Commercial Magazine

Retail is Proving Resilient

Values for this asset class are faring better than others, but occupancy challenges persist

By Joseph M. Miller

While the U.S. commercial real estate market is in the midst of a challenging period, the retail property market is unique. For a stretch of time, retail was a highly impacted property type and was not highly sought after by many investors. As of late, however, retail is no longer the least desirable asset class.

“Given these occupancy challenges, investors are interested in redeveloping malls into other uses, such as medical offices or multifamily communities.”

The slowdown of the commercial real estate market has affected all asset classes, but the retail sector — which faced its own difficulties prior to the period of rising interest rates and return-to-work challenges — is somewhat less impacted. Unlike industrial and multifamily properties, retail did not see significant pricing increases over the past few years. Capital market struggles and capitalization rate increases are being felt across all property types, but the recent changes in retail property values are not as dramatic when compared to other sectors.

Value by subsector

Across the country, there are varying levels of interest in retail properties based on size, quality and tenancy. Single-tenant net-lease properties with long remaining lease terms continue to be the most sought-after assets.

This property type typically attracts a large pool of potential buyers, which drives pricing upward. Net-lease properties with strong credit tenants and remaining lease terms of 10 years or more are seen by many investors as being similar to a corporate bond. The shorter the lease term or the higher the risk associated with rent payments (tenant credit), the less interest the property will gather in the marketplace, pushing pricing downward.

Overall, the second most-desirable retail property type is the grocery-anchored community shopping center. Many institutional investors view grocery-anchored centers as a stable investment opportunity. Typically, grocers have performed well over the years and have been relatively “internet-proof.” Many tenants in grocery-anchored centers strategically lease these spaces due to the increased customer traffic that a grocery store will drive to a center. While grocery-anchored centers are judged as a positive, the specific grocer in place affects this desirability. Many investors still view Whole Foods and some large, national grocers as value-add opportunities, while local grocers and other national chains are not viewed as strong in-place tenants.

Power centers and lifestyle centers can be attractive to investors at higher capitalization rates. These are large outdoor shopping complexes. Power centers typically have three or more big-box stores, while lifestyle centers house upscale shopping, restaurant and fitness options in promenade-style spaces. The main driver of value for a power center is the tenant mix. If there is a good blend of national and local tenants with internet-proof offerings, the center will likely command decent investor interest. Many of these properties have a large entertainment focus (movie theaters, experiential offerings or restaurants) that can create a more attractive tenant mix. The most significant concern for these centers is the occupancy cost that a tenant can bear during their lease term.

As real estate operating costs (e.g., insurance and taxes) continue to rise, tenants are hyperfocused on industry-average occupancy costs, local occupancy cost ratios and brand occupancy cost ratios. If occupancy costs at one location are considerably higher than average, many tenants will look for cost-effective alternatives in the market. As tenants continue to focus on operational expenses, landlords must offer upper-level amenities and incentives to retain existing tenants and attract new ones.

Mortgage environment

Toward the lower end of the range in value for retail properties are smaller neighborhood centers with local tenants, as well as Class C and lower regional malls. Many of these centers have seen continuous declines in occupancy rates and tenant quality, which can result in questions of highest and best use for the center, as well as its long-term viability.

Overall, debt remains available for retail properties, but commercial mortgage lenders are taking a harder look at asset quality, tenant quality and cash-flow stability before financing a transaction. Lenders are still willing to finance upper-tier retail assets and single-tenant net-lease properties with relatively long remaining lease terms.

These types of properties are viewed as strong investments and are less risky than many other retail assets. While lenders are willing to place debt on these assets, property owners are dealing with lower loan-to-value (LTV) ratios compared to prior years. On top of the LTV constraints, the debt-service-coverage ratio may also impede the lending decision, as many borrowers are experiencing lower levels of cash flow than in previous years.

For less desirable assets, traditional financing remains difficult. Lenders are often concerned with the best uses of these properties and their future viability. Owners of these assets may seek alternative financing from private lenders, hard money lenders or mezzanine lenders. The short-term funding offered by a nontraditional lender allows the property to be repositioned or stabilized so that traditional long-term financing can eventually be secured.

Occupancy challenges

As a result of market disruption caused by e-commerce, malls continue to struggle. With brick-and-mortar retail sales permanently impacted by online competition, retailers must reduce expenses to keep physical stores open.

Since they’re among the most expensive retail environments for tenants, malls must reduce rents to remain competitive. Consumer sales are not likely to increase dramatically, so rents must trend down. This leaves mall owners to choose between lower occupancy and more income, or higher occupancy and less income as compared to prior years.

Given these occupancy challenges, investors are interested in redeveloping malls into other uses, such as medical offices or multifamily communities. Municipalities are beginning to work with developers to help loosen the restrictive covenants that have historically hindered redevelopment efforts, resulting in success for some properties. But adaptive reuse can be more costly than ground-up construction, particularly in the case of a retail-to-multifamily conversion.

Vacancy issues, of course, are not limited to malls. With the closure of businesses like Bed Bath and Beyond, vacancies plague owners of big-box retail centers everywhere. Gyms and other types of tenants have absorbed some of these vacancies, and in some markets, landlords have attracted community colleges or churches to replace the former anchor tenants. Where demographics support them, experiential tenants such as golf simulators may lease large spaces — a boon for landlords since these ventures not only solve the vacancy problem but attract valuable foot traffic to other parts of the center.

If they’re unable to attract a replacement tenant, many landlords will have to redevelop these big-box spaces and create smaller spaces. Multiple small spaces will bring in higher rents than one large space, but converting a big-box space into in-line suites requires significant capital investment.

Informed decisions

To undertake any of these options, retail property owners must determine whether a project offers sufficient return on capital. To inform their decision, they may request a market study, performed by a valuation consultant with retail expertise and knowledge of the local market.

A market study can inform income projections for the proposed use by providing an analysis of supply and demand within the local market. Owners may also engage with a qualified engineering consultant to perform a feasibility study. This includes information about the site and its infrastructure, potential improvements, a conceptual layout, permitting requirements and costs, and an estimate of construction costs.

If owners can overcome the obstacles to redevelopment, the overall inventory of retail square footage will decrease to a volume that might be more appropriate for today’s retail industry, where online sales compete with traditional stores. Less inventory will allow for better absorption of space, providing a potential upside for the retail sector in the long term. ●


  • Joseph M. Miller

    Joseph M. Miller is a managing director at Partner Valuation Advisors and serves as national practice lead of the company’s retail valuation practice. He has more than a decade of experience and has appraised some of the most prominent commercial properties in the U.S. He was named a Retail Influencer by and is sought out as a top valuation expert.

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