets are not broken out.

They expect the retail market to hold up much better in Europe, because the average square meter of retail space per capita is so much smaller than it is in the U.S., Mr. Everett said.

Some high-end grocers are expected to follow a trend that started in Europe with a distribution center for their pickup of online orders located at a walk-in store so consumers can choose their own produce and other perishables, Barings' Ms. Boneham said.

Heading into the COVID-19 crisis and recession, DWS Group also had already reduced its retail and office exposures as it positioned its portfolio defensively, said DWS Group's Mr. Henderson said. The gyms, restaurants and entertainment businesses that landlords had been courting the most before the recession are the most affected by the COVID crisis and it could take a few more years before they return to normal operations, he said.

"There's a discussion whether retail will remain an institutional asset class in real estate. I think it's too early to tell," Mr. Henderson said. ''It's a little reactionary to say retail will fall out and that grocery-anchored retail, in particular, will no longer be institutional."

In any case, not many retail properties are expected to sell over the next 12 months given the uncertainty, he said. "There will likely be a shake-out of the retail sector."

However, it will take time for retailers to repair balance sheets impaired by the COVID crisis and for new businesses to take the place of those that do not survive, he said.

"Necessity-based centers will emerge through this crisis and will continue to be an institutional asset class," Mr. Henderson said. ''Other parts of retail may not."