By: Jon Mendis, Managing Partner, Principal, Hyperion Realty Capital
The investing sentiment that it is time to zig while others zag resonates with the team at Hyperon Realty Capital (“HRC”). Many commercial real estate investors (especially larger institutions) continue to sit on the sidelines after year-over-year U.S. retail real estate transaction volume fell roughly 37% for the year ending Dec-2023[1] following the 63% decline in U.S. commercial real estate volume for the year ending Dec-2022[2]. At HRC, we believe it may a good time to invest in retail real estate – albeit with a strategic, thoughtful. defensive approach, and a keen focus on real estate fundamentals:
· Established location with strong incomes and populations growth
· Located in a market with high barriers to entry
· Inherent risk in tenant term and credit, rather than quality of real estate and rental rate
· Below market rents, and
· Potential for income growth.
Recap of 2023
Operations
The U.S. retail real estate market closed out 2023 with continued strong, durable demand outpacing supply. The net absorption was a robust 35 million square feet for the year[3], which surged by 37.2% quarter-over-quarter to 17.6 million (for the quarter-ending Q4 2023)[4]. With little new construction deliveries (currently or on the horizon) – which was at least partially discouraged by high construction costs – vacancy hit 4%, its lowest point on record dating back to 2007[5]. Healthy demand for retail space can arguably be traced to surprisingly strong economic growth in 2023, with U.S. retail sales unexpectedly rising in Nov-2023 as the holiday season got off to a brisk start. The rebound in retail sales reported by the Commerce Department underscored consumers' resilience, resulting from a strong labor market.
Despite numerous headwinds, including inflation, rising interest rates, and reduced savings, spending was largely unimpeded; however, a disproportionate amount of consumer budgets were on essentials like groceries, personal care and medical as well as off-price goods, leaving less disposable income for discretionary items. These trends were clearly reflected in retailer performance and resulted in 769 net retail store openings – primarily driven by discount and grocery – marking the first two-year stretch of net store openings since 2013-2014[6].
HRC Insight: HRC’s portfolio mirrored macro-U.S. trends in 2023. With a predominately grocery-anchored and discount-oriented portfolio, HRC experienced strong leasing momentum and positive net absorption, executing new leases with the likes of Daiso (off-price), Value Pet Clinic (medical), Indigo (medical), RDA Promart (personal care), StretchLab (personal care), and Club Pilates (personal care), and renewing leases with the likes of Dollar Tree (off-price) and Big Lots (off-price).
Capital Markets
At the start of 2023, global markets were vulnerable to deteriorating economic conditions, with the Federal Reserve (“Fed”) raising interest rates 11 times since January 2022 to curb inflation, which made commercial real estate credit tighter. The collapse of Silicon Valley Bank, Signature Bank and First Republic Bank in Q1 / Q2 2023 worsened the credit crunch, with Lenders hyper-focused more than ever before on stringent credit and underwriting policies, all but freezing the capital markets for remotely appealing debt.
Retail real estate transaction volume remained muted, but is outperformed other property types, with grocery-anchored properties leading the way at approximately 21% of the transaction volume[7]. Institutional investors continued to be net sellers of retail real estate, as a relatively less painful way for institutional investors to free-up and/or re-allocate capital. Generally speaking, institutional investors are under-allocated to retail real estate, at least relative to the other major food groups: industrial, multifamily and office. To avoid significantly writing down large swaths of their portfolios, institutional investors have focused on monetizing their under-allocated position in retail assets to free-up capital, while still avoiding massive, macro portfolio write-downs that would be triggered by the sale of industrial, multifamily and office product.
HRC Insight: With the foregoing macro-economic factors in mind, HRC remained disciplined in 2023, acquiring only two retail properties. HRC will continue a disciplined deployment of capital in 2024 and invest in a manner that it believes is in the best interest of its investors.
Outlook for 2024
Why Retail Real Estate Now?
Simply put, retail real estate has strong real estate fundamentals, with limited supply of retail space, strong retail tenant demand for space, and financially healthy tenants. According to Cushman and Wakefield, there is approximately 14.2 billion square feet of retail in the U.S., 5.4 billion of which is shopping centers. As a rule of thumb, real estate needs 1%-2% of existing supply to be built each year to maintain the same amount of square footage. However, over the past 15 years, construction completions of retail real estate have averaged around 12 million square feet, which is just a fraction of a percent of existing inventory. In lock step, retail sales have more than doubled in the last 15 years due to less competition, while retail rents only minimally increased over that same time period (the last 18-24 months excepted)[8], resulting in lower occupancy costs and financially healthier tenants.
Prior to the pandemic, landlords were unable to increase rents to an equilibrant level (i.e., the maximum occupancy cost for a viable retail tenant) because of lower average occupancy levels. Owners were in a precarious position as it was more important to keep as many tenants as possible rather than to chase higher rental rates. Since the pandemic, this paradigm has been shifting in favor of the landlord, as retail vacancy has reached its lowest point on record. With limited vacancy, especially in quality assets in dense, infill locations, negotiating power has swung back toward landlords. The primary wrinkle in realizing increased rents is that we are still in the very early innings of rental growth. Unlike multi-family, office and even industrial properties that tend to have shorter lease terms, retail tenants typically have longer lease terms (5+ years for shop space and 10+ years for anchor space). As a result, realizing leasing spreads and ultimately pushing rents to the prevailing market rates can often take 5 to 10 years (or more). Strategically acquiring retail real estate now – in the infancy of the new positive rental rate reality – implies favorable roll-ups on retail tenant leases for the next decade (or more) and ultimately an increase in the net operating income of such retail properties with below market in-place rents.
As of the first quarter of 2023, the occupancy rate at strip centers stood at 95.3%, a level last reached about eight years ago, and physical occupancy was approximately 92.4%, right around pre-pandemic levels[11]. According to Paulina Rojas Schmidt (leader of Green Street’s strip center team), while often not a good sign, the gap between leased and physical occupancy in today’s environment primarily exists because landlords are signing leases faster than retailers have been able to move in, highlighting the favorable fundamentals that currently exist in the retail strip center space.
Capital Markets Stabilization = Buying Opportunity
While last year’s capital market challenges will likely stretch into 2024, the forward yield curves indicate a low probability of the Fed raising rates again in 2024, providing much needed stability for commercial real estate. In Dec-2023, the Fed held interest rates steady and signaled in new economic projections that the historic tightening of monetary policy engineered over the last two years has reached a natural end and lower borrowing costs are coming at some point in 2024. Retail shopping centers can be acquired in today’s investment environment with strong durable cash flow, low in-place rents relative to market, with substantially no new supply on the horizon. With debt markets projected to stabilize and institutional investors sitting on the sidelines, the stage is set for 2024 to be an opportune year to invest in retail real estate, especially on a risk adjusted basis compared to other traditional asset classes.
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[1] United States Retail Outlook, JLL, Q4 2023
[2] Investment Volume Falls Considerable in Q4, CBRE US Capital Markets, Q1 2023
[3] U.S. Real Estate Market Outlook 2024, Chapter 5 Retail, CBRE
[4] Ibid (Footnote 1)
[5] Ibid (Footnote 1)
[6] MarketBeat: U.S. National Shopping Center, Cushman & Wakefield, Q4 2023
[7] Ibid (Footnote 1)
[8] Retail Real Estate Is Entering A Golden Age, Seeking Alpha, August 7, 2023
[9] Strip Malls Show Resilience in an Evolving Commercial Real Estate Market, Lexology, October 3, 2023 (as sourced from the WSJ)
[10] Strip Malls Are The New King of Retail Real Estate, WSJ, October 30, 2023 (as sourced from RetailStat, a retail and commercial real estate data-analytics firm)
[11] The Hottest Real Estate Play Is In Your Neighborhood, WSJ, July 27, 2023 (as sourced from Green Street)
