Fundamentals for retail real estate appear favorable at mid-year, supported by supply constraints and retailers’ continued commitment to brick and mortar stores as an essential distribution channel. Analysts are watching pockets of consumer stress but remain generally positive that leasing volumes and pricing power will trend higher for REITs during the rest of the year and into 2025.
REIT.com checked in with sector analysts Michael Gorman at BTIG, LLC, RJ Milligan at Raymond James, and Linda Tsai at Jefferies, LLC, for their outlook on REITs that own retail real estate.
How would you describe retail real estate fundamentals at mid-year, and what are you expecting for the rest of 2024?
Michael Gorman: As we sit at mid-year 2024, retail real estate fundamentals for strip centers are quite strong. Retailer demand is some of the strongest we have seen, certainly in the past 15 years. Coupled with a lack of new supply over the past decade, REITs in this space are seeing great leasing volumes and solid pricing power as a result. This should ultimately lead to stronger same store NOI in the back half of this year and into 2025 as the new leases come online and the gap between signed and occupied space shrinks.
The one hold-up on the fundamental front that is getting increased attention is the capex required for backfilling vacant spaces in retail portfolios. That would moderate some if occupancies stabilize, but it is a focus right now.
RJ Milligan: Retail real estate fundamentals in the net lease and shopping center space are as good as they have been since the GFC. COVID-19 was really the big turning point as retail real estate headwinds turned into tailwinds when retailers saw the value of having a brick-and-mortar presence. Concerns about tenant fallout have mostly been overblown, and thus far this year we’ve seen minimal bad debt write-offs, which has resulted in slight increases to guidance.
We expect more of the same for the rest of the year and investors have really pivoted to looking to 2025, as all of the leasing done over the past several years finally drops to the bottom line, resulting in accelerating FFO growth.
Linda Tsai: Given year-to-date stock underperformance, low supply, and contained tenant store closures, shopping centers look attractive in the second half of 2024. Expectations for 2025 earnings growth are lower for shopping centers versus other REITs, but the year-on-year improvement in earnings growth is higher, underscoring favorable valuation.
The transaction environment has been muted overall. REITs have been challenged to issue equity, hamstrung by weak stock prices trading at discounts to NAV. That said, we expect improvement from here, given a lower inflation point and a greater likelihood that interest rates are coming down. Shopping center REITs' eagerness to acquire underscores confidence in the tenant/retailer demand environment, unlike the years leading up to the pandemic, when REITs were net sellers.
What are the most prevalent trends you are seeing in consumer spending?
Gorman: We are seeing lots of conflicting trends right now in the consumer space. Macro data is showing record credit card debt at the consumer level, but also still record checkable deposits. Real wages have started to decline, but consumer sentiment remains elevated off of the lows of 2022. All of the cross currents at the macro level aside, we are seeing and having more conversations about consumer stress, especially at lower income levels, and trading down behavior. We are also seeing a greater focus in our conversations on portfolio quality, income demographics, and also non-discretionary tenant exposure. This certainly has a more defensive feel to it.
Tsai: The consumer has held up, but pressure around the low- and middle-income consumer has increased. We’ve seen this in the types of retailer restructurings (Rue 21, Express, JOANN, 99 cents Only) and store closure announcements (Family Dollar, Walgreens). First quarter credit card delinquencies rose 8 basis points quarter over quarter to 3.16% but remain below the long-term average of 3.7%. The personal savings rate as a percentage of disposable income, 3.8%, remains below the long-term average of 6.1%, having hit a pandemic high in 2020 of 24.5%. Even if the consumer is slowing though, the main story for retail real estate is lack of supply and retailers’ commitment to brick and mortar as the most profitable distribution channel compared to ecommerce alone.
Milligan: We’ve seen some weakness for lower-end consumers, but the good news for REITs is that they really aren’t their core customers. Remember, REITs own the highest quality retail real estate with the best tenants. Retailer demand for space remains very strong.
Where do you see the strongest pockets of opportunity within retail real estate?
Tsai: Net lease has been the underperformer within retail and the ability to grow more accretively again through acquisitions should be well received. We are constructive on shopping center fundamentals. Malls, we are more hesitant towards, given some of the store closures in apparel that focus on the middle income consumer, challenges around bigger boxes like F21, and continued consolidation of department stores (Saks/Neiman), which point to an ongoing supply/demand imbalance that benefits discounters and luxury more in the open air and high street retail.
Milligan: One of the biggest opportunities is upgrading tenants to drive more traffic. With such a limited amount of space available left to lease, the landlords have meaningful negotiating power for higher rents, but also for the best tenants that will drive traffic and increase the value of the overall center.
Gorman: Based on the conversations that we have been having lately, it seems as though there could be more investment opportunity with larger deal sizes both because the buyer pools are smaller and also because there are likely more levers to pull in favor of value-add. We are also seeing institutional landlords use their tenant relationships to take advantage of investments that perhaps have nearer-term lease expirations where they have additional confidence. That said, given some of what we are seeing on the consumer side, we are more skeptical of any “opportunistic vacancy” or “leasing upside” in the market right now.
Do you anticipate any uptick in M&A activity in the sector? What about smaller transactions?
Milligan: We don’t expect more large M&A transactions in the near-term given the high interest rate backdrop. While the transaction market has slowed across all real estate sectors, we continue to see encouraging price discovery on shopping centers that support current NAV estimates. The shopping center REITs trade at an average of approximately 10% discount to NAV, which we believe provides some downside protection given the continued appetite in the private market for shopping center assets.
Gorman: Given the volatility of the financing environment and some of the dislocation in the REIT market, we think the capital markets could lend themselves to targeted deal flow. This includes M&A level activity as well as smaller transactions. That said, strip center REITs have spent the past decade-plus post the GFC honing and refining their portfolios for a shifting retail landscape. This is no longer a sector where bigger automatically equals better, so there would need to be synergies and strategic rationale in addition to compelling pricing.
Moreover, while there could be some challenged sellers of private assets–especially if there are additional retailer failures that lead to capex requirements–we think that much of that deal flow would be in assets that do not rise to the quality level REITs are looking for in their investments.
Tsai: Public-to-public M&A makes less sense now as multiples still trade at discounts relative to history. Smaller companies might be less willing to sell when their future outlooks suddenly have improved upside from a lower cost of capital. Smaller transactions could make sense, but the acquirer would have to be clear on the value and level of accretion a transaction brings. Because retail has a fragmented tenant base, both the credit and quality of the location are important to underwrite.
Are restaurants more attractive tenants to retail REITs today than in the past?
Gorman: As with anything, there continues to be a balance. One of the benefits of the strong retail demand is that landlords can also optimize for the merchandise mix that they want for the center, and not focus simply on backfilling space. So restaurants continue to be an important component, and that is especially true for quick service restaurants as centers see more daytime traffic due to demographic shifts.
Tsai: When you look at the ratio of announced store openings to closures, it is above the long-term average. Year to date, this has been largely dominated by quick service restaurants (QSR) like McDonald’s and Chipotle. Traffic driving food and beverage is critical to the character and merchandising of an open air shopping center or mall.
Restaurant tenants have increased in terms of overall merchandising mix versus pre-pandemic. Food drives traffic, whether it’s a grocer, QSR, or fine or casual dining. At the same time, hybrid work has increased demand and daytime visits. There is an element of risk given restaurants’ low margins, but low vacancy and high demand for brick and mortar mitigates some of the risk and downtime.
To what extent are you seeing notable development or re-development trends in retail real estate?
Milligan: The biggest trend in retail real estate development today is that there really isn’t any. Development costs continue to move higher, making new supply difficult to justify. Replacement cost should become more important to investors as the REIT portfolios approach full occupancy, which only improves the negotiating power for landlords. Redevelopment/re-tenanting presents the best returns today on incremental investment as cap rates for acquisitions haven’t really budged.
Gorman: The consistent trend in retail real estate at the moment is that ground-up development is still very challenging, and that there is not a broad scale move toward increased supply as a result. Outside of that, we are seeing more attempts at, and discussion of, densification at existing sites. This includes additional outparcel development, potentially adding residential units, and more. However, there is a fine line as some of these projects, particularly large mixed-use, can get complicated and require either a specialized skill set or a partner. Additionally, while we have seen increased disclosures around mixed-use zoning for a lot of landlords, the percentage that is currently coming to fruition, or even could come to fruition, is lower.
Tsai: Redevelopments that incorporate food and beverage, entertainment, hotel, fitness, and office will draw the most traffic and create high barriers to entry. This idea isn’t new but is a successful formula because you are bringing people together for different reasons. These types of redevelopments are most feasible in markets with density, education, and better incomes.
Is there anything else you expect to be watching as you monitor the retail real estate sector going forward?
Gorman: The traditional real estate fundamentals of supply/demand dynamics clearly favor retail landlords at the moment. However, we are watching for discussions about where those strong fundamentals run into the upper bounds of retailer business models. Perhaps the fundamentals support a certain rent level, but the occupancy cost that rent implies for the retailer is unsustainable.
We are also watching the WFH trends as well, as neighborhood retail has certainly been a beneficiary of population trends. Finally, tech continues to be a major player in the retail space. The omni-channel environment continues to evolve, and various tech platforms are increasingly playing a role both for landlords and tenants for determining optimal site selection.
As we get more dovish signals from the Fed and inflation data, we are watching the interplay between the potential relief on landlords from financing headwinds with the risks that the reason for the rate relief is a slower consumer and economic environment.
Tsai: It will be interesting to see how Curbline Properties Corp., the spin-off of SITE Centers Corp.’s (NYSE: SITC) convenience centers, trades this fall. Rates coming down for a smaller cap REIT will be fortuitous, even though they will spin out as a separate entity, debt free. Besides having a higher growth profile from higher embedded rent bumps and lower capex spend, demand is far greater for spaces that are 2,000-5,000 square feet versus big box spaces.
While CURB is convenience center focused, the higher rent bump and lower capex model also supports Acadia Realty Trust (NYSE: AKR), a name we like a lot, as its street retail portfolio has these characteristics too, resulting in a longer runway for above average NOI growth.
Milligan: Capex remains elevated due to large signed-not-open pipelines and the backfilling of the vacant Bed Bath & Beyond Inc. (BBBY) boxes. With less space to lease, and the better-than-expected progress of the BBBY re-tenanting, we expect leasing costs to come down materially as we move through 2025.
Please see below for video links to some of Nareit’s member retail REIT CEOs and CFOs speaking at Nareit’s REITweek: 2024 Investor Conference in New York June 3-6.
- Joey Agree, Agree Realty Corp.
- David Lukes, SITE Centers Corp.
- Jeff Edison, Phillips Edison & Company, Inc.
- Lisa Palmer, Regency Centers Corporation
- Jim Taylor, Brixmor Property Group Inc.
- Michael Bilerman, Tanger