Investor, Tenant Demand for Shopping Centers

Investor, Tenant Demand for Shopping Centers Holds Steady Despite Flattening Retail Sales Growth, Looming Store Closures
Lack of High-Quality Available Shopping Center Properties Hampers Both Retailers and Potential Buyers, Though Some Centers May Soon See Gaping Vacancy Holes
By Randyl Drummer
May 11, 2016

The U.S. retail real estate market recorded 11 million square feet of net absorption in the first quarter of 2016, causing the nation’s average vacancy rate to tick down to 6%, the lowest quarterly level since the Great Recession.

Despite a new wave of store closings and weaker-than-expected retail sales in the first quarter, solid U.S. job growth and wage gains suggest that retail demand should rebound over the remainder of 2016, said Suzanne Mulvee, CoStar Portfolio Strategy director of U.S. research, retail, during CoStar’s first-quarter State of the U.S. Retail Market Review and Forecast. Mulvee noted that a similarly weak first quarter occurred in 2015, followed by accelerated activity in the second half of the year.
However, the stable vacancy rate belies a challenging environment for some retailers as an increasing number of store chains look to ‘right-size’ their real estate holdings. The first quarter, typically the season for closures of underperforming stores, saw the largest level of closures since 2010, with retailers as diverse as Wal-Mart, Macy’s, American Eagle, Aeropostale and Kohl’s opting to close hundreds of brick-and-mortar locations, while a number of chains, including Sports Authority, filed for bankruptcy protection, according to Cushman & Wakefield data.

With the second quarter now well under way, the ominous rumbling of weak financial results and the specter of store shuttering continues, with retail analysts receiving several pieces of bad news this week. On Tuesday, a U.S. District Judge granted the Federal Trade Commission’s request to block the proposed $6.3 billion merger of Staples, Inc. and Office Depot. On Wednesday, Macy’s Inc. reported a worse-than-expected 7.4% sales decline in the first quarter, continuing a run of rough quarters for the department store chain.

Gap Inc. also reported weak sales and on Thursday, Kohl’s Corp. reported its first sales decline in six quarters, in a retail environment described by Kohl’s CEO Kevin Mansell and several other retail executives this week as challenging.

The Staples/Office Depot merger would have created a company with $37 billion in revenue and roughly 3,500 stores. Staples plans to host an investor conference call on May 16 to discuss “next steps in our go-forward strategy,” and the status of store closings is likely to be a major topic of interest among analysts. Recent earnings reports have suggested a difficult road ahead for both office supply chains, which are struggling to compete against such Internet retailers as Amazon.com Inc. against a business landscape increasingly oriented toward the digital and paperless office.

Staples closed more than 240 stores in 2014 and 2015 and expected to close another 50 stores this year, the company said in March after reporting lackluster fourth-quarter 2015 results. With the merger ended, Staples announced Tuesday it plans to cut $300 million in expenses and weigh the potential sale of its European operations. Office Depot closed nearly 350 stores over the same two-year period and has previously identified at least 400 stores for closing through 2016 as sales fell 10% in 2015.

Shopping center landlords faced with the losses of additional department stores anchor and junior anchor stores such Office Depot, Stables and Sports Authority are watching their tenants’ business situations very carefully.

“We’ve had intense conversations with both Staples and Office Depot. Whether there is a merger or not, once that’s decided, you will see store closings in that category,” noted Paul Freddo, senior executive vice president of leasing and development for shopping center owner DDR Corp.

The weak performance of Macy’s, meanwhile, prompted its executives on Wednesday to announce that the 700-store chain will consider proposals from potential joint venture partners for its mall stores. The company, which announced the closure of 40 stores in January, said Wednesday it has hired an executive to reevaluate its property portfolio to “monetize unproductive real estate.”
Retail Market Moving Past Recovery Stage

Despite the raft of store closings, retailer appetite for well-located space remains sharp. However, an increasing shortage of the most productive shopping center space, and limited new construction, is weighing on demand. As a result, retail vacancy may soon start to rise in New York City, San Francisco, Boston and other large metros.

Large retailers as a group have posted record profits and sales on a trailing four-quarter basis. However, net sales have plateaued over the last year and CoStar expects slowing sales growth to limit physical expansion for both high-end and discount chains. Median comparable-store sales growth was down to about 1% in early 2016, the lowest of the cycle, from a high of more than 3.5% in 2012.

“These numbers in aggregate indicate that public retailers will be pulling back on their expansion plans,” said Ryan McCullough, senior real estate economist for CoStar Portfolio Strategy. “The second implication of that is that the retail recovery has matured. We’re beyond the point where we’re talking about pent-up demand for retail and are now looking at underlying fundamentals driving retail sales growth.”
“There could be plenty of growth left, but calling it a recovery from this point forward may not be entirely accurate,” McCullough added.
Investors Eyeing Humble Neighborhood Shopping Center

Investment sales declined across all commercial property types in a seasonally weak first quarter following the record $500 billion sales volume in 2015. Retail property sales declined about 25.3% in the first three months, with sales of power centers slowing particularly rapidly, despite strong performance by home improvement anchors benefiting from the housing recovery such as Lowe’s and Home Depot.

Mulvee attributed the power center slowdown to lack of available product for sale rather than a pullback in tenant demand.

“We’ve seen so much buying by institutional investors who are now holding those properties, that there isn’t a lot of product available,” Mulvee said. “Some of the best fundamentals we’ve seen are in power centers, so the pullback doesn’t seem to be an indictment of that type of center.”

That being said, malls and power centers, particularly those located in strong commercial areas with strong household density and spending power, have hardly fallen out of favor among investors. For example, the largest transaction of the first quarter, Macerich Co.’s $770 million sale to Heitman of a 49% interest in a 3.3 million-square-foot portfolio of three malls in Colorado and New Jersey, includes properties in the upper echelon of U.S. retail clusters, with plenty of growth potential, McCullough noted.

Overall however, declining retail cap rates have started to flatten, in part due to the slowdown in power center sales, which have recorded the lowest cap rates of the cycle. Sales of strip and neighborhood centers, which tend to sell at higher cap rates, have become more active of late.
While cap rates of other retail subtypes seem to be reaching a bottom, “I would argue there is more runway for strip and neighborhood centers given the demand trends,” McCullough said.

“They’ve become more attractive to investors. The market hasn’t yet fully corrected for the demand shift, so there might be a relatively attractive yield,” McCullough added.

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