Optimism Is Returning To Battle-Tested Retail Sector — But More Importantly, So Are Investors

After years of trepidation, institutional money is flowing back into retail.

Crow Holdings and Lincoln Property Co. are among the prominent firms that have launched new endeavors aimed at spending billions of dollars to acquire more retail real estate. The trend represents a stark reversal for the once-beleaguered asset class, which had long been kept at arm’s length by investors who viewed the sector as systematically flawed.

“In open-air retail, we’ve seen more institutional investors interested, in part because it was really battle-tested during Covid,” said Mark Horgan, chief investment officer at Brixmor Property Group. “It proved its mettle, from an occupancy perspective, from a rebound in tenant demand perspective, from a rent growth perspective. Institutional investors are taking note of that.”

Now that the pandemic is largely in the rearview mirror, foot traffic has returned to shopping centers, vacancies remain low and demand has strengthened, driven mostly by a historic dearth of new construction. The wave of tenant bankruptcies seen over the past decade has slowed to a drip, instilling a renewed level of comfort that has eluded the space for years. 

“You’ve got a really powerful supply-demand imbalance, you’ve had a performance period in the crucible of an unprecedented event, and you can — in some cases — still navigate a much higher borrowing-cost environment,” said Sterling Hillman, managing director in Crow Holdings Capital's food and service retail group. “When you add all that up, retail is starting to become a really interesting prospect for folks.”

Commercial real estate investment volume in the second quarter fell 64% to $75B as lenders tightened their standards in response to the Federal Reserve’s run-up on interest rates. Retail transactions were down more than 67%, according to CBRE, yet the sector’s relatively strong yields offer a beacon of hope in an otherwise bleak environment.

Annualized returns in Q2 fell to negative 6.6% across property types from 5.5% a year prior, per data from the National Council of Real Estate Investment Fiduciaries. While industrial and multifamily returns fell to negative 4% and negative 5.1%, respectively, retail took a more modest dip to negative 0.9%.

“This is the only asset class that currently has positive leverage,” Lincoln Property Co. co-CEO David Binswanger said. “You can buy a deal at a cap rate and borrow at a rate that is lower than the cap rate you’re buying. Currently, you can’t really do that in industrial, you can’t really do that in multifamily.” 

Institutional investors have responded to those fundamentals by doubling down on retail. Over the past two years, 97 large-format retail centers and enclosed malls have traded hands, per data from commercial real estate investment firm Steerpoint Capital, with disclosed prices ranging from $25M to $785M. 

In July, LPC formed a joint venture with California-based Paragon Commercial Group, a move expected to propel the company’s strategy of acquiring institutional-quality retail assets on the West Coast.

“The fundamentals are there, particularly for neighborhood necessity retail,” Binswanger said. “Retailers have figured out what Amazon and Walmart mean, what e-commerce means and where they need to have a local presence.” 

Crow Holdings formed a $2.6B JV with a global institutional investor in May aimed at acquiring small-format, open-air shopping centers. Its goal of investing in food and service retail rather than goods predates the pandemic and has proved prescient given the rise of online shopping.

“The original thesis back in 2014 was simple enough for a kindergartner to understand,” said Hillman’s co-managing director, Sam Peck. “You can’t replicate a haircut on the internet. You can’t replicate a pedicure on the internet.”

There was a lot of fear surrounding retail even prior to the pandemic, said Bo Okoroji, managing partner at Steerpoint Capital. The market was viewed as oversupplied, and as e-commerce grew in popularity, investors began to reduce their retail allocations.

To add to the risk, many large-format retailers acquired through leveraged buyouts coming out of the Global Financial Crisis went bankrupt, Okoroji said. This period of sustained closures, termed the retail apocalypse, accelerated through the pandemic. 

The event had the effect of culling the herd, he said, leaving behind a pool of tenants that proved their resiliency under unthinkable circumstances.

“Those retailers that were circling the drain couldn't make it out of the pandemic,” he said. “Now, you have a healthier retailer base and you have better, more efficient retailers, which shows they have strength in their balance sheets and that they’re solid operators.”

Tenant bankruptcies have in some cases proved profitable for investors. Several retail REITs in their second-quarter earnings reported backfilling shuttered Bed Bath & Beyond storefronts at rent increases of 20% or greater as historically tight inventory placed a premium on available space.

“In today’s cost-of-capital environment, you won’t really see new supply being built,” Horgan said. “That’s really led to stronger demand for box space … and that’s allowing us to drive higher rent spreads, higher rent growth.”

The pandemic solidified what was an emerging system of winners and losers in retail. Enclosed malls saw 1.1M SF of negative absorption in the second quarter, per JLL, with prominent owners like Simon Property Group cutting its year-end profit forecast due to a dip in sales. 

Meanwhile, open-air retail has thrived, so much so that some mall retailers are making the switch, a Jefferies senior analyst for the U.S. REIT team told Bisnow in a previous interview. The pandemic had lingering impacts on consumer habits, according to a CBRE report, with consumers opting to stay close to home and shopping within their communities.

In the second half of 2022, urban retail availability surpassed suburban availability for the first time since 2013, per CBRE. Asking rent growth in the suburbs also outpaced urban counterparts.

“The focus has really shifted more into community or neighborhood retail, which in many cases entails grocery-anchored or smaller centers,” said Christine Mastandrea, chief operating officer at Whitestone REIT. “There’s always been a focus on big, and [investors] are starting to see there’s performance in another area that is starting to improve the dynamics for investing in retail that is based on convenience and community.”

The contracting capital environment could present an opportunity to snap up shopping centers from owners that aren’t able to secure financing, Mastandrea and Horgan said. The bid-ask spread hasn't yet narrowed enough for those deals to close, but they anticipate less competition for assets in the coming months.

“Retail is being rediscovered, particularly our type of retail, as an investable space. But price points haven’t really shifted that much between private and public yet,” Mastandrea said. “We are starting to see that movement, but as with anything in real estate, price discovery takes a little bit of time, and so we just make sure we are ready for those opportunities.”

More institutional money flowing into the space means retail’s ownership profile could become less fragmented. Somewhere between 8% and 10% of retail is held by institutions like REITs, pension funds and private equity shops, but because of the sector’s complexity, retail could benefit from more well-heeled owners with strong tenant relationships, Horgan said. 

“It's a business that really takes expertise,” he said. “You need those tenant relationships. You need to understand what kind of capital it takes to maintain a center in a first-class way.” 

Retail isn’t immune to the capital market challenges faced by other sectors, and like all asset types, the strength of lender relationships will ultimately dictate which companies are able to secure funding in a downturn, said Stuart Baldwin, partner at Hodes Weill & Associates. 

The current focus on retail affirms what groups like Whitestone and Brixmor have always believed: The right retail real estate can withstand a recession. 

“The right retail strategy will always have a place in a well-diversified investor’s portfolio,” Baldwin said. “Do I think retail is going to be the most in-favor asset class in the next three years? Likely no. But I do think the right type of retail … will continue to perform well.”