The retail REIT sector (Bloomberg: BBRERTL), which includes malls and shopping centers, underperformed the MSCI US REIT Index (Bloomberg: RMZ) in both 2016 and 2017 by an average of 870 basis points (bps) on a total return basis. Year to date through November, retail REITs have continued the trend of underperformance, though the 110 bps gap is much tighter than previous years. There are multiple reasons that can be given for the underperformance, but tenant risk seems to be the primary culprit.
Since the proliferation of e-commerce, many brick-and-mortar (B&M) retailers failed to prepare for the onslaught of competition. As a result, B&M retail sales growth slowed and bankruptcies increased. From 2016-2017, there were 69 retail bankruptcies, a 40% increase from the prior two years. However, despite the difficult retailer environment, retail REIT fundamentals have held up well. Same Store Net Operating Income (SSNOI) has averaged +2.0% per year since 2016, and occupancy rates have stayed above 94%!
Regardless, decent fundamentals in the face of negative retail headlines have not been enough to support stock prices. We attribute this, in part, to the capital that a landlord must spend to reposition properties and win tenants. In an effort to raise capital and increase portfolio quality, many of the shopping center REITs have been selling properties and lowering debt, which has lowered risk but negatively impacted earnings growth.
While the market seems to be focusing on the lost tenants and near-term muted earnings growth, we are focused on the growing retailers that are using e-commerce to their advantage and leasing the vacant spaces, often at higher rents. As a result, we believe that the market is currently undervaluing the dramatic transformation occurring in both property quality and balance sheet flexibility that will result in attractive long-term risk adjusted returns for shareholders.
Breaking Down Tenant Sales Growth
Tenant sales are important for the negotiations between retail landlords and tenants. It is part of the calculation for occupancy cost (rent/sales), which influences the tenant’s decision to renew upon lease expiration and the rent that the landlord is able to charge in the next lease.
If the tenant’s occupancy cost is higher than where it was when the lease was signed, the landlord will likely either need to reduce rent levels to retain a tenant or find a replacement that could generate higher sales to cover the rent. The decision to bring in a new tenant is also influenced by the additional costs of leasing commissions, tenant improvement allowances, and downtime.
Year-to-date, retailers are enjoying the best retail sales environment in years. Based on US census data, total retail and food services sales (which includes e-commerce), have increased +5.8% compared to the same period last year. Additionally, GAFO sales, which represents general merchandise, apparel and accessories, furniture and other sales (a good proxy for B&M tenants because it excludes e-commerce), have increased +3.4% year to date. Our proprietary analysis of 140 publicly traded retailers across 16 retail category types and multiple real estate formats paint a similarly positive retailer picture and forecasts continued improvement in sales growth.
Same-Store Sales (or SSS) growth across the Chilton Retail Tracker shows an inflection in 2017 and has tracked similarly to the trajectory of census reported GAFO sales growth. Additionally, our analysis shows that average sales growth should finish above +1% in 2018 and compound over +2% from 2019 to 2021. This is a marked improvement from our analysis in 2017, which forecasted 0% and +1.5% growth for 2018 and 2019, respectively.
As sentiment improves and retailers continue to implement “omnichannel” retailing, a process that marries e-commerce with B&M, we would expect further upward revisions to these forecasts. For example, ‘buy online, pick up in store’ (or BOPIS) increased 73% this Thanksgiving and Black Friday as compared to last year, according to Adobe Analytics!
The retail categories most struggling with the changing retail environment are consumer electronics, accessories/apparel, and sporting goods. While we forecast all three categories to have positive same-store sales growth by 2020, the recent decline has created negative headlines for those retailers that failed to adapt. For example, Sports Authority, a popular sporting goods anchor tenant, declared bankruptcy in 2016, closing all 460 of its stores across the country.
What didn’t make the headlines was the swift response by REIT management teams, which have backfilled most of the vacant boxes with many of the retail categories that are leaders in retail sales growth such as fitness, discount, home improvement, and beauty. Unsurprisingly, these categories are more resistant to e-commerce competition, can drive traffic to other retailers in the center, and often pay higher rent.
Our analysis also classifies each retailer according to whether most of its locations are in a shopping center or in a mall (Figure 1). We project shopping center tenants will grow sales over +2% annually for the next few years with anchors, such as Walmart (NYSE: WMT), outperforming.
We forecast mall tenants, on the other hand, to grow SSS below +2% annually, but the group is weighed down by department stores, which are expected to grow SSS by less than +1% per year. The mall REITs have been reducing their exposure to traditional department stores and, in the process, have redefined the mall experience and added other uses such as apartments, hotels, and office.
Thanks to the demise of underperforming department stores, mall owners have finally been able to incorporate the ‘live, work, play’ theme in vacant boxes, replacing them with experiential tenants such as high-end restaurants, grocery stores, fitness centers, and entertainment concepts such as Round 1 Entertainment, a bowling and arcade tenant. Many of these tenants would not have considered mall locations in the past, but now have bought into the ecosystem created by the landlords that should (and already has) produce a higher outlook for sales growth and traffic.
The Chilton Retail Tracker also aggregates the market’s outlook for demand by tracking net store openings. Over the next two years, we estimate 17,400 net store openings. We expect 40% of the openings to come from outparcel demand (primarily restaurants located in the parking lots of retail centers), and 30% to come from junior anchors (tenants, such as dollar stores, with square footage around 20,000 square feet).
We expect anchor stores to only make up 3% of total net openings; however, on a relative basis, the outlook for anchor space has improved. Our tracker expects 9% more anchor store openings over the next two years than last year’s analysis, a major positive for the segment that has created the most vacancy in retail centers.
Retailer Watch List
Much of the recent retailer fallout can be attributed to retailers that have taken on too much debt. As the internet created an alternative to the B&M experience, adept B&M retailers spent capital to remain relevant and attract customers to the physical store. However, some retailers were late to recognize the changing tides, while others put themselves in a box by taking on too much leverage, whether due to over-expansion or a private equity led leveraged buyout.
These companies have been restricted in their ability to invest in the physical store experience as cash flow has been directed toward debt payments, which can create a death spiral for a company (albeit the spiral can take many years to result in closings or bankruptcy). Toys R Us, Brookstone, Bon-ton, and Sears (NYSE: SHLDQ) are all recent examples. These retailers alone will account for 1,300 store closures in 2018 and will have closed 75% of their stores on average by year-end.
Knowing that debt leverage plays a crucial role in tenant viability, we closely follow the retailer public debt market as part of our process in forming a tenant ‘watch list’. The watch list helps us gauge the potential risk to cash flows within the retail REIT space and allows us to judge REIT management teams on how well they manage tenant risk. Upcoming large debt maturities are typically the trigger for retailers to file for bankruptcy as the companies struggle to refinance the debt.
Keeping Things In Context
Bankruptcies and store closures may grab the headlines, but it is important to keep everything in context when discussing the state of retail. Store closures should be expected. In fact, it is a normal part of the business. They have averaged almost 5,000 per year since 2001. However, they do not impact all stores and real estate owners in the same manner. Of the 24 square feet per capita of retail space in the United States, REITs only own 3 square feet, or 12.5%, and virtually all of it is of institutional quality.
To get a better understanding of the impact from store closures, we analyzed the exposure of 50 retailers to 25 REIT portfolios. These retailers span across all retail categories, property types, and risk levels, and are some of the most prominent tenants of REITs as they account for 414 million square feet across 17,500 stores.
We found that, on average, retailers had only 20% of their stores within REIT portfolios, which means retailers could theoretically close over 68,000 stores without directly impacting the REITs. For perspective, that would be the equivalent of all store closures from 2003 to 2017. Though it is unrealistic to assume that the REITs will be completely unimpacted, we do believe that the quality of REIT portfolios should greatly minimize the risk of exposure to store closure announcements.
Our analysis also shows the quality bias of retailer locations within REIT portfolios as compared to locations owned by ‘others’ within our database. The Chilton Location Quality Score is based on a scale from 1 to 10 with 1 being the highest quality locations and 10 being the lowest. REIT locations averaged a score of 4.3, which compares to 5.0 for ‘others’. To determine the location scores, we consider the demographics surrounding the location, quality of the building, and sales productivity.
With an average location quality differential of 2 points between REITs and ‘other’ locations, Burlington (NYSE: BURL), Bed Bath & Beyond (NASDAQ: BBBY), Ross (NASDAQ: ROST), J.C. Penney (NYSE: JCP), and Sears stand out as the best examples of the quality of REIT locations. In the case of store closures within these retailers, we would expect the REITs to be relatively less impacted and have much higher demand for backfill opportunities in the case of store closures due to the higher quality locations.
Tiffany & Co (NYSE: TIF), Urban Outfitters (NASDAQ: URBN), Lululemon (NASDAQ: LULU), Microsoft (NASDAQ: MSFT), and Apple (NASDAQ: AAPL) have the overall highest quality locations within REIT portfolios with an average of 1.9. We would assume a high probability for lease renewals and rent increases for these tenants in REIT portfolios. The bottom of the list includes Stage (NYSE: SSI), Office Depot (NYSE: ODP), Petco, and Pier 1 (NYSE: PIR) with a 6.1 average score. Many of the REITs have been opportunistically reducing their exposure to these tenants through lease roll and asset dispositions.
Bankruptcies Aren’t Always Negative
High quality locations should protect retail REITs from bearing the brunt of systematic store closures due to retailer right-sizing, but closures due to bankruptcy filings can be different. For healthy retailers, right-sizing store counts typically comes at the end of a lease term. Most landlords would already be aware of the tenant’s plan to leave and it is common for the tenant to pay the landlord a lease termination fee for an early exit. However, the process is much different and more complicated once a retailer files for bankruptcy protection.
The negatives of the bankruptcy process for landlords include: 1) potential rent relief on remaining stores, 2) no control over replacement tenants if the tenant rejects the lease and it goes to auction, 3) loss of rent if the lease isn’t assumed at auction, and 4) an increase in capital expenditures to reposition the space for a new tenant.
However, there could also be positives from the landlord perspective. Many bankruptcies have given landlords access to prime space on their properties that have significant mark to market rent opportunities and have even opened up the possibility for densification projects.
Additionally, the landlord could benefit if the bankrupt tenant remains open in their property through the bankruptcy process. Remaining stores are poised to experience an increase in sales due to the closure of overlapping stores. Also, the landlord should be left with a much higher quality tenant as its liabilities will have been reduced and it is able to reinvest into its business again.
Private Market Pricing Stable
We believe the public markets have painted the shopping center space with a much broader brush than is deserved, and current pricing is not representative of where the high quality REIT assets would trade in the private market. For example, the implied cap rate for the retail REIT sector has increased 60 basis points since 2013, while private market cap rates for retail properties have actually decreased by 60 bps according to Real Capital Analytics over the same period.
We use proprietary research to track private market transactions that inform the cap rate assumptions in our NAV estimates. Because there are significantly fewer malls and thus mall transactions, we find the shopping center transaction analysis to be the most useful. It is comprised of over 2,500 transactions since 2013 across all geographies and sizes. Not all centers are created equal and location and center type (i.e. neighborhood center, community center, power center) are an important factor in valuations.
Currently, the most liquid transaction market is for assets below $50 million and priced in the 7.0% cap rate range. These assets are attractive to value-add capital, and the demand for these assets has allowed REITs to prune their portfolios at prices much higher than what is implied by their stock prices. The intense demand at this level has also helped put a ceiling on cap rates.
High-quality, core asset pricing has remained steady over the past few years with cap rates of 5% or lower. Admittedly, however, the definition of core has become more stringent as assets are now examined under a microscope. Tenant roster, lease roll, lease covenants, and capital expenditure assumptions have become more prominent in the underwriting process, as well as a tighter focus on asset location within submarkets rather than broad metropolitan areas.
Additionally, the changing retail environment has widened the valuation gap between high and low quality properties. According to our analysis, the premium on a per square foot basis for assets within the nation’s most desirable zip codes based on household income, population density, and educational attainment versus the least desirable has increased from 74% to 93% since 2013.
An Improved Outlook
In the current retail environment, we favor core over value-add assets, and neighborhood centers, which are typically anchored by a grocer and focus on service-oriented tenants, over power centers and community centers that have outsized risk to big-box retailers. It is in the latter two categories where the balance of power has shifted to the tenant due to higher vacancy rates and oversupply.
As of November 30, the Chilton REIT Composite holds Regency Centers (NYSE: REG) and ROIC (NYSE: ROIC), which boast the highest neighborhood center exposure out of our 13 REIT shopping center peer group. The composite also holds Urban Edge (NYSE: UE,) which is included in the top five REIT portfolios along with REG and ROIC based on our Chilton Location Quality Score.
Since we reiterated our conviction in retail REITs in July 2017, the BBRERTL total return has outperformed the total return of the RMZ by 382 bps through November 30, 2018, and we believe there is more room to run as the sector still trades at an 18% discount to Net Asset Value ("NAV"). While AFFO growth is estimated to be below average for the next three years, we believe the dividend yield of 7.3% more than compensates investors for the lack of growth. For example, if we assume multiples in 2020 are equal to today, investors would receive an annualized total return of +11.0%.
Additionally, the retail environment today is in a much better position than last July. The overhang from a Sears bankruptcy announcement has been removed, and e-commerce retailers such as Amazon, Wayfair, and Casper continue to open B&M locations. Mastercard (NYSE:MA) recently projected that Black Friday sales were up 9% from last year, and eMarketer forecasts that the 2018 holiday shopping season could be the best since 2011.
Despite the positive retail environment though, there will always be a few struggling retailers to grab headlines. However, innovative retailers will continue to take market share from those retailers, and, even if the new retailer is born online, we believe that a combination of B&M with e-commerce is the most profitable long-term strategy for retail today (and the future).
Disclosure: I am/we are long REG, UE, ROIC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.