I think the last month has been incredibly interesting, from an investment perspective. Four months ago, following the election of Donald Trump, “everyone” knew this year was going to be all about bond yields rising…..the US dollar rising (relative to other currencies)……and massive earnings growth for US companies. The expectations written above we to be caused by Trump’s push for deregulation and enormous tax cuts. Most people believed that those things would be accomplished, because the Republican party controls both branches of Congress and the White House. I don’t personally consider Trump a Republican, but that’s my own issue. What is obvious just a few months after the election, is that nothing is a “given” in the current political climate. I readily admit that I am only writing this in the middle of April, but so far the Trump administration and congress have been unable to agree on much of anything. In fact, this looks like the most fractured and confused US government that I remember.
Soft data such as sentiment and optimism surveys have been wildly bullish since the election, leading some to ask if the “animal spirits” of the 1990s have returned. I don’t think so, but there is certainly a disconnect between the soft data (how people feel) and the hard economic data. For starters, where has the consumer gone?! Sure (the value of) retail consumption has increased the last few quarters, but I would expect that……all else being equal. The US population is expanding, both through birth and immigration. Plus, those retail sales numbers are usually given in nominal terms. Unless you are talking about cars or electronics, you are almost certainly paying more for a given product than you did one year ago. Since the majority of the US economy is driven by consumption, an unhealthy consumer can be a big problem.
It’s probably not much of a surprise that our family tries really hard to limit our spending. We try to be very intentional, only buying what we need, and little that we don’t. This ethos has taken on an extra emphasis over the last few months, as we currently live in a small apartment….. in a much more expensive area. We are doing fine from a cash flow perspective, but not saving as much per month as we were before the move. Still, I hear a lot of talk about money being tight in the community. Not just among the tightwads in my own circle of friends, but among complete strangers in places like the park or church.
The State of Traditional Retail
It is against this backdrop that I wish to initiate a conversation about the collapse of “bricks and mortar” retail stores, and the danger those stores pose to REITs. I think it best to start with a few trends and facts that have been well covered in the mainstream media. After that, I’ll share some observations from my development work and the retailers I consult for.
It is no secret that a great many of America’s traditional retailers have filed bankruptcy over the last few years, and many more are on the verge. Particularly hard hit are the apparel companies and the department stores who have failed to differentiate themselves from the competition. Think: Payless, HH Gregg, Radio Shack, Gander Mountain, Gordmanns, and too many teen brands to name. Even among the retailers that aren’t in bankruptcy, there are plenty of store closures as a result of poor sales. Below is a handy graphic from Business Insider, showing the number of closures announced already this year by company. I feel very confident that Payless, JC Pennys, Kmart, and Sears will increase the number of announced closures as the year goes on.
A few headwinds are converging at the same time, and it’s making things really tough on traditional retailer. First off, there is way too many retailers selling similar products to not enough people. A fun fact from a Morningstar article last fall stated that the US has approximately 23.5 sq ft of physical retail space per capita. The next closest countries are Canada and Australia with 16.4 sq ft and 11.1 sq ft of retail space per capita, respectively. I can tell you from our travels in Europe, that there are far fewer stores (and those that exist are more compact) on the continent.
This metric would suggest that far fewer stores are required in order to serve the typical retail consumer in a developed market economy. That isn’t inherently bad for stores, but fewer stores mean problems for the owners/landlords of those commercial shopping centers. I will tell you that many of the retail clients I work with have a laser focus on doing more sales with fewer physical stores. Part of this focus is that a greater percentage of retail sales are migrating online, but even where physical stores are concerned….. there is a focus on efficiency. That means not just fewer stores, but also the stores that exist having a smaller physical footprint.
Fewer stores, and the shrinking size of the stores that do exist, require some creativity on the part of landlords. One of my clients is a particular mall operator, who has retained my services to suggest revisions to tenant mixes and store layouts within the malls his company owns. Occasionally revising layouts is easy, such as dividing a vacant 4800 sq ft space into two 2400 sq ft spaces to accommodate a shoe store and a local boutique. More often however, I have been asked to make suggestions about massive vacant anchor stores. In one recent instance, the questions surrounded an otherwise solid mall…..with a vacant 200,000+ sq ft anchor store. Our best uses for the space were medical, office, restaurant/entertainment, or breaking the space up for other retailers. In this particular case, my client chose the medical option……and it appears to be a great fit for his property. His daily foot traffic is up at that property, and I expect the sales per sq ft metrics to improve over the next 12-14 months.
Renovating properties to reflect different layouts, as well as the tenant improvements (called TI in the industry), can cost a property owner a ton of money. I distinctly remember a client spending over $13 million building an addition to accommodate a movie theater, a sit down restaurant, and a quick service restaurant, on his property. That’s big money, but many property owners realize that they need to keep their properties as relevant as possible in order to keep local shoppers visiting the property. Financing such renovations has become much more difficult recently, as banks have recently become more risk averse. This LINK is to recent Retail Dive article you may enjoy, concerning financing issues in the space. I often enjoy Retail Dive for industry specific article, so you may want to check them out if commercial real estate interests you.
I can tell you that the glut of unleased space being dumped on the market, as a result of store closures, has really dampened the retail development industry. Why would a midsized store chose to pay a higher price for a built to suit space constructed for them, when they could just take over the recently vacated space from a HH Greg or Staples? The lease price would probably be at least 25% less than the price of new, and the landlord is almost certain to provide favorable terms to renovate the space. In real estate, location matters first and foremost……..and many of the best locations were developed long ago.
The chart above from Credit Suise/Bloomberg, extrapolates how many retail stores may close this year based on the trend over the past several months. Extrapolating such trends can always be a risky game, because at some point they end and reverse. Your guess about when this trend will end is as good as mine, but it looks like store closures in 2017 may surpass closures during the 2008/2009 financial crisis.
All those vacancies are really hurting the mall operators/owners. It’s important to note that there is tremendous stratification within the “mall” space. Depending how you define a shopping mall, there are between 1,100 and 1,200 shopping malls in the US. Probably 1/3 of those are top quality modern malls, located in areas where they can/will thrive. They probably have nice restaurant/entertainment areas and have a modern layout. These properties are doing pretty well, and have continued to have low vacancy rates. They are typically referred to as “A” malls, think of the grading system in your school. They also trade at great Cap Rates, comfortably still in the 5s. Likewise, the companies that own these properties find it relatively easy to borrow against these properties…..or more likely refinance their debt. (As a note, most malls have short term financing between 5 years and 10 years in duration…… which of course means that the loans need to be rolled over every few years.)
Probably 25% of malls fall into what I would call the stable category. They hare in a decent location, ok demographics and very little local competition. These properties aren’t really thriving, but they aren’t failing either. They just kinda muddle along…..doing well enough to put a little cash in the owner’s pocket…..but not much better. What is interesting in the current environment is that these properties, typically called “B” malls, are trading hands at substantially higher Cap Rates and very few lenders are willing to lend on the properties. I didn’t realize the situation was so dire, until I befriended a owner/operator whose business model is an arbitrage play on buying and improving these properties. For lack of a better term, his company operates as “mall flippers”. His team is experienced and really knows their stuff. They have had a tremendous amount of trouble rolling over their debt the last couple years, even as interest rates are very low and the monetary authorities have printed plenty of dollars. One project in particular hit the oddities of this market home. The mall property was acquired and financed a few years ago with very cheap money. The team renovated and stabilized it. It has a vacancy rate below 7% and is throwing off a tremendous amount of cash. When the initial 5 year loan came due, they had a heck of a time finding anyone to refinance it. I don’t mean they couldn’t find another loan in the 5% range…..I mean they had trouble finding a loan at 7-8-9%. It was the craziest thing I have ever seen. Even at a 9% interest rate, the property will still be throwing off millions of dollars per year in free cash flow. There is not a wave of leases ending or anything, there just aren’t many financial institutions that want to lend tens of millions of dollars on a mall right now. :/
The third type of mall property should be considered “C” properties, and they total probably 40% of the malls in the US. These properties are going away. Whether they are shut down soon, or die a slow death as their stores close one by one, they will almost certainly be closed in 5 years. There can be many reasons for these failures, but most revolve around demographics or retail competition. If once prosperous areas fall on hard times, the local residents may no longer have the disposable income to buy things at the mall. Likewise, there are plenty of areas that only have enough residents to support one mall……but where two malls and plenty of strip retail exist. Something has to give, and it will be these “C” properties.
Some areas of retail are still doing fine and expanding, but these are small niches within the overall industry. In our part of Florida, for instance, gas stations and dollar stores are still expanding at a steady pace. There is enough desire to develop gas stations in Florida that companies from out of state have moved into the area over the last four years. Likewise, stores like Ross/Marshalls/TJ Maxx seem to be doing well. I see them continuing to expand. This is good for troubled strip plazas, because these type of stores can fill other recently vacated store fronts.
You may be wondering what the actionable advice is, in this post. My suggestion would be this. If you own any REITs, take a look at what they own. REITs that own a lot of retail shopping centers and shopping malls, may have trouble in the coming years. Some only own “A” properties and will do fine, while others will likely struggle. Also keep a lookout for REITs that own a large number of single tenant restaurant properties in the US. The US also has an oversupply of restaurant options, which has been putting pressure on restaurant corporations over the last couple years. As always, it’s good to know what you own. Even if you are in a diversified REIT ETF or fund, 25% or more of the holdings may be in the retail subsector. You could be in for a bumpy ride over the next couple years. Other REIT sectors will likely perform better.
Disclosure: This discussion is for informational purposes only and should not be considered a recommendation to buy, sell, or hold any equities. I am not a financial professional. The information above is provided by Morningstar.com, Bloomberg, Business Insider and Retail Dive. Please make investment decisions based on your specific circumstances, after speaking to an investing professional.