The U.S. retail property market has weathered some tough times in recent years, from sinking value amid the country’s property crisis to threats from the online retailers that challenge the brick-and-mortar sales model. But, experts note that the submarket is very resilient and still offers investors good value for the money, particularly when it has been proven that many people still pursue the prospect of shopping for products in person. Now that retail property construction is at an all-time low and cap rates are still comparably competitive, the market is seeing more attention from investors who can see the benefits of storefront sales space. For more on this continue reading the following article from National Real Estate Investor.
Retail real estate has demonstrated its staying power in the years since the financial crisis and has the opportunity to continue to perform well based on market fundamentals. Americans have put their finances in order. Household net worth and personal savings rates are back to historically normal levels per the Federal Reserve and Bureau of Economic Analysis respectively. Americans are thus well positioned to spend more as the economy gathers momentum. Meanwhile, new construction remains at generational lows, paving the way for rents on existing properties to increase. And while prices for retail properties are no longer cheap, they continue to offer good value, certainly relative to other commercial real estate property types.
Fears that Internet providers will sound the death knell of traditional brick-and-mortar retail may be overstated: population growth and consumers’ penchant for recreational and other services, as well as necessity-based goods, will continue to fuel demand for physical stores. Like all asset classes, a downturn will eventually come, likely when the economy suffers its next recession. But even then, if history is any guide, retail could hold up better than other real-estate sectors and possibly other asset classes.
Stronger consumer fundamentals
It is clear with hindsight that consumers overspent during the housing boom, gorging on cheap and plentiful credit backed by inflated home values. But after a wrenching recession, Americans have deleveraged: savings rates have climbed to pre-boom levels, and debts have been pared back by nearly $1 trillion, according to the Federal Reserve. Meanwhile, recovering housing and financial markets have boosted household wealth to more than 5.5 times disposable income, the historical average since 1993 (see Exhibit 1).
Exhibit 1: Household net worth and savings rate (percent of disposable income)
Source: Federal Reserve
Stronger household fundamentals, coupled with pent-up demand after years of thrift, have fostered a consumer revival. Per the Bureau of Labor Statistics, retail sales are expanding at a healthy 6 percent annual rate and are now more than 12 percent above their pre-crisis level (3 percent after adjusting for inflation). Auto sales are running at 15 million units annually, up from 10 million in 2009, according to AutoData Corp. It does not appear that consumers are reverting to their pre-recession spendthrift ,but having repaired their balance sheets, they are in a strong position to fully participate in the economic recovery, increasing spending at a moderate pace consistent with job creation and income growth.
Supply at near historic lows
Commercial real estate, including retail property, is a game of supply and demand. Stronger economic growth fuels more consumer-spending, which prompts retailers to open more stores. Yet if this demand is overwhelmed by a surge of new construction, retail fundamentals suffer as they did in the supply overhang of the 1980s.
The situation today could not be more different. Commercial real estate construction (relative to the overall economy), including retail development, is near its lowest level in more than half a century (see Exhibit 2). The reason is simple: After falling during the recession, rents are generally too low—about 10 percent to 15 percent below their long-run equilibrium on a national basis per CBRE—to make new projects financially viable. Development financing is also in short supply, although it has started to pick up recently. In this low-supply environment, even moderate economic growth can go a long way to improving retail real-estate conditions. CBRE data indicates that vacancy rates in neighborhood and community centers have dropped sharply from its 2011 peak, setting the stage for rents to grow 4 percent annually, on average, over the next few years, double the rate of inflation, according to the CBRE-EA Market Trends Report.
Exhibit 2: Commercial Construction
Source: Bureau of Economic Analysis
According to NCREIF, the average national cap rate (yield) for retail properties was 6.4 percent in the second quarter of 2013, in line with its 10-year average (6.7 percent) and above those for offices (5.7 percent) and apartments (5.4 percent). Retail cap rates are not particularly high from a longer-term perspective (they have averaged 7.7 percent over the past 30 years per NCREIF), but they remain compelling on a relative basis. Despite recent interest-rate increases, the spread between retail cap rates and 10-year Treasury yields is close to an all-time high and well above its historical average (see Exhibit 3). And it should be noted that cap rates on retail properties in secondary and tertiary markets, which may be underrepresented in the NCREIF index, are typically higher: RCA reported an average national retail cap rate of 7.4 percent in the second quarter.
Exhibit 3: Retail cap rate spread to 10-year Treasury yield
Sources: NCREIF (Cap Rate); Federal Reserve (10-Year Treasury)
Interest rates will likely increase as the Federal Reserve unwinds its monetary stimulus during the next few years. Yet today’s cap rates also likely reflect two other features. First, improving fundamentals are reducing cyclical leasing risks and lifting rent growth forecasts. Second, the maturation of real estate as an asset class—including the expansion of public debt (CMBS) and equity (REIT) markets—might have structurally lowered the real-estate risk premium over the past two decades. The bottom line is that while retail property may not be cheap, neither does it appear substantially overpriced.
Internet retail: not yet a major disrupter
There has been much consternation about the perceived threat to brick-and-mortar stores from internet retailers. Online vendors have been blamed for the demise of Borders and Circuit City, and the travails of other well-known retailers, in the book and electronics space in particular, but also more broadly. There is certainly no denying the eye-popping growth of the online industry: e-commerce is increasing at a nearly 20 percent annual rate, more than five times the pace of retail sales generally. At the same time, it is important to recognize that this growth comes off of a very low base: despite rapid gains over the past decade, e-commerce still constitutes only a 5 percent share of total retail sales per the Census Bureau. The drag on brick-and-mortar retail-sales growth has been minimal at about 30 to 40 basis points annually (see Exhibit 4).
Exhibit 4: Internet and brick-and-mortar retail sales
Source: Census Bureau Quarterly Retail E-Commerce Sales Report
While e-commerce should continue to expand, this should not cause undue alarm to real estate investors, for several reasons. First, while Americans may buy more goods online, the country’s population increases by approximately three million people annually according to the Census Bureau, expanding the pool of shoppers. Even if brick-and-mortar retailers receive a smaller piece of the pie, it is a pie that is growing over time. Second, Americans’ consumption preferences continue to shift from goods to services, such as restaurant meals, fitness training, and health care, which cannot be delivered online and are often provided in retail centers. Third, any slowdown in traditional retail sales growth due to internet activity will also likely translate into fewer new construction projects, keeping overall retail conditions in balance.
While the economy continues to brighten, a recession will eventually come, causing some retailers to shutter. But if history is any guide, cyclical downside risks to retail investments are moderate (see Exhibit 5). During the past 35 years, commercial real estate has exhibited lower volatility than stocks for several reasons, including the prevalence of extended lease terms and somewhat stickier capital flows (a corollary to real estate’s relative illiquidity), which dampen income and pricing fluctuations. Within the broader commercial real estate universe, retail properties have experienced lower volatility than other segments, such as city-center offices, thanks to longer lease terms and the durability of consumer spending relative to employment over economic cycles (even when businesses go bankrupt and vacate office space, former employees continue to consume, whether from savings or government subsidies).
Exhibit 5: Standard deviation of annual total returns (1978-2012)
Sources: S&P 500 (stocks); NCREIF Property Index (CRE); NCREIF Property Index Retail (Retail CRE); Barclays U.S. Aggregate Index (Bonds)
An improving economy, healthy consumer balance sheets, limited new supply and reasonable valuations could auger well for the performance of retail real estate. To be sure, no investment is ever risk-free, and commercial real estate is no exception. However, structural concerns about the impact of e-commerce are likely exaggerated, and cyclical risks seem moderate relative to investment alternatives. We believe that retail real estate fundamentals are currently strong and improving and we therefore believe it represents an attractive investment opportunity.
David Lynn, Ph.D. serves as executive vice president and chief investment strategist at Cole Real Estate Investments Inc. The views and opinions expressed in this commentary are those of the contributor as of the date of publication and are subject to change, and do not necessarily reflect the views of Cole Real Estate Investments and/or its affiliates.