The competitive retail landscape is changing, with diversified REITs spinning off retail properties into new pure-play models. Christopher O’Dea reports
After three years during which there was virtually no new construction in some major sub-segments of the retail REIT industry, the sector has become as competitive as the rag trade, the fashion industry on New York City’s Seventh Avenue. Several major changes are under way in the retail REIT industry, which means investors will need to be as nimble as fashion editors to stay ahead of the trends that are driving revenue and funds from operations (FFO).
The ongoing, if uneven, US economic recovery is benefitting local retailers and mom-and-pop shops alike, supporting a range of shopping centres. Outlet malls, which developers and property owners previously located far from their upscale properties hosting premium brands, are now being built in closer proximity to the upmarket outlets – and including global fashion icons in the line-up.
At the same time, REITs are reconfiguring the competitive retail landscape, with multi-class REITs spinning off retail properties into new retail-only REITs, and some retail REITs sharpening their focus on a single type of property. This push to pure-play REITs – while pronounced in the retail segment – is occurring across the industry, and could have implications for asset allocation, allowing investors to tailor REIT exposures to the property types they believe are best positioned with regard to economic, demographic and financial factors at any given time. The reasons are financial and strategic – including the desire to reduce leverage, while achieving better valuations for streamlined REITs holding higher-quality or more focused assets.
Fundamentals in the shopping centre segment should continue to improve in the second half of 2014, says Fitch Ratings, with new leases for space commonly occupied by smaller tenants (in-line) boosting occupancy.
Fitch sees improving home equity, declining unemployment and generally improving financing across the broader economic setting benefitting local retailers and mom-and-pop. Over time, says Fitch, these entities have come to comprise a smaller portion of in-line space among many REITs as they have been opportunistic and merged smaller spaces into larger areas that can then be leased to stronger national or regional tenants. Overall, Fitch expects “negotiating leverage on future lease terms will continue to transition more toward the landlord”.
There is already a pure-play REIT in the local shopping centre sector. Formed in 2009, Retail Opportunity Investments Corporation (ROIC) specialises in the acquisition, ownership and management of necessity-based community and neighbourhood shopping centres, anchored by national or regional supermarkets and drugstores. As of 31 March 2014, ROIC owned 56 shopping centres encompassing approximately 6m sqft in its $1.4bn (€1.1bn) portfolio, with a full 52 of the properties unencumbered. It was added to the S&P Small Cap 600 index in May.
ROIC is a ground-up implementation, including infrastructure that uses the technological capabilities of the latest accounting and property management software. During REITWeek2014 in New York in June, the company said its focus was “primarily on unique, not widely-marketed opportunities to acquire assets from distressed and/or undercapitalised owners, partially leased properties with inexperienced management unable to achieve market occupancy”. Such assets “may have deferred capital expenditures or design flaws, or other ‘perceived risks’ such as tenancy issues, near-term lease expirations and temporary market weakness”, it said.
It is a large, nationwide market with highly fragmented ownership – there were more than 108,000 shopping centres in the US at the end of 2012, representing approximately 7.5bn sqft of gross leasable area, according to the International Council of Shopping Centers (ICSC). ROIC’s target markets are mainly on the West Coast, where the company sees favourable demographics such as population and income growth, as well as high barriers to entry like limited construction space and high occupancy.
“The credit crunch continues to create significant opportunities to buy assets from distressed owners or lenders,” says ROIC. Of the $68.1bn of retail property mortgages that became troubled over the past cycle, $26.2bn remains distressed, according to Real Capital Analytics, providing a large market for potential opportunities
Malls are evolving as well. A cyclical recovery in retail sales and essentially no new supply over the previous three years have brought about low occupancy costs, solid leasing spreads and occupancy levels greater than the previous peak reached in 2007, according to Fitch. These factors drove solid same store net operating income (SSNOI) growth of 4.1% in 2013 and 2.6% in the first three months of 2014 for rated retail REITs, with the dip from 3.9% in Q1 2013 driven, in part, by weather-related expense growth. However, Fitch “expects that declining mall sales and an uneven retail environment will begin to temper the solid leasing spreads seen during the previous 12 months”.
Nevertheless, Fitch says REITs will “mitigate a softening retail setting by opportunistically replacing weaker-performing tenants with healthier retailers generating higher sales per square foot”. The agency expects this tenant replacement strategy to be much more feasible for class-A malls, as retailers continue to concentrate their presence in higher-productivity centres. The economic resilience of class-A mall cash flow is illustrated by 3.2% average SSNOI growth over the past 10 years, compared with 0.6% for REITs focused on lower-productivity assets, says Fitch.
While class-A malls are the kings of cash flow, outlet shopping centres, where big brands sell discounted goods, have been moving up the food chain. Since 2006, 40 outlet centres have opened in the US, while only one new regional mall has emerged, according to ICSC. In the past year, the number of retailing chains operating discount stores in outlet malls rose to 368 from 322, and some are close enough to their regular stores to almost be neighbours.
Outlet centres are getting a lot closer to full-price retail malls, says Robert Cohen, president of the Southern California region for RKF, a leading retail real estate firm based in New York City. Big REITs are reshaping their strategies accordingly. Simon Property Group (SPG), for example, recently completed a $100m 50-store expansion at its Desert Hills Premium Outlets, and a centre near a highway in Riverside County, California. To enhance its focus on its highest-quality properties, Simon, the premier mall owner in the US, spun off some of its regional mall holdings and shopping centres into a company called Washington Prime Group that began trading as a standalone REIT in May.
Spin-offs are taking place across the retail REIT spectrum. American Realty Capital Partners (ARCP) recently agreed to sell its multi-tenant shopping centres to a unit of Blackstone Group for just under $2bn, in a move that reinforces its focus on single-tenant retail property such as free-standing restaurants. Some observers say ARCP has “bet the proverbial fish farm” on the move, as it recently purchased 500 Red Lobster locations in the US for over $1.5bn.
Vornado Realty Trust (VNO) is in the process of spinning off its non-Manhattan portfolio of 81 strip shopping centres and four malls into a new publicly traded REIT that will have $200m income in 2014. The transaction “makes strategic sense, in our view, providing a choice of more focused opportunities for investors,” said Citi REIT analyst Michael Bileman in an investor note when the deal was announced. Bileman added that Tornado’s portfolio generates two-thirds of its pre-tax and depreciation earnings from it New York City properties, comprised of 48% office and 19% street-level retail, and 24% from Washington, DC office holdings.
The fledgling REIT will have a strong portfolio. The strip centres are located mostly in the Northeast, totalling 16.1m sqft – with an average occupancy of 95.5% at year-end 2013. Vornado’s spin-off has resulted in a better-focused company, says Alexander Goldfarb of Sandler O’Neill & Partners.
“Over two years ago, we had advocated the company split up, sell off or spin off the shopping centre portfolio and focus its attention on its core office and street retail portfolio and, in fact, that’s what the company has done,” Goldfarb says. During that time much news flow was about potential simplification. “Looking at the company’s results and press releases this year, much has revolved around announcing leases that are adding NOI, which boosts NAV and grows FFO,” he says.