CREJ - Retail Properties Quarterly - May 3, 2017
Is the internet killing retail as an investment product type? If you have been following the recent store closure announcements, one might be inclined to believe that was the case. Macy’s, J.C. Penney, Abercrombie & Fitch, Gander Mountain, Sears/Kmart and Whole Foods are among a number of retailers closing stores across the country. Others such as Sports Authority, The Limited, HH Gregg and American Apparel have filed bankruptcy and either went out of business completely or are moving to an online presence only. However, this frequently discussed narrative overlooks the fact that while some retailers have faced difficulties, due to a constrained supply of new retail construction, shopping center fundamentals are strong and improving. The Denver metro area has seen its fair share of store closures, yet in total vacancies continue to decline. Rents continue to increase. There is no shortage of demand for well located, appropriately priced retail shopping centers. In fact, investor demand for retail centers far outpaces supply. These trends are seen on a national level as well. The internet clearly is having a negative impact on certain types of retailers, and it is forcing landlords to revise their tenant line-ups to favor food service, health and value oriented retailers, but its cumulative impact has not changed the appeal and viability of shopping centers as an investment. Since peaking in fourth-quarter 2009, the Denver metro area retail vacancy rate has fallen every year and is projected to hit 4.8 percent in 2017. This is despite the area absorbing a number of closures during this period from retailers such as Safeway/Albertsons, Sports Authority, Office Depot/Office Max and Golf Smith, to name a few. As the vacancy rate has decreased, rents have been increasing. Retail rents grew by 3.6 percent in 2016 and are projected to increase by 3.1 percent to $17.19 per square foot in 2017. The driving factor at work here is that while population and consumer demand have increased, the supply of new retail construction has remained relatively constrained. Since the recession, deliveries of new retail construction have been less than one-third of what they averaged prior to the recession. This has put a significant premium on viable retail shopping centers for tenants and investors. Well-located shopping centers in the Denver metro area continue to be highly sought after and are trading at more aggressive values relative to income than they were prior to the recession. Assuming a property is properly priced, numerous offers can be generated in relatively short periods of time. Newly constructed small strip retail centers, often featuring restaurants and food-service-related retailers, are highly coveted by 1031 exchange buyers looking for passive income. Most likely we have seen the peak of this cycle with respect to capitalization rate compression; however, this is largely a product of the changing interest rate environment. The 10-year Treasury has increased 60 basis points since the election (at the time of this writing), and the federal funds rate is projected to see an additional six increases over the next 18 months. Assuming the Fed continues increasing interest rates, there is a strong possibility that the 10-year Treasury reaches 3 percent by the end of 2017 for the first time since December 2013. As interest rates rise, buyers will require higher capitalization rates to achieve their targeted returns. It’s important to point out that capitalization rates have decreased every year, on a year-over-year basis, since 2010 – the same period of time that has seen exponential growth in internet retail sales. Strong and stable job creation in the Denver metro area continues in 2017 and is expected to create another 41,500 jobs by the end of the year. This is in spite of the fact that the unemployment rate in Colorado is at 2.9 percent, its lowest level since 2001. Continued job creation, combined with a low unemployment rate, has led to several consecutive years of wage growth. Incomes in Denver have seen an increase of nearly 25 percent since 2010, according to our research. The corresponding increase in consumer spending has encouraged a number of retailers to expand their existing footprint in the Denver metro area, while a number of others have entered the market or are attempting to do so when the right opportunity arises. These underlying fundamental trends, while not as pronounced as they are in Denver, also exist on a national basis. Vacancy rates are decreasing and are projected to hit a 16-year low in 2017. Rental rates are increasing, and a constrained supply of new retail construction has put a premium on existing retail space. Retail sales, excluding the internet, increased on a nationwide basis by 2.8 percent in 2016. So why is there such concern over the impact of online retail? After all, internet sales currently account for only 10 to 12 percent of total retail sales. The concern isn’t just the current market share, but the rate at which internet retail sales have grown relative to brick-and-mortar store sales. In 2016, for instance, internet sales increased by 12 percent on a year-over-year basis, more than four times greater than the increase in brick-and-mortar store sales. This has disproportionately impacted larger retailers offering products that are easily found online at a less expensive price. Electronic and office supply retailers have been obvious victims, while department stores and certain soft good retailers have felt the impact as well. While certain retailers, or retail segments, are negatively impacted by the internet, not all retailers are struggling. Food service sales are up more than 50 percent since 2009, while home improvement store sales have risen almost 45 percent over that same period. Value-oriented retailers such as Five Below and the TJX Cos. (Marshalls, T.J. Maxx and HomeGoods) saw significant increases in their 2016 sales, 20 percent and 7 percent, respectively. Retailers such as Ulta, Dollar General and T-Mobile are expected to increase their brick-and-mortar presence on a national basis this year. Health and fitness tenants have been expanding and are projected to absorb a significant amount of retail vacancy. Locally, VASA Fitness opened its first Denver metro area location at the corner of South Buckley Road and East Quincy Avenue and is expected to grow its footprint moving forward. As internet retailers have taken a larger share of the market and increased their reach into everyday retail consumption, a constrained supply of new retail construction has put downward pressure on brick-and-mortar vacancies, while pushing rents higher. Investors have driven pricing for investment retail properties to values, relative to income, that have surpassed their prerecession levels. There is no question that internet retail sales are impacting shopping centers and putting certain retailer’s business models into question. Moving forward, retail owners will need to re-evaluate what constitutes the optimal tenant mix for their respective centers while focusing on tenants that are difficult to disintermediate through online options. However, the market fundamentals, especially in the Denver metro area, demonstrate that retail shopping centers are on strong ground and remain a sound investment product type moving forward.