Retail Real Estate Discussion with Cedrik Lachance, Managing Director at Green Street Advisors.
Montesi: What is your view about retail formats in the future, and do you believe that hybrids are emerging?
Lachance: When you travel internationally, you see retail centers that integrate different types of shopping trips. You get daily and convenience shopping integrated with monthly or quarterly discretionary shopping. You see it in Europe and in Australia. Australia is a wonderful example where the main anchors of good quality malls are large grocers, which often but not always, co-exist with fashion department stores. Over time we’re going to see more blurring of the lines as to how you deliver goods to consumers and in what format.
In addition, a lot of people will think more and more creatively about how to fill vacant anchor space in malls. It’s given rise to Target, for instance, as an important retailer in the mall environment.
But, when I think about retailers finding the right avenue to distribute their products, it’s really about finding the right trade area. Whether it’s done in an enclosed mall, in street retail, or in a lifestyle center, the format is secondary to the trade area. That said, I do like how you guys refer to this evolving category of shopping centers as “experiential retail”. I think we’ll definitely see more mixing of basic goods and services with fashion, discretionary spending, and entertainment in the U.S. overtime.
I am intrigued, though, as to how long it might take to make grocery shopping successful in U.S. malls and, in general, how long it’s going to take to bring more daily convenience to the mall. Target has been a nice success there, but we haven’t seen a lot of true grocers going to the mall as of yet. You see the occasional Whole Foods or higher-end grocer, but it’s still something new to this country and the roll out could take quite some time.
Miller: Give us your perspective on current economic and demographic trend impacting the consumer – strips and malls?
Lachance: Our view on the economy hasn’t changed for a couple of years. We are in somewhat of a “New Normal”. Most people think of the “New Normal” as an environment of slow economic growth. That translates into a slow pace of job, income, and retail sales growth. An interesting additional wrinkle in the near term is the impact of higher taxes on disposable income. While job growth could average 150-200,000 a month, and income will grow somewhat, tax rates are increasing and cutting into disposable income. This is impacting almost every consumer. Higher taxes are a reality at the Federal and some State levels. So the effects can differ regionally. Being a resident of California, higher taxes have been visible in our daily lives. As the government takes more out of our paychecks it certainly reduces the amount of money that’s available for consumption. Strictly based on changes in tax rates, high-end mall should be most negatively impacted.
For middle income consumers, the end of the 2% payroll tax cut that we had for a couple of years, will have a big impact on disposable income. It means that for a consumer that already has modest means, there’s even less money available to spend on discretionary goods. And that is likely to be a challenge for middle quality malls.
But, there’s a big offset that needs to be considered, and it’s net worth. Net worth has risen dramatically over the past three years. We’re at all-time highs in the stock market and many other asset classes. So for those who have had the means to be invested, and that’s more likely than not a high-end shopper, their bank accounts, or their fund statements, are much more interesting to look at nowadays. Net worth is a primary driver of consumption for higher end shoppers. That has given rise to a tug-of-war between higher taxes and increasing net worth in determining the direction of high-end sales.
High-end malls experienced a 30% sales increase in the last three years. That’s a giant recovery from two years of downturn. It’s taken sales productivity in high-end malls to levels that are in excess of what they were five and six years ago. Middle-productivity malls or so called “B” malls had a more subdued decline during the downturn, but you’re seeing a much more subdued increase in sales productivity since then. Over the next five years, I think we’re going to see low, single-digit sales increases in high end malls, and minimal growth in ‘B’ and ‘C’ malls in general.
As for community centers and power centers, there you have a number of other dynamics. First, that industry caters more to non-discretionary spending. When you look at power centers, their main anchors now have a very large element of non-discretionary spending. Costco has become a tremendous food provider, and is as much a non-discretionary spending trip as it is discretionary.
A lot of the space demand on the part of retailers in the last few years has come in discount formats. We’ve seen a potentially secular change in the mind of consumers, in that they will look for value fairly aggressively. And the discounters – the TJ Maxx and Ross’ of the world – provide a value to the consumer and therefore are providing more demand in power centers.
Miller: Could you address supply and the flight to quality and the disparity between high quality properties versus B properties in the strip center world?
Lachance: The great silver lining of the last few years was the very low pace of new supply. And when we look out over the next few years, the retail sector is highly likely to experience the slowest pace of supply growth among all real estate sectors. That is helping the retail real estate business tremendously. It really forces a retailer to think hard about the quality of centers in which it wants to operate. Let’s look at the strip center business. Over the last couple of years there hasn’t been much net absorption, but the REITs that own some of the better quality assets have experienced a significant increase in their occupancy levels. That’s a demonstration of the flight to quality on the part of retailers, as they focus on the best locations and the best demographics.
The big questions going forward are will we see dramatic increases in net operating income in the higher quality mall and strip properties, because we’ve reached a much better level of occupancy and landlords can push rents more aggressively? Or will we see more development to respond to the retailers desire to grow in certain areas? Or will retailers go down the quality spectrum and try to plant flags in secondary markets that could create four-wall profitability?
Overall, I think that the retailers are more careful today in how they implement their growth plans, and are much more likely to look to online opportunities versus store growth. What we’re seeing now, are retailers creating symbiotic relationships between their online and real estate presence. By doing so, merchants don’t need as many stores and concentrate their bricks and mortar brand presence in the better quality properties versus being spread thin. I think for a period of time, retailers will choose not to grow into lower quality assets. They will also be more cautious about new development than they were in the last cycle. We’re going to be in an extended period of low supply growth for these reasons.
Miller: That makes sense. In terms of public versus private, you seem to forecast less potential upside in valuations in the strip business versus the mall business. Could you explain the differentiation between the two property types?
Lachance: In order to determine the direction of property prices, we look at the relationship between property returns and those of corporate bond yields. Our analysis suggests that if we were to return to the spreads that have existed historically between real estate returns and the yields on some corporate bonds, there should be significant upside to real estate values.
We believe there is approximately 10-15% upside in strip center values in the private market. By contrast, on the mall side, the upside is more generous – in the mid-twenties. We believe there is much better long term NOI growth potential in the mall sector. And that’s really the part that’s interesting here from an investor point of view. In the next five years, we think that, the mall REIT industry, from which our data is derived, will probably experience 4% annual growth in NOI. On the strip side, it’s going to be around 3%. The short term NOI growth difference between the two sectors is not that big and growth should moderate beyond the short term as we have experienced a big run up coming off the bottom. The long term NOI growth difference is actually greater and more important in determining expected total returns. We think that over the long term, mall properties can deliver, give or take, 2% NOI growth, and strip centers, about 125 basis points less than malls. This long-term outlook is really the difference between the expected returns over time for these two sectors. That said, we believe the cap rates at which you can buy each of these sectors do not appropriately reflect the long term growth potential. Hence our view that values should go up.
We all read a lot of articles about dead malls, and there’s always a story in the local newspaper about a local mall that was the place to shop at in the 70’s, and is now virtually empty. But when you think about the value of the mall industry in the United States, the majority of that value is in high-end malls. So the returns an investor can experience, on average, from the mall business, are primarily derived from the better malls. We believe that high-end malls have tremendous staying power and strong NOI growth potential due to their competitive position, because these assets can evolve over time to attract the right retailers and consumers.
The strip business by contrast, is a business where supply over time plays a disrupting role to long term NOI growth. It’s easier to build a strip center than a mall, and as a result of that, and some of the changes taking place in the strip center industry, primarily in the grocer-anchored segment, I think the long term NOI growth of the strip center industry is much less attractive than the mall business.
Miller: You have mentioned that occupancy cost ratios are at historic low levels in the mall business, compared to where they were even a couple of years ago. Is that part of what’s driving the attractiveness of malls and maybe retail overall?
Lachance: I think it’s a very good point. The occupancy cost ratio is a metric that is very interesting. It tells us what a retailer can pay as a percentage of their sales productivity. And it’s true that it’s declined to levels that are particularly low from a historical perspective. In addition to occupancy cost ratios, we’ve started spending much more time on analyzing retailer profitability metrics. The OCR itself just indicates that a retailer can take 15 cents of every dollar it sells and give it to its landlord. That’s a relationship that a retailer can sustain over time at current profit levels. But if a retailer is not as profitable on every dollar of sales, it might not be able to sustain the 15%. So we started looking much more at the profitability of the retailers and gross margin in particular. We want to determine how much a retailer can pay the landlord after it has covered the cost of the goods sold. We also want to know how much retailers take home in profit for each dollar of sales.
When we analyze sales and retailer margins together, we can create a more accurate health index for the retailers. Sales have increased, and the profitability of the sales has also been moving in the right direction. Said differently, most retailers can pay more rent today than they could a year ago, and that gives landlords the ability to push rent some more. It’s not just the occupancy cost ratio being where it is. But the profitability of the sales has been improving as well.
It’s also true for, on the power center side, the junior anchors – and by that we mean the TJ Maxx’s and the Dick’s Sporting Goods of the world, the good size box users, but not the large anchors – like Target and Costco. The retailers on the power center side have enjoyed good increases in their sales, and good profitability growth as well, and that’s positioning landlords in power centers to be able to push rent a little bit more. There are still some issues though in regards to potential supply of space, not necessarily from new supply, but from retailers that might want to shed some space, so rent growth potential is not as exciting as in malls.
Miller: The retailers have improved their balance sheets and are doing well generally. Could you discuss the relative health of retailers, maybe more by category?
Lachance: On the strip side, the category that’s been the healthiest is the junior anchor. They’ve done a good job of rightsizing and sales are growing.
I think one aspect that is misunderstood is the low cost of real estate for these junior anchors. They have very low occupancy cost ratios with the extreme example being Best Buy. Best Buy does have challenges, but not on the real estate cost side. Best Buy spends less than 2% of every dollar of sales in rent and other charges and is very capable of being four-wall profitable despite the business challenges. So they will likely continue to renew leases even as the overall business struggles.
If you think about Target, Walmart, Costco, you can put them into one big category as the large anchors of the strip business. These companies, during and coming out of the recession have held up. Their sales productivity and profitability levels are growing slowly. So they’re OK, but they’re certainly not in position to pay more rent.
The one group that is of most concern in the strip center industry is the traditional grocer. Many have questioned the long term viability of the traditional grocer model. I think that the traditional grocer is viable over time. But they face real challenges. There’s no doubt that shoppers have become a lot more interested in finding products in specialty stores. You see that in the rise of ethnic grocers and you see that in the rise of specialty grocers that focus on the healthier segment. You’ll see the Whole Foods, the Sprouts, the Fresh Markets, or grocers like Trader Joes, which frankly is more of a low-end grocer, capture share. So you’ve got specialty grocers that have created tremendous brand equity and take customers away from the traditional grocers.
On the value side, you’ve had a tremendous amount of sales growth at Walmart, which has become the largest grocer in the US. You’ve had sales move to power centers, with Target becoming a more active grocer. Costco is an important grocer. More and more, large formats like these, will be growing their grocery component. This is a big threat to the traditional grocer. That said, there are traditional grocers that are finding ways to generate profits and meet customers’ needs. Kroger, Publix, and HEB are good examples. But at the end of the day, it’s a very difficult business with thin margins. That does create some question marks as to what will happen to grocery-anchored centers over time. And I think we’re going to see a far larger gap between a good grocery-anchored center and not so good ones in terms of real estate returns over time.
The one category we didn’t talk about is the small shop tenant. Small shop tenants are much more difficult to analyze because they don’t tend to be publicly traded companies. What we’re seeing on the small shop side is more rental income being derived from regional players and from franchisees. Small shop retailers are much healthier today than at the height of the previous economic boom, when a lot of people used their credit card or their home equity to put together the business of their dreams, and couldn’t withstand any shock when the downturn came. Overall demand for space on the part of this group is now growing, especially in good quality centers.
Miller: Well, I can’t resist, so we’ll go right to the department store. Obviously Sears and JCPenney are on the radar screen and their long-term viability is in question. I’d love your thoughts on both of those, in particular JCPenney.
Lachance: Those are big topics. I think the stories are a little different for each of these retailers. Will these retailers find ways to be relevant to consumers? Sears has been on a decade long decline. There’s no real evidence that there will be an operational turnaround at Sears. It’s a business that continues to extract cash from its existing locations, while spending little on the retail experience. Sears is slowly bleeding, and will continue to do so for an extended period of time.
JCPenney is a little different and there is a lot of uncertainty with the recent change at the top. Two or three years ago they were serving the consumer profitably. The JCPenney of today is a different story. The short tenure of Ron Johnson ended poorly and now the company’s financials are concerning. It appears that Mike Ullman was brought back to calm everyone down, from vendors to employees. There’s some irony in the return of an individual that just two years ago was considered part of the problem rather than part of the solution. But times have changed and the pricing experiment developed by Ron Johnson has backfired. JCP now needs to chart a course and decide whether it wants to fully implement Ron Johnson’s layout and merchandising vision.
As a mall analyst, I think of JCP from the perspective of the impact it can have on the malls it anchors. JCP is in about two thirds of U.S. malls. The best outcome for the mall business in general is for JCP to recreate its role as a traffic driver to the mall and re-acquire the customers it lost over the past two years.
But to get there, JCP needs to overcome some near-term concerns in regards to its cash position. The partial roll out of a shop-in-shop concept has drained cash resources from the company. What will they do to improve their cash position? I believe that their real estate will be part of the solution. JCP owns about 40% of its 1,100 stores. But whether owned or leased, the stores can have value to others. The real estate value is therefore a function of what else can be in these boxes. In top malls, the mall owners would be natural buyers of the JCP boxes and could repurpose them with another anchor or redevelop the box into in-line space. We saw a transaction last year between GGP and Sears in which GGP recaptured 11 Sears boxes at its malls and is likely to turn this transaction into a solid return, while Sears was able to unlock a sizable amount of cash from stores that likely were not overly (if at all) profitable. So the JCP story can evolve positively for high-end mall owners and JCP if it harvests some cash from its real estate and stabilizes operations. But in lower-end malls, finding replacements to JCP is more difficult and far less lucrative to the mall owner. As a result, there is much less value per box in such malls – and often no value at all – and I suspect the mall owners would much rather JCP fixes its operations and continues to be a viable anchor in ‘B’ and ‘C’ malls.
Montesi: As you think about the retail business, what is your opinion about Amazon and online retailing more broadly and its future impact on malls and strip centers?
Lachance: Obviously you can’t talk about retail real estate without focusing on the online world. I think that retailers more and more are trying to create an experience for the consumer that can be lived both at the store and online. And so, omni-channel retailing is really what the smarter retailers are all about. They’re finding ways to communicate with their consumers on their terms, and where they prefer to be. And what they’re finding is that there is a true symbiotic relationship between the online and real estate presence, and retailers that can be good at both can be very successful.
My favorite observation on the risks of online retail to bricks and mortar landlords is Apple. Apple had all the makings of an online-only presence. It’s selling a tech-oriented product to a savvy, highly educated consumer that allegedly would prefer to buy that product online. But somehow, Apple has created a wonderful brand experience in their stores, and has driven an amazing amount of consumers to the mall. Apple has turned out to be the biggest success story in the mall business. This is encouraging from the landlord perspective.
So is Amazon going to conquer the world and will we all be shopping only on Amazon? In the near term, that’s certainly not a worry. Yes, the company is growing, expanding its distribution network, and making it easier for consumers to receive goods in a short amount of time. It’s seemingly adding new products all the time. So Amazon is potentially a real threat to the retail real estate industry. However, it does not have the ability to give consumers the in-store experience, which consumers still want. Interestingly, Amazon and Google have been looking at opening stores. Both the online and the real estate can live together, and in fact, might be better together.
Online sales will still grow at a much faster clip than retail sales in stores. For a number of retailers, it’s going to create better profitability by being able to leverage both the online and the store presence. And it’s also curtailing real estate supply. I believe that online growth is a big part of the explanation for the stunningly low growth in new retail real estate supply. A lot of retailers are investing primarily in their online presence and are interacting differently with consumers and the current supply of retail real estate generally is sufficient for the type of sales that can be expected to be done in those environments for the next several years.
Montesi: Yes retail sales growth used to be driven by opening new stores, and this last cycle it has been accommodated by online retailing growth.
Miller: And Cedrik, we talked about the higher-end malls and mall companies spending a disproportionate amount of investment dollars in redeveloping their most successful malls. This leaves a lot of properties in their portfolios – their ‘B’ properties, or ‘A’ properties in secondary markets – that have been under invested in, and have not evolved. What opportunities do you see for investors in the middle part of mall companies’ portfolios? Will these properties be attractive investment opportunities?
Lachance: We do put a lot of focus on the higher end. Meanwhile, there’s a giant amount of real estate that exists, and let’s call it a ‘B’ mall business, with reasonably positive prospects in many cases. So how do you define ‘B’ malls? I think people have different views there. Our definition of a ‘B’ mall is an established property that does, give or take, $350 to $400 a foot in sales. There are two subgroups of “B” malls. There are malls in major metros that have OK to declining competitive positions and there are malls that we deem “only game in town” or properties that have a good competitive market position as the only mall within a relatively large radius.
A big challenge is how to position B malls in large metropolitan areas. Let’s say a mall that’s number seven or ten in sales in Atlanta. Retailers looking at their online versus physical presence tend to not need store number seven or ten in Atlanta and therefore those properties are vulnerable. There are certainly better potential in the ‘B’ mall business. But they come more with the risk associated with potentially picking the wrong assets or not operating the assets appropriately. The stakes are high. To be successful, in owning ‘B’ malls, you need to be a successful operator.
Miller: Improving experience – do you think that’s important?
Lachance: Yes it’s very important. I think more and more you can create, basically, town centers in some of those malls. That’s certainly something we hear from mall owners. What they’re trying to create is the main street of the community. And it’s creating centers that really serve a broad community purpose. So you will have a fashion component, but you’ll have many more reasons to be there outside of shopping for clothes. Restaurants, entertainment and daily needs become more important. I think these malls can get better, but it comes with a risk, potentially a go-to-zero scenario if something goes wrong. And that’s the part that’s most difficult to gauge. In terms of risk, why would the market allow ‘B’ malls to trade at much better potential IRRs? It’s because there’s a real possibility of a property being worth nothing five to ten years from now, because for some reason it has not been positioned appropriately, or demographics have continued to change, or supply of other retail has made the mall irrelevant.
Miller: I remember back in the 90’s when a lot of these large retail REITs were created. But 20 years later, there’s really been very few great retail operating companies created with fresh strategies. Do you think there’s investor demand for new companies?
Lachance: There has been tremendous consolidation over the last fifteen plus years, in the mall business. Public companies control 80% of the malls in the United States, whether wholly owned or in institutional JVs. The number of mall REITs will likely remain fairly unchanged over the next several years. It’s truly unusual in the commercial real estate business to have such concentration of ownership, which makes it unlikely that new public mall operators will emerge.
On the strip side, I think that we will see more public companies. But there is often a high hurdle to clear to list shares. Public market investors do look for a certain quality in the portfolio and the balance sheet, as well as a track record as an operator. A question on the public side in the near term is, what will Blackstone do with its large strip center portfolio? The public market, from our perspective, prices strip centers more aggressively than the private market, so I would argue that a public market exit could be a compelling proposition.