Risk & Return: Investing in Retail Shopping Centers

by | May 27, 2022

Over the last decade, a lot has been written about the coming demise of brick-and-mortar retail. I’ve read more than my fair share. It’s some of the lowest-hanging fruit to beat up on if you are a journalist or economist trying to predict the future. We are all consumers of retail. We all participate in it daily. Unless you are a hermit, you can’t avoid it. Naturally, we all understand it to a certain extent; your credit card bill is proof of that, is it not? Brick and mortar total annual retail sales grow around 3% on average and represent approximately 80% of all retail sales or over $4.3 trillion annually. Amazon entered the brick-and-mortar business out of necessity, and brick-and-mortar retailers have improved their e-commerce platforms to accommodate consumers’ demands. Contrary to what some might guess, there are no brick-and-mortar retailers on a bankruptcy “watch list.” Both brick and mortar and e-commerce continue to evolve, and the more they do, the more they seem to rely on each other to grow.    

We have all heard the term “location, location, location.” Good real estate is crucial for a retailer to succeed, and it’s the first ingredient to a successful project and the hardest to overcome for a retailer that picks a lousy location. When we analyze a shopping center, the tenants’ overall performance at that location indicates how good or bad the real estate is within a particular trade area. A shopping center must be located on great real estate to be successful. An office building, industrial building, or apartment complex can certainly be located on great real estate, but it isn’t as crucial to the project’s success. Having asset-backed investments as part of your portfolio is excellent; wouldn’t it be better if those investments are also sitting on irreplaceable real estate?  

The doomsday prediction that brick-and-mortar retail is becoming extinct due to e-commerce has pushed large investors out of the space. Given the “headline risk” mentioned in my introduction, few people are willing to risk their jobs by driving a retail deal through an investment committee when apartment or industrial assets are a rubber stamp. Institutions have the loudest voice in the marketplace, but they also stroke the most significant checks. Hence, their actions tend to move the market based on what they are buying — resulting in meager yields within the asset classes they are most active in. These facts have created a basic supply-demand imbalance resulting in an outsized risk-reward opportunity for retail investment. While the largest institutions have bid up the industrial and multifamily assets all over the country, over 70% of retail transactions in 2021 went to private buyers desperate for fixed income investments in a yield-starved environment.

Private buyers are primarily focused on cash flow, and shopping centers are an excellent vehicle for that. Typical leases are five years in duration, with rental increases designed to keep up with or outpace inflation. Buying in a higher inflationary environment presents the opportunity to buy into below-market leases, creating an upside opportunity as leases expire without fixed-rate options. Most leases are “net leases,” meaning all additional costs associated with the real estate are passed through to the tenant. Hence, it limits the exposure the income derived from a shopping center has against rising and unexpected costs. The income from a shopping center is very predictable. Unlike most other asset classes, the overall return generated during the life of these investments is a healthy balance of current cash flow and asset appreciation (recognized through a capital event). In some cases, you can recoup your principal investment through cash flow simply by holding the asset for 8 to 12 years. The exact length of a potential payback can be determined using an extended cash flow model reflecting market debt terms.  

Cycles are part of a free economy, and no investment is immune to them. One of the major contributors to real estate cycles is overbuilding. Typically, the demand signals will cause the market to build housing, for example, and in a free economy, there is a risk of overbuilding and thus a slowdown in that asset class. The market sentiment towards retail over the last several years has dampened new construction such that retail fundamentals are in the healthiest place they have been in decades. The pandemic wiped out all the weak tenants, yet retail occupancy in most significant markets still sits at 95%, and retail sales continue to increase year over year. These attributes, combined with the basic structure and length of leases within a shopping center, put retail in a favorable position to avoid a self-induced correction and withstand economic downturns. 

Retail continues to fly under the radar of some of the largest investors in the real estate business. To say they are unaware of the yield premiums available in retail investments would suggest they aren’t paying attention which certainly isn’t the case. They just aren’t built to buy “small” retail centers and struggle to get consistent consensus at the committee level when presented with large retail assets. Whether they ever pivot to retail in a meaningful way or not, for all of the reasons stated in this article, private capital is finding ways to deploy capital into retail assets and has created much wealth doing so.