Changing consumer behavior and the rapid growth of e-commerce have altered the retail landscape. The retail sector has experienced waves of bankruptcies and store closings in recent quarters. This tension was reflected in Situs RERC’s institutional investment survey responses. Respondents noted that while prices seem favorable for the retail sector right now, the sector faces risks due to the rising popularity of e-commerce. In particular, respondents said that malls and big-box retailers will be especially hard hit as businesses deploy technology to accommodate changes in shopping habits.
Situs RERC President Ken Riggs noted that “Retail real estate is not down for the count – it’s catching its breath and adapting to a rapid pace of change, as it always has.”
Situs RERC’s investment conditions ratings for each of the retail subsectors declined in first quarter 2017 compared to fourth quarter 2016 (see Exhibit 1). Among the subsectors, the neighborhood/community retail sector retained the best investment conditions with a rating of 5.8, on a scale of 1 to 10, with 10 being excellent. The ratings for the regional retail mall and retail power center sectors declined to 5.1 and 5.2, respectively, during the first quarter, though respondents indicated that investment conditions remained about average. Investment conditions for the retail power center and regional retail mall sectors were considered the worst among the property sectors surveyed by Situs RERC.
Situs RERC also surveyed institutional investors about required (i.e., expected) rates of return. Situs RERC’s weighted average required pre-tax yield rate (IRR or discount rate) for all three retail sectors overall remained stable at 7.6 percent during first quarter 2017. The weighted average required going-in and terminal cap rates for the overall retail sector decreased to 6.1 percent and 6.6 percent, respectively. Notably, cap rates decreased for the first time in over a year.
Ken Riggs explains, “The declining cap rate does not necessarily imply that values are increasing. The decrease in cap rates can be attributable to initially lower estimates of net operating income (NOI) in the first few years with strong NOI growth in later years given market-wide revised rent forecasts for retail.”
Among the regional retail mall, retail power center and neighborhood/community retail subsectors, the required going-in cap rates declined from the prior quarter to 6.1 percent, 6.4 percent and 5.8 percent, respectively. The required terminal cap rates for the regional retail mall, retail power center and neighborhood/community retail sectors also decreased from the previous quarter to 6.6 percent, 6.9 percent and 6.4 percent, respectively.
Within the various rates, we can focus on the spread between the required IRR (discount rate) and required going-in cap rate (see Exhibit 2). This spread may generally be thought of as a signal of growth expectations for a particular asset, with a widening spread indicative of greater growth expectations. However, due to the uncertainties the retail sector is facing, the increase in spread may be more reflective of investors pursuing a strategy of price exploration and building in a high required IRR to compensate for the future unknown risks. Situs RERC tracks rate expectations, and the spread between the retail sector required IRR and required going-in cap rates has been widening, from 130 basis points near the end of 2015 to 150 basis points as of the first quarter of 2017. This comes directly after the spread narrowed significantly to 40 basis points in mid-2015.
Many financial analysts have considered the retail sector to be struggling, with a relatively bleak outlook. However, based upon Situs RERC’s extensive experience in navigating through previous real estate cycles, we believe that there may be some opportunity in the retail sector, specifically in Class A assets and in markets that have seen strong post-recession economic recoveries. Increased competition and a focus on creating a unique, entertaining experience for customers have been a catalyst for success in the retail sector. Despite the increase in spread for the retail sector, many analysts believe that expectations created by this gap will not be met without an increase in earnings growth.
Exhibit 2: Situs RERC Retail IRR and Cap Rate Composition
Source: Situs RERC, 1Q 2017.