Will Online Kill Retail-Focused REITs?

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Includes: BRX, DLR, GTY, NNN, SPG
by: Reuben Gregg Brewer

Summary

Online sales were up 16% last year.

Brick and mortar sales were up, just under 3%.

How worried should you be about this trend?

On a recent article, a frequent reader commented that he's concerned about online sales and how they are impacting retail REITs. This reader has proven to be an astute market watcher and, in this case, a boots on the ground analyst, investing directly in brick and mortar shopping centers. Indeed, if you look at the sales trends, there appears to be a good reason to be concerned.

Growing like a weed
According to the U.S. Census Bureau, online sales have grown from 2.8% of retail sales in this country during the first quarter of 2006 to 7% of retail sales in the first quarter of 2015. Online sales have grown at double digits in almost every quarter through that period, with just six quarters falling below that level - all of which occurred during the deep 2007 to 2009 recession. Retail sales were lucky to break out of the low single digits in any quarter through that 10-year period.

During the recession there was another interesting trend in the data. Retail sales fell deeper and suffered longer than online sales. For example, the worst quarter for retail sales was a nearly 12% decline in the second quarter of 2009. That was the third quarter of double-digit drops. The worst quarter for online sales was a 7.6% drop in the fourth quarter of 2008, when retail sales first dipped into double-digit declines with a 10.2% fall. Online sales trends started to improve from that point, while retail sales overall continued to get worse for a couple more quarters.

Over the ten-year span the U.S. Census Bureau looked at, total retail sales increased roughly 20%. Online sales increased 200%. To be fair, online sales started at a comparatively small number, which makes growth much easier to achieve. However, it's hard to deny that online sales are changing the dynamics in the retail industry when you look at these numbers.

So what about retail properties
There's clearly no way to tell what's going to happen to retail properties with any certainty. However, there are things to consider that are important. For example, what type of stores occupy a property? If the answer is necessity items and services that can't easily be replaced by an online store, then there's protection from e-commerce.

For example, you can't get your laundry done online or work out at a gym online. You'll probably want to get your prescription right away after a doctor's visit. And while grocery stores are increasingly moving online, most people still go to the store. Don't forget your car, filling up with gas can't happen online and while you're topping up, you might be tempted to buy a soda and candy bar. Which brings to mind breakfast, if you didn't have time to make it you might find yourself at a Dunkin' Donuts (NASDAQ:DNKN) or McDonald's (NYSE:MCD) - can't do that online.

I could keep going, but the point is that not everything can be moved online or improved if it is. Yes, you can order coffee from the Internet, but it's so much easier to hit a Starbucks. So, when looking at retail properties you need to consider what types of properties they are. For example, Getty Realty Corp. (NYSE:GTY) owns gas stations and convenience stores. Probably a safe niche for the foreseeable future.

Strip malls, such as the ones owned by Brixmor Property Group (NYSE:BRX) are, generally speaking, the types of places you go for daily needs and wants. For example, 70% of its portfolio is anchored by grocery stores. In fact, the company estimates that 90% of its portfolio is e-commerce "defensive." The 10% of its portfolio that's "at risk" includes stores that sell things like books, hobby and party supplies, electronics, and office supplies. In other words, you need to dig a little deeper to see the real risks in a real estate investment trust's, or REIT's, portfolio.

So what about a company like National Retail Properties, Inc. (NYSE:NNN)? This triple net lease landlord owns single tenant properties primarily in the retail space. A look at its portfolio shows that it has a lot of exposure to things like restaurants, convenience stores, auto repair shops, and family entertainment establishments. These are things that aren't easily displaced by the Internet. To be sure, it has exposure to sectors that could be described as at-risk, but not as much as you might at first think.

But that's not the end of the story at NNN. Although it has a large portfolio of over 2,000 properties, it still takes a hands-on approach to growth. That means getting to know its lessees and their long-term prospects. After all NNN is taking on the risk of long-term leases; it wants to make sure the tenant will be there to keep paying. And so far, it's done a decent job, with many tenants getting credit upgrades after NNN acquired their properties. Moreover, consistently high occupancy rates, slow and steady portfolio growth, and solid rent growth have all been hallmarks of this REIT that's increased dividends annually for over 25 consecutive years. Could all that change, yes, but it's likely that NNN will adjust before there's too big an impact.

The bigger concern I have is with malls like the ones owned by Simon Property Group (NYSE:SPG). But even there, you have to take a closer look before acting. For example, Simon's bread and butter is owning well-placed and high-quality malls. There may be turnover in the types of stores in its malls, but its properties are destinations that people go out of their way to visit. And Simon recently spun off the malls it didn't want - ones in secondary markets or that were simply less desirable. That should help protect it, particularly when you juxtapose that against the family outing/entertainment nature of its properties.

So I don't have to worry?
I'm suggesting that e-commerce isn't as big a deal as it may at first seem. However, I'm not suggesting that it isn't a big deal. I've presented a number of examples where I think the companies either have unique niches that will protect them or where management is already dealing with the issue in some way. Not all REITs are so well-positioned. You have to take them one at a time.

Not to mention that there are REITs that will benefit from e-commerce. The best example is probably data center REITs like Digital Realty Trust, Inc. (NYSE:DLR). And some sectors that e-commerce can't displace - like hotels. In fact, the ability to rent rooms online is probably more a benefit than a detractor.

So e-commerce is a noteworthy issue and one you should keep in mind when selecting a retail-focused REIT (and other types, too). However, it isn't likely to deliver a death blow to the industry either. You just need to know what you own and focus on managements that have a solid history of dealing with change.

In the end, people don't sit home all alone attached to a computer. They go out and do things. Some of the favorites in this country are shopping and eating out. Some of the have-to-do activities include groceries and services like dry cleaning. And these things aren't likely to change too much over time. There will be winners and loser for sure, but don't treat all REITs with the same brush. Consider e-commerce and just be selective when you decide to buy a REIT that might be impacted by the growth of online sales.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.