We’re Overbuilt in Retail
America’s inventory of shopping centers is ominously overbuilt. Even if the migration of retail sales to the internet had not brought chronic overbuilding into sharp relief like it has, pre-recession overbuilding created a distorted ratio of retail space to consumers in the US. By comparison, the ratio of retail space to population in the US is double the rate in Canada, and quadruple the rate in Germany. Think about that for a moment.
Prior to the Great Recession, REITs and other institutional owners had four means to grow their revenue pie:
- Build new shopping centers, which they did with their in-house development teams.
- Acquire individual existing shopping center assets that met their investment criteria.
- Acquire competing institutional portfolios.
- Improve operating margins via increased rents or reduced costs.
Pre-recession, businesses such as DDR, Brixmor, Regency Centers, Kimco and Weingarten each had extensive in-house development teams tasked to develop new shopping centers. However, as the reality of overbuilding and internet competition, as well as other factors, has stifled the pace of new shopping center development, institutional owners have dramatically reduced ground-up development expectations as a means to grow revenues. This in turn has put increased pressure on fostering growth through other means, such as the acquisition of existing centers, preferably in core markets.
Yet, while twenty or even ten years ago, institutions could reliably secure several independently-owned assets annually, relentless consolidation in the industry and the success of numerous high quality REITS has mercilessly winnowed down the playing field of better quality one-off assets that come to market each year.
With the growth in institutional ownership has come the parallel rise of more sophisticated owners and managers of these assets. That sophistication has put constant pressure on rents and costs over the past two decades. Today, revenue growth through further operational improvements can at best have a single digit impact on a portfolio’s annual returns.
These limitations to revenue growth – from reduced ground up development, to declining individual asset purchases to decelerating rent growth have conspired to create a greater focus on growth through acquisition, or merger. 2017’s acquisition of Equity One by Regency Centers, and Property Development Centers by TRC, and Westfield by Unibail-Rodamco were examples of these market pressures.
Look for more consolidation over the next five years. The combined influences of an overbuilt US marketplace, surging internet competition, further retailer bankruptcies and creeping interest rates will unquestionably result in shrinking avenues for growth among REITS and their institutional peers. The firms with the weakest ability to generate revenue growth for the hedge funds, retirement systems and other patrons that invest with them will face an interesting two-sided truth. On the one hand they will confront the reality that the only option to create value may be through a sale. But on the other hand, a limited supply of institutional caliber assets will likely result in intense competition and soaring valuations once their portfolio hits the market.
The sober CEO who sees a sale as a realistic possibility should already be thinking about timing. Depending the on the size of the portfolio, a quarter point increase in rates may result in tens of millions of dollars in lost value. Interest rates are clearly set to move steadily higher after years of ultra-low rates, with the Wall Street Journal recently suggesting that up to four interest rate increases may be in store for 2018.
CEOs and their investment bankers should work double time in 2018 trying to identify the right interested seller, or acquirer, before interest rate movement reduces, or eliminates, the advantages to capture value through a sale or merger.
In addition to more sale and merger activity, these changing market dynamics are also creating pressure for owners to both diversify and densify their properties, as a method to create new streams of revenue. The densification of historically retail-only sites into mixed use environments, with housing or office space that creates the opportunity for these properties to grow vertically has begun to take root with some, but not all, institutional owners.
Wall Street has historically invested in REITs because of something called the purity of the play. REITs create the opportunity for investors to place specific bets on targeted assets classes, such as suburban grocery-anchored centers (Regency Centers), power centers (DDR), apartments (Essex Property Trust) or class A office in core downtowns (Equity Office). As market pressures compel owners to create new revenue streams and diversify, the purity of the play will have to be replaced by a new narrative. One that speaks more to mixed-use, core markets and densification. Given the overbuilt landscape of US retail space, diversification away from pure retail will represent both a desperately needed new stream of income beyond retail rentals and a hedge against flattening retail rents, retail bankruptcies and thinning operating margins.
While an overbuilt US market for retail will continue to take a toll on select owners and investors, a market-driven correction in the form of more acquisitions & mergers, and the diversification and densification of historically retail-only properties is already well underway.
Source: The Registry, February 24, 2018.
Author: John Cumbelich
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