Chapter 01: Major Asset Classes

Section 05: Retail

Outlook

Retail was undeniably one of the hardest hit sectors during the pandemic, but it has made notable strides in its recovery. In fact, CBRE reported that 2022 was one of retail’s “best years,” with strong performance among neighborhood, community and strip centers, while lifestyle and mall segments performed inconsistently. It’s important to note that retail is a mixed bag of subtypes and the outlook is varied as such. Retail activity in neighborhood and community centers is expected to remain generally strong, especially in stores with essential products and services, while power centers may be exposed to a higher level of risk as they are more vulnerable to e-commerce growth with higher capital expenditures.

Retail activity in neighborhood and community centers is expected to remain generally strong, especially in stores with essential products and services.
CrowdStreet Advisors Market Outlook - Retail Real Estate Investing

CoStar reports that retail rents in the United States grew at their fastest pace in over a decade in 2022 due to tight market fundamentals, low availability rates, and low numbers of projects in the pipeline across the nation. In a year dominated by negative news, the performance of the retail sector didn’t fit that narrative and, as a result, it was not a story that garnered attention. Gleaning from CoStar data, retail occupancy is expected to remain relatively high (in the 95%+ range), however, rent growth is expected to temper slightly but remain positive.

Figure 8: Retail Market Fundamentals

Figure 8

Source: Retail, United States, CoStar Data, as of May 2023.

Despite the solid year the retail sector enjoyed, there are macro headwinds in 2023 that could dampen further recovery. Consumers are “feeling the pinch” of high inflation with increased credit card purchases and erosion of real income, according to a report by Green Street, suggesting that the near future could bring challenges to the retail sector.15

Immediately after the pandemic, the consumer savings rate had jumped to an anomalous 30%, which has now dropped all the way back down to about 5.1% (Bureau of Economic Analysis data as of April 28, 2023 release). Retail sales data from the previous few months suggests that with rising interest rates and uncertainty in the market, consumers have pulled back on their spending habits. Some of consumer’s conscious spending habits were to avoid discretionary activity while they continued shopping more for essential or “core” retail such as grocery stores, general merchandise, beauty, health, medical, and online sales, etc.

Opportunity

Despite what the headlines are touting against it, retail may be an overlooked asset class from an investment standpoint. We believe that Retail is in the next phase of its evolution with a narrow window of opportunity, especially in grocery-anchored and neighborhood centers. We published an article in 2022 titled “Retail Real Estate Investments are Back in Style” going into more detail about why we believed that the sector was sitting in an interesting spot with many tailwinds that could potentially benefit its recovery.

First, foot traffic has returned to physical retail stores. For the first time since 2017, sales growth in physical retail stores surpassed online sales growth in 2021, helping to push up the profitability of physical retail which was severely hit during the pandemic.

Second, retail centers that are functioning generally well today may have a chance of functioning well moving forward because they were able to endure the brunt of the pandemic which brought a unique set of challenges.

Third, CoStar data shows that retail has strong fundamentals as compared to its recent history, with low availability and a dearth of supply, with only about 0.5% of its inventory under construction. Therefore, we believe that retail is set up to experience demand that will outstrip supply in upcoming years. Until new supply can be generated to meet demand, which could take years, we believe the current discount to replacement cost for retail will narrow over the next few years, possibly leading to some cap rate compression.

Despite what the headlines are touting against it, retail may be an overlooked asset class from an investment standpoint.
CrowdStreet Market Outlook - Retail

We will continue to tune into retail, particularly grocery-anchored stores in well-located, neighborhood or community centers, as opposed to traditional shopping malls or second-tier big-box stores. The reason for our focused admiration is based primarily on the performance of grocery-anchored retail. CBRE reported that roughly $14.6 billion of grocery-anchored centers traded in 2022, (which was up 24% year-over-year and the highest number in over a decade) in a year that was considered a down year for CRE transactions, overall.

The non-discretionary nature of grocery shopping keeps the fire burning for this industry sector and is one of the reasons why retail had a pulse during the depths of the pandemic while activity in many other non-essential stores had come to a complete halt.

There is one major financial strategy that we will pay attention to when considering retail investments and that is the potential to enter a deal at positive leverage which is difficult to achieve in today’s high interest rate climate for many asset classes, especially those with very low cap rates.

Retail cap rates are currently in the 5.0% to 7.5% range, depending on the type of retail and its vintage, according to Green Street.15 This makes retail a potential candidate for achieving positive leverage at acquisition. Positive leverage occurs when the debt costs less to service than the cash flow received from the leveraged portion of the project (negative leverage is the opposite, when the debt service exceeds the cash flow on the leveraged portion of the project). Another way to tell if leverage is positive is when the operating cap rate from a deal is greater than the interest rate of its debt. 

We feel that retail assets today (especially grocery-anchored neighborhood centers) have a unique pairing of strong market fundamentals, surging demand, low supply collectively achieving durable cash flow and a potential for positive leverage at acquisition. And as such, we will continue to seek retail opportunities that fit this criteria.

 

15 “U.S. Strip Outlook, 2023,” Green Street, 2023.

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