Investors’ herd mentality is beginning to shift

Peter Keepper

Peter Keepper
Managing principal, Essex Financial Group, Denver

The availability of capital for most retail centers is strong, despite all the negative headlines in the media in 2017 about retailers closing stores, filing bankruptcy due to overexpanding, and declining sales from online competition and changing consumer trends. There is a herd mentality in retail more than other property segments because this property type has experienced the most change over the last few decades.

Michael Salzman

Michael Salzman
Vice president, loan production, Essex Financial Group, Denver

For example, the retail equity and mortgage investor herd was spooked when Amazon announced it was acquiring Whole Foods last year. Suddenly everything retail seemed to be in turmoil. This created an even darker cloud and triggered more conservative underwriting, particularly for retail centers occupied by junior or major tenant(s) with flat or declining sales attributed to competition from e-commerce. As we enter 2018 though, the herd mentality is slowly shifting, and there’s a realization that online sales could likely hit a cap of retail total sales.

Many retail industry experts have estimated that we’ll reach a cap of 20 to 25 percent online retail sales as a percentage of total sales. They’re projecting bricks-and-mortar retail properties are simply going through an evolution phase. Some suggest we have too much big-box and mid-sized bricks-and-mortar retail due to overbuilding over the past few decades. Many national retailers made a mistake by overexpanding and created way too much supply as their demise. A big portion of those that filed for bankruptcy last year were overleveraged and failed because they overexpanded and missed the demand in a short period of time versus a slow bleed from online competition.

The National Retail Federation reported that retailers had their best holiday season since 2010, and total retail sales in November and December were up 5.5 percent over the prior year. However, department store sales were down 1.1 percent in December. Sales at nonstore retailers, which mainly consist of online retailers, increased 12.9 percent. The bricks-and-mortar retail sales growth is reported to be driven by building material stores and restaurants. Most big-box retailers, many in Class B malls, skewed the total bricks-and-mortar sales increases downward.

Consumer confidence has been strengthening and the recent passage of the new tax legislation is estimated by many economists to result in a spending spree as corporations are anticipated to spend tax savings on rewarding employees with salary and bonus increases in a tight labor market. Recent articles in the Wall Street Journal mention the savings rate of American consumers is at an all-time low and when we get more cash, there has been a direct correlation with increasing retail sales.

The cloud over retail since Amazon acquired Whole Foods appears to be lifting, especially considering the big picture of bricks-and-mortar sales. After seeing a few commercials on, the online pet food retailer, one might think PetSmart and Petco stores are going to consolidate and downsize the average store size; however, it turns out PetSmart just announced it’s buying, which could give the company an advantage of stocking pet food at bricks-and-mortar stores with same-day delivery. Amazon bought Whole Foods to gain an entry into the grocery market, but also bought Whole Foods for the excellent locations and logistics of the bricks-and-mortar stores. Traditional bricks-and-mortar retailers like PetSmart are figuring out how to execute “omnichannel” marketing by increasing their online sales.

Another interesting theme as we enter 2018 is the changing lender sentiment toward fitness tenants, grocery stores and restaurants. Lenders didn’t like fitness tenants 10 years ago because they had high tenant improvement build-out costs and they were perceived to lack the consumer visits that is created by a grocery store. Today’s reality is that some centers with a 60,000-square-foot fitness center formerly occupied by a grocery store are drawing more customers on a weekly basis because fitness customers typically visit more than once per week. Accordingly, some destination restaurants and entertainment concepts are viewed as good replacement tenants in enclosed malls that can be redeveloped vs. traditional mall anchors like Macy’s.

For the most part, underwriting standards and financing terms for quality grocery-anchored centers and infill neighborhood strip centers haven’t changed. Most of these centers are internet resistant because the majority of tenants provide a convenient service or amenity to the neighborhood. Strip centers with a strong occupancy history with tenants like a drop-off dry cleaner, liquor store, corner gas station/convenience store, nail salon, fitness tenant and some local restaurants have become more of a preferred property type as they have infill locations surrounded by residential rooftops that can’t be replaced. There is no delivery service or drone that can pick up a 12-pack of Heineken and my dry cleaning faster than I can go down the street.   Retail centers with grocery anchors that have a top-three market share usually have the same type of inline tenant line up as strip centers, but with more national franchisee tenants. Insurance companies as lenders will offer the lowest rates on these types of properties for fixed-rate terms of five years or longer at an average loan to value of 65 percent. Current fixed rates average 4 to 4.5 percent for 10-year fixed-rate terms, up 50 basis points compared to a year ago. These rate increases are almost solely due to Treasury rate increases, as lender spreads have remained mostly unchanged.

Power centers, which typically contain a combination of big-box, midsize and strip retail, are not good candidates for insurance companies in 2018 unless they have a strong occupancy history, credit tenants, increasing sales and good demographics in an infill location. A power center that fits this description is unusual and is likely located in a major metropolitan statistical area. Commercial mortgage-backed securities lenders or debt funds usually are the best sources for these types of properties. CMBS lenders can lend up to 75 percent loan to value on power centers in some situations and debt funds may be able to finance more if there is a viable redevelopment plan that can be achieved within two to three years.

Class B quality malls in secondary and tertiary locations as well as power centers with big-box retailers selling products that are easier and cheaper to purchase online are a different story. These properties are in major need of a redevelopment plan and likely with higher alternative uses. They’re the most challenging because they usually have co-tenancy clauses tied to major tenants with declining sales and susceptible to a “domino effect.” They often have anchor tenants like J.C. Penny Co. or Sears and one of these anchors may own its store, which makes it more difficult to redevelop due to uncertainty about controlling the entire site. There is capital for Class B malls and big-box power centers, but the investor needs to have a detailed plan to replace any of these types of tenants with a destination- and/or entertainment-type concept or higher alternative use. There are virtually no nonrecourse lenders interested in financing a Class B mall or power center even at a very high debt yield unless there is a redevelopment plan to replace the struggling tenants that’s realistically achievable within two to three years. Debt funds, CMBS lenders and banks are the best candidates for these types of investment opportunities.

Overall, we expect investor sentiment toward retail will continue to improve in 2018 as we continue to develop a better understanding of consumer habits. In the meantime, there is plenty of mortgage capital available, but real estate investors with loans maturing this year should get started early, especially if they own one of the more challenging subsectors of retail.

Featured in CREJ’s February 2018 issue of Retail Properties Quarterly.

Edited by the Colorado Real Estate Journal staff.