Is Retail Real Estate a Good Investment in 2024?
Wellings Capital and its affiliates have invested in commercial real estate, including mobile home parks and self-storage, for years. Last year, we added a small number of open-air shopping centers, and we've invested in a few more this year. This asset type provides meaningful risk-adjusted returns for investors in two of our funds. This article explores our thoughts on this broad topic.
As a fund manager focused on historically recession-resistant asset types, we have invested in mobile home parks, RV parks, self-storage, and more. When a trusted industry contact recommended we look into retail for our funds, we were a bit repulsed!
What about the Amazon Effect?
And the so-called Retail Apocalypse we have been hearing about on the news?
What about the former malls converted to self-storage, data centers, and haunted houses?
I was skeptical, but I dug into the data. What I learned surprised me. I think it will surprise you, too.
Types of Retail Real Estate and Definitions
When it comes to retail real estate, there are several sub-asset types that we need to define. These include:
Open-Air Shopping Centers, also known as Community Shopping Centers, Neighborhood Shopping Centers, Strip Centers, or Strip Malls: Open-air shopping centers are typically a collection of small retail stores, restaurants, and service providers arranged in a row with shared parking spaces. They are usually anchored by a larger store(s) or a grocery store, along with a variety of smaller retail stores, pharmacies, banks, and other essential services. Open-air shopping centers are designed to provide convenience to shoppers and are commonly found in suburban areas.
Power Centers: Power centers have national big-box retailers as tenants, such as Target, Walmart, Dick’s Sporting Goods, Best Buy, Costco, Home Depot, Lowes, Ross, etc. These centers are usually located in suburban areas, have ample parking, and draw customers looking for discounted prices and a wide selection of goods.
Regional Malls: Regional malls are large enclosed shopping centers with a wide range of retail stores, including department stores, fashion retailers, specialty shops, restaurants, and entertainment facilities such as cinemas. They often have multiple levels and attract shoppers from a broader geographic region, offering a diverse shopping experience.
Lifestyle Centers: Lifestyle centers aim to provide an upscale and leisure-oriented shopping experience. They feature a mix of high-end retailers, restaurants, cafes, and entertainment options, such as theaters or art galleries. Lifestyle centers often have an open-air design, with pedestrian-friendly layouts, landscaping, and outdoor seating areas.
Mixed-Use Developments: Mixed-use developments combine residential, commercial, and retail spaces within a single project. These developments aim to create a vibrant community by integrating retail establishments with residential units, offices, entertainment venues, and public spaces. Mixed-use developments offer convenience and a live-work-play environment.
Outlet Centers: Outlet centers offer discounted prices on brand-name merchandise. They usually feature a collection of outlet stores from different national retail chains, offering products at lower prices compared to traditional retail locations. Outlet centers often attract bargain shoppers and tourists seeking deals.
For context, Wellings Capital has only invested in open-air shopping centers and power centers and does not foresee investing in any other retail sub-asset types.
What About the Amazon Effect and the Retail Apocalypse?
While Amazon has taken the world by storm in under three decades, e-Commerce still only accounts for about 15% of total retail sales as of Q1 2023, according to the U.S. Census Bureau.
We all watched the demise of Sears, JCPenney, and Toys-R-Us over the past decade or two. Bed Bath & Beyond joined the list more recently.
But discount retailers are booming amid these failures. Brands like Dollar General, Five Below, Family Dollar, Burlington, TJ Maxx, Homegoods, Nordstrom Rack, Ross, and The Container Store are filling these vacancies as fast as they are available in many locations. These retailers love these locations because they are typically small, already built, and exist in high-traffic areas where land is hard to acquire.
But it’s not just retailers who are filling these spaces. According to a March 2023 CNN article, Planet Fitness is opening about 200 gyms annually as of 2023. “Bed Bath and Beyond sites are interesting to us, and we are exploring available opportunities with our franchisees,” a spokesperson told CNN. The company has previously opened gyms in abandoned Toys-R-Us and Sears locations.
According to Coresight Research, retail store openings outnumbered closings in 2022, and most retail issues stem from mall-based retailers and retailers with bad business models and/or over-leveraged balance sheets. Store closures continue to be materially lower today than in both 2019 and 2020, as many of the weaker national retailers have closed while stronger retailers have been growing across all categories.
And this points out one of the reasons we are bullish on open-air shopping centers right now: There has been very little addition to the 911 million+ square feet in domestic retail supply since the Great Financial Crisis while leading retailers continue to increase their store counts each year. This creates a significant supply/demand dynamic in retail compared to other sectors.
Retail store space, especially in grocery-anchored strip centers, is scarce. CBRE states that new commercial retail construction reached a new low in 2022 for the third consecutive year. For existing spaces, the retail space vacancy fell to 4.9% at the end of 2022, the lowest level since CBRE started tracking in 2005. This does not look like an apocalypse to me. And from what we’ve seen, there’s just not much land available in suitable locations to build new open-air shopping centers that would attract national retailers.
Retail in the Current Investment Climate
Investor uncertainty remains elevated in 2023. The Federal Reserve has continued raising interest rates and remains heavily focused on curbing inflation. Economic growth remains uncertain and reflects reduced liquidity in the market, going-in cap rates in the real estate world are continuing to rise from historic lows. The recent banking crisis required significant central bank intervention in order to stave off widespread contagion. Underwriting across all property types should reflect more conservative growth expectations going forward. The cost and availability of debt financing remains muted compared to 12 months ago.
In conversations with investors, our retail operating partner continues to field regular questions about inflation, rising interest rates, exit cap rates, and the financing environment for retail real estate. Please click here for responses to some of the questions our operating partner has received.
The REIT Situation
High-quality shopping centers (the type we invest in) are typically owned by REITs or larger institutional investors. Current market conditions put shopping center REITs under pressure to generate cash flow and reduce leverage. They must often fund significant redevelopment pipelines, stock buybacks, or asset purchases in their primary markets. Capital constraints tied to weak public market demand have historically led to forced asset sales to raise money.
While this may be the worst time to sell, their folly can provide an excellent acquisition opportunity to acquire assets at depressed prices. For example, in May 2023, our current fund invested in retail assets that were sold at a discount by a struggling REIT.
What We Look for in a Retail Real Estate Investment in 2024
Sub-asset type. We only invest in neighborhood and community shopping centers. We avoid regional enclosed malls and other retail types.
Location. We invest in the #1 or #2-positioned retail properties with strong visibility and access. We seek strong demographics like demonstrable population and income growth, and good schools. Most of these are infill locations with minimal risk of new development competition.
Upside. We look for assets with rental rates at or below market and tenants in their appropriate-sized boxes
Timing. REITs sell retail assets for various reasons, including fulfillment of business plans, loan payoffs, and economic considerations. Especially in light of limited new supply, we believe 2023 provides the best opportunity of the last ten years to meet investor objectives that we have seen in this sector.
Inflation Hedge. Retail leases are almost always NNN (triple net), meaning that expenses are passed through to tenants and have minimal impact on cash flow for a well-occupied shopping center.
Discount Retailers and Irreplaceable Locals. We look for necessity-based and service-oriented tenants that have performed well through varied economic cycles. Off-price retailers historically outperform in recessionary periods. Local restaurants, salons, gyms, and pet stores can’t be replicated online.
High Yield and DSCR. We have invested in assets with relatively high cash flow and moderate leverage, resulting in an increased safety margin from a higher DSCR (debt service coverage ratio).
Strategic Capital Outlays: REITs are pressured to deliver short-term results. Many REIT retail asset acquisitions are undercapitalized and have a “dated” look. We look for opportunities for enhancements like LED lighting, painting, minor structural work, colorful landscaping, and parking lot refurbishment that can improve marketability, rents, and resale value.
Arbitrage Opportunities. We look for assets that include outparcels with tenants like banks, restaurants, jewelry stores, etc. Operators can often sell these parcels to tenants or investors at a lower cap rate (2-3% lower on average) compared to the cap rate for a large retail property. This may provide a significant return of capital that can reduce leverage and accelerate investor ROIs.
A Brief Case Study: North Rivers Towne Center in Charleston, SC
Our operating partner acquired North Rivers Towne Center in June 2019, and it has outperformed initial underwriting. At the time of acquisition, the property had 141,463 rentable square feet.
Overview: Shadow-anchored by Target and anchored by Ross, Advance Auto Parts, and pOpShelf, North Rivers sits in the heart of a North Charleston retail corridor near major employers including the Joint Base Charleston (22,000 employees), Boeing (7,000), Trident Technical College (1,200 employees, 12,000 students), and Mercedes-Benz (1,100). The center, at acquisition, featured a box lease-up opportunity, as well as three multi-tenant outparcels which could be improved and then monetized.
Performance: Our operating partner executed three major leases that brought the center to 100% occupancy in 2022, though one of them, Buy Buy Baby, is closing due to the financial troubles of its parent company (Bed Bath & Beyond). Our operating partner also sold three multi-tenant outparcels at a blended 6.7% cap rate, shrinking the center to 122,067 square feet. Upon this sale and getting leases to an advanced stage, they were able to refinance in 2022, both to finance costs associated with the leases and return capital to LPs. They distributed ~$2.25 million to LPs as a return of equity in 2022, and they intend to return additional capital once they address the pending Buy Buy Baby vacancy. Distributions – which have been robust – are expected to continue at a strong level. Q4 2022 distributions were at a 16.5% annualized rate.
Please note that this property is not in any of the Wellings Capital funds, and no one can invest in this property as it was acquired in 2019.
Conclusion
Is retail real estate a good investment in 2024 and the next 3-6 years? We believe it is for us and our investors.
If you have any questions, please email us at invest@wellingscapital.com or use this link to schedule a call.
This article is for educational purposes only and is not to be relied upon as the basis for entering into any transaction or advisory relationship or making any investment decision. All investments involve the risk of loss, including the loss of principal. Past performance and any performance results reflected in this article are not an indication of future results.