Industrial REITs Won 2020; Retail REITs Lost. The Dichotomy Isn’t So Clear Moving Forward

During the coronavirus pandemic, as e-commerce ballooned, industrial’s gains seemed to be in direct proportion to retail’s losses. Industrial was a story of heightened demand and increasing valuations; retail was a tale of woe as tenants went dark or quit paying rent. 

In 2021’s post-pandemic environment, the interplay between industrial and retail isn’t as simple as a winner and a loser. Further demand for industrial hinges in part on how retailers are able to leverage e-commerce to support their physical stores.

By the end of 2020, the shift toward e-commerce was clear, but the longer term for retail is murkier. In 2019, U.S. retail sales (excluding restaurants, cars and gas stations) totaled $3.78 trillion, with online sales totaling $598B of that, according to Census Bureau data. In 2020, total retail sales were up to $4.04 trillion, with e-commerce taking a considerably bigger slice: $861B. Year-over-year online sales jumped to 21.3% of the total, up from 15.8%.

All of the retail growth last year was because of e-commerce growth, marking the first time in history that has happened, Digital Commerce 360 reports.

"Retailers got a preview of what higher e-commerce sales looks like during the pandemic, and most realize that they do not have the warehouse capacity today to accommodate the volume of sales that will occur as e-commerce continues to expand," LaSalle Investment Management securities portfolio manager Ben Lentz said.  

The growth of e-commerce looks to weed out the weaker retail properties and, with them, the weaker retail REITs, experts said. 

“What type of reduction do you think we could see? Overall, we’re looking at 50% reduction in store base for U.S. malls as e-commerce comes to represent 35% of retail sales by 2025,” Bloomberg Intelligence senior e-commerce analyst Poonam Goyal said.

“How many malls will still exist then?” Goyal said. “How many of them will have to morph into something else? There will be closures.”

PGIM Real Estate Managing Director and Head of Global Real Estate Securities Rick Romano, while noting that the well-known dynamic of e-commerce disrupting physical retail was accelerated by the pandemic, pointed out that industrial's gain wasn't necessarily a loss for retail. Not all retail, at least.

"While the pandemic created considerable stress through bankruptcies and business loss for retail real estate, it also highlighted the benefit of close-to-consumer retail real estate as a necessary distribution location for retailers to pursue omnichannel strategies," Romano said.

"This has resulted in less store closings than anticipated, a reversal of bad debt expense and increased space demand as retailers look to profitably capitalize on pent-up consumer demand," Romano said. "We see opportunities this year, especially in open-air U.S. retail."

Retail REITs have regained much of their momentum as shoppers return to shopping centers and retailers fine-tune the relationship between their online and offline sales. Industrial REITs are having another strong year, but as their growth slows, nothing like the pandemic boom of 2020.

During the initial month of the pandemic, Feb. 21-March 23, 2020, the returns of all kinds of REITs crashed, and all by double digits, according to Nareit data. The difference since then between industrial and retail REITs has been how fast and how much they have been able to crawl out of that hole.

Between March 23 and Nov. 8, 2020, total returns for industrial REITs were 58.6%, bouncing back well from the pandemic crush, Nareit reports. Between Nov. 8, 2020, and May 21 this year, returns were positive but more subdued for the industrial sector: 13.1%.

“E-commerce demand remains elevated, representing 25% of new lease signings in the first quarter,” Prologis Chief Financial Officer Thomas Olinger said during the company’s most recent conference call.

After the initial crash, Prologis' share prices bounced back quickly and have risen steadily since then. At the beginning of 2020, the REIT traded for nearly $90 per share; now it trades for about $125 a share.

“The balance of leasing is diverse, with outsized growth among companies that provide food and consumer products as well as renewed momentum in the construction segment as housing expands,” Olinger said. “In the U.S., we now expect net absorption of 300M SF in 2021, which would be the highest in history. This strong demand is being masked by supply, and we expect 300M SF of deliveries this year. However, supply remains broadly disciplined.”

Retail has shown the opposite behavior in returns. Between March 23 and Nov. 8, 2020, REIT returns grew by 25.9%, a more modest revival compared to the crash. But from Nov. 8, 2020, to May 21 this year, retail REIT returns were 63.5%, pointing to a more recent upswing in business for the sector.

Simon Property Group, whose stock price crashed to around $48 at the beginning of the pandemic, has recovered to roughly $134 a share.

"We collected over 95% of our net billed rents for the first quarter, and our in-line tenant collections are back to pre-Covid levels in the approximate 98% range," Simon Property Group CEO David Simon said during the company's Q1 conference call. 

Despite retail's more recent surge, industrial remains the healthier sector. Since the onset of the pandemic, including the crash month, total industrial returns have been 18.2%, according to Nareit data. Retail REITs, by contrast, lost 6.5% over that period. In other words, retail hasn't crawled out of the hole yet, while industrial escaped without a problem.

"The forced closure of storefronts nationwide introduced e-commerce to an entire new swath of U.S. consumers, likely resulting in a permanent demand shift in online retail consumption," Romano said. "The ability to deliver goods to consumers within several days has become critical to any successful retailer, allowing industrial landlords significant pricing power to push rents to record highs."

On average, commercial rents paid to industrial landlords represent just 5% of the retailer supply chain costs, compared to transportation costs at 50%, suggesting a long runway of above-average rental growth for the sector, Romano said.

Warehouse demand is likely to continue to remain above the normal levels this year as long as e-commerce sales continue at their elevated levels, Lentz said.

"There is a tremendous amount of market-by-market variation here, and supply-constrained locations will have an advantage, but we expect that as occupancy is no longer at multi-cycle lows and rents are growing strongly, we'll see industrial supply growth accelerate," Lentz said.

"So far, we haven't seen enough supply growth to catch up to robust demand, and it is likely that it may take some years before that happens," Lentz said. "In this environment, the industrial REITs should get their fair share of acquisitions and development as they have a cost of capital, an opportunity set and the platforms to capitalize on it."

One type of growth anticipated for industrial REITs that isn’t expected among retail REITs is further consolidation. Lentz said that there has been a slow but steady pace of M&A activity among the industrial REITs recently, with three mergers in the past four years, but there is only so much more consolidation that the sector can undertake.

"As fewer companies are left in the public arena — nine sizable companies remain today — this activity is likely to slow," Lentz said. "We saw this in the apartment space, as over 30 companies either combined or privatized until only around seven companies remained."

Lentz says he expects a few more deals over the coming years, as most of the remaining companies have similar strategies, and valuation differences between companies are wide enough, in some cases, to provide an optimal outcome for both the acquirer and seller.

Retailers and their landlords are making investments in e-commerce, which might also help sustain at least some physical stores as part of the overall e-commerce supply chains but tap the brakes on industrial demand. In theory, the more retailers can use their stores as links in their own e-commerce distribution points, the less they would need other distribution space.

“We found that retailers made approximately $10B in e-commerce investments, acquisitions and partnerships from May to July 2020,” Kathy Gramling, Jeff Orschell and Joshua Chernoff wrote in the Harvard Business Review in May.

These investments included logistics capabilities to enable last-mile and asset-light approaches like ghost and dark stores, which are retail distribution centers that cater exclusively to online shopping, the HBR reported.

A few categories of retail sales still have room to grow their online portion in the United States, since sales are still below the level of e-commerce sales in countries such as the U.K. or China, Lentz said. Some 14% of U.K. customers will continue their grocery shopping online compared to 9% of U.S. customers, according to a consumer survey by VoCoVo. As for electronics, 28% of U.K. customers plan to buy them online, compared to 19% of U.S. shoppers.  

As more retail transactions of all kinds originate on the internet, Simon reiterated to shareholders and analysts that retailers' success as e-commerce operators is linked to physical retail space.

"When they close a store and that's their store in their marketplace, they lose the e-commerce business," Simon said. "Or vice versa: When they open a store, their e-commerce business goes up."

He called the ability to fulfill orders from stores "a real advantage to" e-commerce retailers.

"There's no question that most of the sophisticated retailers really want to be — I don't want to use all the buzzwords, but seamless between online and ship from store, pick up in-store, all of that stuff," he said. "It's interesting, when we talk to retailers, the majority want to do that. Some like to fulfill it still in the distribution facility. So it's not uniform across the board, but they all want a seamless experience.