The retail real estate sector has faced a considerable number of challenges since the recession and the rise of online purchasing. While certain areas of the sector have not survived in their traditional form (think malls and big-box stores), instead of completely disappearing they have been forced to reinvent themselves in order to provide customers with what they need and crave: services, dining options, entertainment and experiences.
Some areas of retail real estate have become especially healthy and desirable to investors. According to Marcus & Millichap’s 2017 Retail Investment Forecast, despite head-lines highlighting the demise of several high-profile retailers, local retail centers and net-leased properties continue to post gains. National retail vacancy rates will hit their lowest level in 16 years, bolstering rent growth and investor interest. Elevated uncertainty surrounding proposed tax reform, interest rates and other headwinds will persist, but eventual policy clarity should reduce uncertainty and spur increased transactions.
Adding to the level of uncertainty has been consolidation. In February, Cushman & Wakefield reported that Burger King’s parent, Restaurant Brands International, is buying Popeye’s for $1.8 billion; the much-anticipated Walgreens/Rite-Aid merger still hangs in the balance at press time; and a variety of other mergers and acquisitions, such as Samsonite acquiring eBags, are being announced daily.
One thing on which the experts agree: retail is not standing still. But some see the glass as half full and others as half empty. “I characterize today’s real estate market as quite fragmentized,” says Lindsay Parton, president of retail development firm DJM Capital Partners. “It’s certainly a tenant’s market, not a landlord’s market like five years ago. Everyone seems to be downsizing, and the larger-format big boxes are either closing up shop or trying to find ways to get rid of space. In general, it’s a varied market with everyone still trying to find their footing.”
Nate Cadieux, president of real estate for Moniker Group Inc., developer of San Diego-based multipurpose retail store Moniker General as well as other properties under the Moniker brand, characterizes the retail sector as evolving. “The Internet is causing retail to change, but retail is not at war with e-commerce. Rather, e-commerce is forcing developers and retailers to focus on the irreplaceable strength of brick-and-mortar real estate: human connection. Retail developers are now fostering environments that create connection through spaces and concepts that engage guests to interact and experience something special.”
But all retail types are not equal. When analyzing current conditions, Jeff Edison, CEO of Phillips Edison & Co., a grocery-focused owner and developer, relates, “it’s important to segment out mall, power and grocery-anchored shopping centers. Grocery-anchored centers, which Phillips Edison continues to focus on, continue to have strong fundamental and strong operating results. Our retailers are less impacted by the Internet than the mall segment.”
While online retailing has been a disrupter for brick-and-mortar stores, digital sales still only make up a small percentage of total retail sales—although this number is growing. Patrick Ward, founder of MetroGroup Realty Finance, says that total online sales are increasing annually at approximately 17%. However, “94% of retail sales remain in-store, and now we are starting to see online retailers open physical locations across the country. Amazon Fresh food is anticipated to open approximately 2,000 brick-and-mortar stores over the course of the next 10 years.”
Ward says these physical stores are complementing the retailers’ online models, “which we believe will result in the continued growth” of online retailers opening physical locations. These stores “provide a missing component for online retailers by offering an ease of returns for consumers.” He cites a recent study by JLL that found 40% of Millennials are more likely to buy online if they know they can make a return in-store, 60% of overall retail purchasers prefer to make returns in a physical store, and 70% of respondents would likely make additional purchases while returning items at a physical store.
These statistics mean that retail real estate will continue to be in demand for years to come, yet the space requirements for retailers are evolving, says Ward. “As more retailers—both pure-play online and traditional retailers—adopt an omni-channel approach, we will continue to see the size and types of storefronts change focus.”
According to Westwood Financial’s co-CEO Joe Dykstra, only 3.5% of all US retail sales are completed by pure-play online retailers. “There is an enormous cost associated within online returns and consumers prefer to make returns in-store. This is why we are starting to see these once-purely online retailers incorporate storefronts and take an omni-channel approach.”
If you look purely at the numbers, brick-and-mortar retail is alive and well. To paint the overall landscape based on what’s going on with national, mall-based brands such as Sears, JCPenneys and Macy’s is not an accurate depiction of the state of the retail market, stresses Randy Banchik, co-CEO of Westwood Financial. “These retailers are suffering as a result of poor business practices, not the rise of e-commerce or a down-turn of brick-and-mortar retail,” he says. “If you look at the TJ Maxxes and Marshalls of the world, they’re performing extremely well in centers across the country because they meet more current shopping patterns and are typically located in centers in highly dense areas surrounded by strong demographics. These centers are will continue to thrive for years to come.”
Faced with mounting pressures from e-commerce and the changing demands of today’s consumers, many retail owners are working to reposition or develop centers into destination-driven environments that are comfortable and conducive to shopping, yet deliver the ultimate experience to guests, Julie Brinkerhoff-Jacobs, president of landscaping form Lifescapes International, relates, “Consumers today are seeking multi-sensory experiences that cannot be replicated through online channels. The growing demand for these enriching experiences is driving this shift toward creating destination centers where people can eat, shop and socialize all in one place.”
As such, public spaces have emerged as the new anchor at retail centers and mixed-use developments across the nation, she adds, many of which have public ‘central park’ areas for retail owners to host concerts, movies and other interactive events. “These areas help to establish the experience-driven and community-building environments that shoppers are demanding, as well as keep customers at the center longer so they spend more money on products and services.”
The retail sector’s need to adapt significantly to consumer preferences and out-side influences has resulted in a significant shift in the types and sizes of retailers that occupy a center today, points out Howard Wong, managing director of retail for Passco Cos. “We’re seeing a growth among independent and regional retailers, as well as a shift in the overall size and the experience of a store. National creditworthy ten-ants who traditionally would have dominated a retail center are right-sizing their locations and closing a number of stores throughout the country, which has opened up a significant amount of space to local, regional and independent retailers.”
These independent retailers are also becoming more sophisticated and savvy in their approach. “They recognize consumers are demanding niche concepts and unique experiences and delivering these types of environments two-fold,” says Wong. “We anticipate more integration of diverse and unique tenants into the centers, including fast-casual dining options and food halls, fitness centers and yoga studios and specialty medical users.”
In this cycle, footprints for the majority of retailers selling durable goods—clothes, electronics and books—have shrunk, notes Philip Voorhees, an EVP with CBRE. “In many cases, traditional ‘box’ retailers like Sears and Kmart (150 recent closings), JCPenney (138 closings just announced) and Walmart (250-plus stores in 2016) are closing stores, and in some cases like Sports Authority, are ceasing operations entirely. Small retailers, even value-focused ones like RadioShack and Payless ShoeSource, are also calling it quits, as are ‘mall tenants’ from Aeropostale and Abercrombie & Fitch to The Limited and Wet Seal. In January, Macy’s announced plans to close an additional 68 stores, almost 10% of its total store count. The head-spinning pace of store closures shows no signs of stopping.”
But the news is not all bad, says Voorhees. The retail-development pipeline remains at a fraction of the peak levels of 2005 to 2007, and consequently, rents (and NOI) are growing fast as the market tightens.”
He adds that REITs are a great proxy for what’s happening in the retail market. “For example, Brixmor and Kimco report better than a 35% increase in rents for new tenants over prior tenants in Q4 2016, with 12% and 7% rental increase for renewal tenants during the same period. This is sensational and demonstrates that the existing retail inventory, particularly in primary, coastal or gateway markets, will become scarcer and correspondingly, more valuable. We are seeing this already with REITs, pension fund advisors and institutional investors who are reticent to sell better assets with limited prospects for replacing these properties. To an extent, CBRE expects this tightening of the market will offset anticipated store closures and bankruptcies of retailers unable to adapt to the new retail landscape.”
According to Bill Asher, EVP of Hanley Investment Group, rising interest rates are at the top of everyone’s mind and continue to have a direct impact on investors’ purchasing decisions. “Interest rates have increased approximately 50 to 75 basis points since November 1, 2016. After a quarter-point rate hike on March 15, the Fed has indicated two more rate hikes in 2017, with prospectively three more increases in 2018.”
With that said, the single-tenant investment market remains hot and pricing is stable, Asher says. “The largest pool of buyers still exists in this category and newly built assets leased to national credits ten-ants on long-term leases are still producing record pricing for sellers as buyers continue to pay premium yields in the 4% range unleveraged and even most recently sub-4% (specifically in major MSAs nation-ally) for tenants such as McDonald’s, Chick-fil-A and Starbucks. This category will be the last to adjust since most buyers are acquiring assets all-cash with no debt.”
Larger multi-tenant shopping centers priced $5 million and up have started to change, with noticeable price adjustments in the market in early January, Asher adds. “The most dramatic difference early on in 2017, compared to the third and fourth quarters of 2016, is the overall renewed activity from investors in the market nation-wide. The ‘wait and see’ attitude leading up to last year’s election has now passed, and investor activity has at least doubled” by comparison to six to 12 months ago.
Many investors expected a more robust number of retail assets to hit the market in early 2017, says Asher. But feedback to date from buyers in the market this year, whether a small private investor or a REIT, is the lack of available class-A investments located in dense infill locations. “Investors may have to consider stretching their acquisition criteria outside of their com-fort zone this year, otherwise, they may find themselves on the sidelines.”
In addition to determining which retail uses and brands will remain sustainable, the retail property market is also redefining the way we use retail-shopping-center land and buildings, observes Nicholas Coo, senior managing director of Faris Lee Investments. “The market is redefining the ‘highest and best’ use within retail properties at the regional-mall and community-shopping-center levels. In certain cases, other product types are working their way back into what were historically shopping center sites—in the form of residential, medical or office uses and, even light industrial.”
When it comes to core retail centers in prime, promotional-style locations that feature experiential elements, it is safe to say that they will be sustainable for the long-term; however, Coo says he believes that as online shopping and consumers’ tastes change, there are many retail centers that are no longer a fit for the local community. “Simply stated, some retail is broken, and it is broken for a reason. Those assets will need to be scrutinized in a much different way from not only a tenant-mix or repositioning perspective, but one step beyond that into an adaptive-reuse scenario.”
In today’s challenging retail environment, the sector remains highly fluid and ultra-competitive, says Glenn Rudy, senior managing director for NGKF Retail Capital Markets, West. “Whether it be in leasing or investment, there continues to be a flight to quality. In the investment arena, core product, true value-add and/or ‘cash cow’ opportunities are still experiencing staggering valuations and com-petition due to the sheer abundance of capital in each sector and relatively limited supply of opportunities in these sectors. Everything in between is a bit stagnant with low bid support and extremely discerning investors who are slow to engage as most await the interest-rate environment to arrive to a new norm and any further retailer fallout or contraction that may be on the horizon.”
Keith Kropfl, a principal with Avison Young, says although the retail sector is constantly evolving, “we are we are starting to see more of a shake-up than ever before. I work with large owners and national ten-ants on a daily basis, and there is concern and uncertainty for them with the amount of big and small retailers filing for bankruptcy and closing their doors. However, there is also an opportunity to create new value in strategic ways that are a better fit with consumer needs and demands.”
Additionally, Kropfl says he is seeing new boutique/specialty retailers emerge and the restaurant sector growing with new chef-driven concepts. “All this is part of a new consumer economy, which is driven primarily by the Millennial demographic that has overtaken the Baby Boomers as the largest living generation in America.”
Retail owners need to have a keen eye on what consumers will leave their computers or, the experts say. “We think specialty-type retail is what is in vogue,” says DJM’s Parton. “We see many different food concepts that are driving lots of other retail concepts, and that’s really where the best prospects are—that along with certain types of smaller- format specialty soft-good operators.”
Cadieux, of Moniker, says the biggest opportunity he sees for the retail sector is “art”—and this is not defined by painting on a canvas or molding clay. “Art is any-thing created by someone who specializes their craft and offers it to the world in a way that represents them as individuals. These products are what people want to buy: the story, the care, the risk from the artist to offer something special and unique. It’s brands that are creating products with a story—products that are hand-made and made in America. It’s these stories, these craftsmen, that customers are supporting when they choose to purchase those goods.”
Edison says in-line stores with a necessity-based focus continue to show positive results in the current economy. He adds that muted new development bodes well for the grocery-anchored business.
In addition to central gathering areas for events, as well as “mini-destinations” throughout a retail property, food will continue to be a major attraction and a huge draw for retail owners, says Brinkerhoff-Jacobs. She adds that the trend toward mixed use will continue to evolve.
Regardless of e-commerce, some things simply can’t be gotten online, says Westwood’s Dykstra. “People want to see what they are buying, they want to socialize with friends and family, and they want places where they can create lasting experiences. Retail centers that deliver these types of environments and focus on necessity retail will be in demand for years to come.”