By Jed Chew
In February last year, WUREC published a blog post by Sanders Deutsch titled “Malls Must Evolve to Survive.” In that post, Sanders described how many malls have been losing their anchor tenants due to the bankruptcy of large department chains. This phenomenon has thus jeopardized the typical mall business model of relying on anchor tenants to attract in-line tenants which generate the bulk of both base and percentage rent.
However, Sanders also made the prescient conclusion that there will always be a need for in-person retail despite how COVID-19 accelerated the e-commerce wave. True enough, the retail sector has bounced back strongly in 2023, with Hines regarding retail as a “favorite asset” and the Urban Land Institute’s (ULI) 2024 Emerging Trends in Real Estate report describing the emergence of retail as a “CRE darling.”
Economic Drivers spurring Retail – Supply & Demand
“Today’s retail resurgence is better explained by a collective reassessment of the sector than by any dramatic recent shifts in supply and demand dynamics.”
~ Urban Land Institute
While some high-profile U.S. department store chains such as JCPenney, Neiman Marcus and Lord & Taylor filed for bankruptcy during the COVID-19 pandemic, many of these chains had already been facing serious disruptions from the rise of e-commerce and changing consumer tastes. A notable example is Sears, which filed for bankruptcy in end 2018 after its revenues more than halved over 5 years.
In an interview with PERE, Hines Americas CIO Alfonso Munk thus contended that the retail sector has been in “restructure mode for years.” This has led to continued write-downs and higher implied cap rates which face less pressure from elevated interest rates that are projected to remain “higher for longer.”
This price adjustment has also led to supply-side constraints, as the soaring costs of construction and the tight credit market simply do not match the projected value of retail space and current cap rates. This trend of limited new constructions has been further exacerbated by demolitions from extensive store bankruptcies and closures in the late 2010s.
According to CBRE’s U.S. Real Estate Market Outlook for 2024, the overall retail availability rate (measured by both existing vacancies and projected future available space) dropped to an 18-year low in Q3 2023.
In addition, only approximately 14 million square feet of multi-tenant retail space is set to hit the market in 2024. This represents half of projected demand, and is likely to result in the retail availability rate to drop even further to 4.6% by end-2024.
Despite persistent inflation worries as well as concerns over how the resumption of student loan payments might impact millennial spending, tenant demand for retail space has remained robust due to several years of industry “restructuring” characterized by the embrace of omnichannel business models and the consolidation of larger retailers in higher-footfall locations.
Given this context, I believe that the ULI report is accurate in contending that today’s retail resurgence is “better explained by a collective reassessment of the sector than by any dramatic recent shifts in supply and demand dynamics.”
“COre” CRE Assets
Historically, downtown offices and regional malls were considered staples of “Core” CRE investment portfolios for three main reasons:
Large, Capital-Intensive Assets: fund managers could invest large sums of capital into office and mall assets in a single underwriting
Stable Cash Flows: long-term leases signed by both anchor and inline tenants often included rent escalations as a hedge against inflation
Relative Liquidity: because of how offices and malls were portfolio staples, they were perceived as “in-demand assets” with high transaction volumes
As the retail sector became increasingly tainted by the struggling fortunes of anchor tenants and the oversupply of certain mall products, the investment theses of stable cash flows and relative liquidity began to fray.
However, as larger chains proceeded to consolidate and investors began embracing grocery anchors such as Whole Foods and Walmart, rent growth has slowly returned in the retail sector.
In addition, relative liquidity has been somewhat restored by two key trends. Continued construction shortfalls have addressed previous issues of oversupply, and there has been renewed interest in retail as investors pivot their portfolios away from office space.
Hence, the retail resurgence that we seem to be suddenly observing today has different drivers from Joey Holahan’s recent blog post on “Demand Shock Drives Golf Course Development,” which explained the pandemic-induced spike in the number of people watching and/or playing golf.
Bifurcation in Retail – Implications for Office
Like most real estate classes today, there has also been a bifurcation in the retail estate sector. However, because this restructuring cycle began much earlier for retail, some CRE analysts believe that the retail resurgence can serve as a “prism” through which to look at the troubled office sector today.
In a recent Odd Lots podcast titled “What Dead Malls Tell Us About the Future of Commercial Real Estate,” Liza Crawford, Managing Director at TCW, highlighted how regional malls faced debt distress in the 2010s as consumers jumped to e-commerce and anchor tenants downsized or capitulated.
A similar story is arguably playing out in the office sector today, as businesses accept that remote working is here to stay and many tech anchors begin cutting both their headcount and real estate footprint.
But while websites such as DeadMalls.com dramatically tracked the emergence of “ghost malls” across the United States, there were also malls that thrived through a combination of downsizing, rehabilitating, and attracting promising new tenants that pay triple-net-leases such as Top Golf and Dave & Busters. These “eatertainment” chains were especially successful during the pandemic because of the “midweek outing” trend facilitated by remote working.
While Hines’ publicly regards retail as one of its “favorite asset classes,” it focuses on investing in a narrow subtype of grocery-anchored, open-air placemaking centers that have strategic advantages over e-commerce. In addition, Hines’ retail portfolio is geographically concentrated in the Sun Belt states, gateway cities, and densely populated metros – areas with strong and sustainable demand drivers for continued retail momentum.
Similarly, despite broad concerns about the office space, the sector has had bright spots in more niche subtypes such as Medical Office Buildings (MOBs). The office sector has also been transformed by the emergence of “Trophy/Lifestyle Offices” like Hudson Yards that rent at a premium to Class A offices because of their fantastic locations and new, state-of-the-art amenities. And as highlighted by the ULI report, close to 90% of office absorption occurring today has taken place in the top 10% of available office stock.
In future posts, I will thus seek to dive further into what it might mean for the office sector to have its transformative moment as its very purpose is being fundamentally challenged.
Hudson Yards (Source: Oxford Properties)