Malled to death: How investors can benefit from the fear of retail property
Retail property has become a bad word. We believe the fear of property labelled “retail” creates opportunity for investors willing to take a closer look. Michelle Russell-Dowe, Head of Securitised Credit, US Fixed Income and Jeffrey Williams, CFA, Fund Manager.
Provocative headlines sell, which is why most news stories focus on stores closing and the demise of the American mall. But, in reality, the headlines are much more negative than the facts. When we brought in the fact checkers, as shown in Figure 1, and bulleted below, we found that:
1. In 2018, there were 3,835 net store openings: 12,663 new stores opened, and 8,828 stores closed.
2. Even for major retailers, bankruptcy filings don’t look much different this year when compared to each prior year during the last decade.
3. Certain types of retail are suffering, including drug stores, department stores and specialty Soft goods, i.e. clothing and bedding.
4. Stores like mass merchants/super stores, convenience stores and restaurants are doing well, yet the positives in retail properties are rarely mentioned.
While we see a problem with obsolescence for certain malls, the shakeout of the mall sector has roots dating back almost 50 years, when tax incentives resulted in overbuilding, which we discuss in the following section.
The history of malls – sowing the seeds of destruction
The evolution of the mall sector provides an interesting and critical perspective for today’s markets. The creation of the first enclosed mall took place in 1956, with Southdale Mall in Edina, Minnesota. The Southdale property had 72 stores, two levels, and was “anchored” by two department store tenants, Donaldson’s and Dayton’s. Prior to Southdale, almost all other shopping centres had been open air with stores connected by outdoor passageways. The concept was a hit with the press and consumers, and a template for almost every future mall was born.
If one mall is good, are many more malls better? Malls generally suffer now because there are too many. The catalyst for the mall excess was a tax law passed in 1954 that allowed for accelerated depreciation. The intention of the tax law was to stimulate investment in manufacturing. The unintended consequence was that mall developers could recoup the cost of their investment much more quickly, creating a development incentive. Rather than develop where demographics dictated a need, mall developers were quickly adding projects for the tax break. The incentive to build new malls, as opposed to maintaining existing malls, also created a substantial decline in quality by the late 1990s. The culling of excess malls has been going on for years. For example, between 2007 and 2009, 400 of the largest 2,000 malls closed (20%).
Should “mall” really be a four-letter word for investors?
Schroders tracks over 1,300 malls in the US, as shown below. Based on metrics such as sales per square foot, population growth and the proximity of higher quality competing malls, we believe that nearly one in five malls are “at risk”. This is quite similar to the closing rate seen in 2007-2009.
However, it’s worth emphasizing that not all malls are bad. Those we characterize as “high quality” include centres that are in locations with strong demographics, which tend to be an attraction for successful tenants. Quality tenants are less focused on reducing the rent they pay, and more focused on locating in a centre with strong consumer foot traffic. Within diverse pools, it is possible to find mall concentrations that are acceptable, or even attractive, if the investment offers enough compensation for the risk and more limited liquidity.
The problem for malls remains over-represented in the media. The reality is that malls make up a relatively small part of the overall retail property sector (only 8% according to CoStar). This fact surprises most people, but malls have a very visible presence in communities, so the troubles faced by about 20% of malls have tarnished the term “retail”. Power centres (7% of all retail square footage) are the cousin to the mall. They are usually occupied by three or four “big box” retailers, like Best Buy, Home Depot, and in the past, Linens N’ Things, etc. Store sizes for retailers in this format are typically 25,000 square feet and greater. This sector has been negatively impacted by the rise of omni-channel (on-line and physical) retail strategies, which reduce the amount of total space needed. A disproportionate number of store closings are represented by those with larger than 25,000 square feet. These power centres are very visible and, again, lend to the “tale” about retail.
With the overbuilding of malls, and the change in format affecting power centres, the problematic performance has created an environment where “retail property” carries a negative connotation. This bias has been applied to a much broader set of properties included in retail, far beyond malls and power centres. An investment bias, however, especially one that focuses on emotional content over factual content, has created an opportunity for those able to dig in and better understand the range of fundamentals around different retail properties.
A bit of silver lining to the retail property cloud is that there is more demand for certain store formats. Data shows neighbourhood centres and strip centres performing very well. Neighbourhood and strip centres are properties containing 100,000 square feet of space or less, and are occupied by multiple tenants. While strip centres often don’t have an anchor tenant, neighbourhood centres are usually anchored by a grocery or drug store/pharmacy. All of our readers will have frequently been to a neighbourhood or strip centre.
Neighbourhood and strip centres (at 33% of total retail square footage, combined) are a much larger segment of the retail sector, and in many ways exhibit much stronger fundamentals and advantages. The tenants tend to focus on sales of convenience goods and personal services, which are less vulnerable to competition from internet retailing, and the centres cater to frequent customer visits. Currently, the vacancy trend for neighbourhood and strip centres is improving versus the deterioration for malls and power centres. Improving vacancy rates results in more stable property cash flows and loan debt service coverage.
Because these properties are considered retail, they are often eliminated by many investors as potential investments.
The retail property sector – Not all retail is mall
Since the troubles plaguing the mall sector have tainted the entire retail property sector, many investors avoid any property in the retail sector. As a result, there has been a substantial decline in lending volume for retail properties. This creates a financing gap for non-mall retail. In other words, since some investors avoid it, an opportunity has been created to deploy capital into this market at an attractive spread premium. In many cases, there is such a lack of financing that lenders can get additional protection through lower loan-to-value (LTV) ratios.
Real estate loan opportunity
What is it worth to understand the differences among retail properties?
Industrial properties are the sweetheart of the investor community in real estate, as they are widely viewed as benefiting from internet retailing trends. Investor appetite for this property type creates highly competitive bidding situations pushing lenders to provide larger loans (higher LTV) at lower rates (less spread). Loans on industrial portfolios often have one senior mortgage and two mezzanine loans providing for a total financing of 75% of the portfolio value.
For a neighbourhood centre, the lack of available financing creates a favourable opportunity. Not only is the total debt lower, with total financing of 65% of the property value, valuations are often more conservative. Additionally, the loan rates/spread is very different.
If you compare a loan we’d consider a typical industrial portfolio loan representing a 65% LTV exposure to a loan on the neighbourhood centre at the same LTV, the neighbourhood centre loan has a spread premium of more than 320 basis points. The neighbourhood centre loan earns 650 basis points (bps) over LIBOR, whereas the industrial portfolio loans earn only 330 bps over LIBOR.
Emotional bias, or “emotion over fact”, is a common bias investors face when they make decisions. For those willing to understand the underlying real estate trends, and who can underwrite and lend on properties, the prevalent anti-retail sentiment offers the potential to generate an additional 3.25% in income. Now, this is a “tale” where we all live “happily ever after”.
Most of the weakness in retail property fundamentals is concentrated in malls and power centres. These troubled properties represent only 15% of the retail property sector, combined. Negative headlines surrounding retailing has caused many investors to completely avoid the retail property sector.
This bias creates an opportunity in retail properties, such as smaller format stores and neighbourhood centres which are benefitting from improving occupancy trends and improving fundamental factors. Many neighbourhood and strip centres are also less vulnerable to competition from internet retailers as they focus on convenience goods and services. Understanding the real drivers of the trouble in a sub-sector of retail properties is key, and investors that can direct capital into fundamentally-sound, out-of-favour opportunities can potentially be rewarded with attractive risk/return opportunities.
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