This is the final part of a three-part series that explores the remarkable resilience of the retail sector and sheds light on its continued growth in an ever-evolving landscape. In this article, we set the foundation for what we believe will be a renewed and robust investment cycle for retail.
Retail Looks Relatively Attractive on Pricing
The ultra-low interest rate environment that persisted during the pandemic spawned a massive injection of capital into property markets. The CRE sector broadly experienced a 23.5% increase in sales from 2020-2022 compared to the prior three years. Meanwhile, retail investment sales registered a 0.8% decline over that period, as a lack of regional mall activity weighed on sector totals; open-air retail experienced robust years of individual transactions as well as healthy M&A activity.
The retail sector’s lagging performance relative to other property types is likely to be a tailwind going forward. Other asset classes saw a larger spike in price appreciation, disincentivizing owners who purchased in that environment from selling in today’s market, which is characterized by sizable price adjustments and relatively healthy cash flows. Meanwhile, potential buyers are faced with the prospect of underwriting purchases with negative leverage—meaning debt costs are higher than the going-in yields. In this situation, a property needs to demonstrate the potential to generate additional income from its future earnings to achieve positive returns over time. Purchasing an asset with negative going-in leverage, especially in the current environment where income growth across most CRE types is entering a more subdued phase, is a risky strategy. The lack of seller urgency and challenges in buyer underwriting has led to a disconnect between buyer and seller expectations and a sluggish transaction market.
This dichotomy is not as acute for the retail sector. From 2019 to mid-2022, retail prices per square foot rose just 9.6%, compared to the staggering increases of 40%-50% in the apartment and industrial sectors. While counterintuitive, the relative benefit of less price appreciation is now coming to bear, as retail’s recent price adjustments have been relatively muted. In the past four quarters, capital depreciation for retail properties has been 6.3%, or about half as much as the overall CRE sector. These less brash movements mitigate pricing disconnects, allowing transaction volume to be less impeded. Through the third quarter of 2023, overall CRE sales volumes were down 55% from 2022, but retail transactions were off only 40%, the smallest decline among the five major CRE asset types.
Income-Driven Investing Favors Retail
All corners of the CRE market are set to experience ongoing capital depreciation, as higher interest rates require an upward adjustment in yields. Once that adjustment occurs, and as buyers gain more conviction in debt and pricing expectations, buying opportunities will increasingly emerge. Given that significant cap rate compression is no longer a reliable outcome, income expectations—both from a stability and growth standpoint—will emerge as a more pivotal driver of property returns and portfolio performance. Retail stacks up favorably here, too, for several reasons:
- Tenant demand remains robust, with the number of store openings announced this year outpacing closures, supporting favorable occupancy and mark-to-market rental rates, particularly in suburban Sun Belt shopping centers where demographic and economic trends are strongest. This is a multi-year phenomenon that is expected to continue.
- Net operating incomes (NOI) have stabilized following rent abatements during the pandemic, and income returns over the past four quarters have been a healthy 5.2% cumulatively, exceeding returns for office, apartment and industrial assets. Retail sales per occupied square foot have increased by about 25% since 2019, giving landlords leverage to push rents.
- The size of the investable retail universe has not grown meaningfully over the last decade. Construction of new retail CRE has been declining steadily since 2017, from already subdued levels. Construction hit a multi-decade low in the first half of 2023, as higher debt costs and a risk-off mindset among lenders slowed development to a halt. Limited supply in a market with already high occupancy presents an upside to income fundamentals.
During times of capital markets uncertainty, investors tend to favor strategies that solidify income streams and limit downside risk—and retail shopping centers exhibit these characteristics. The Cushman & Wakefield baseline forecast, which assumes a modest economic recession in 2024, projects that retail asking rent growth will decelerate modestly from 4.3% this year to 3.3% in 2024, maintaining positive growth, while other sectors, such as multifamily and office, see average rent declines and negative NOI growth. Even in the industrial space, where fundamentals trend more robustly than retail on average, there is still a higher degree of variation across markets and subtypes due to the sector’s high concentration of new construction and a cyclical ebbing in demand. Investors are growing increasingly aware of retail’s resilience:
over 90% of retail investors in the fourth quarter expected retail occupancy to remain the same or increase in 2024, and virtually all expected positive rent growth.
Although CRE investors will remain drawn to multifamily, industrial and certain niche property types, given their recent success and long-term potential, there is a growing opportunity for retail to absorb some of the pullback in office, which faces structural headwinds and excess inventory. Since 2019, the office sector’s share of Open-End Diversified Core Equity (ODCE) portfolios has fallen from one-third to one-fifth, as capital has funneled toward better performing, less uncertain sectors. Retail has not yet regained share from institutional players, but the pricing and income fundamentals make it an attractive option. In our forecast, cap rates for retail properties are expected to adjust upward in 2024 but remain lower than office cap rates over the next five years due to favorable fundamentals and comparatively lower risk premiums required by lenders and investors.
Lending Headwinds Not as Impactful for Private Investors
Debt remains an important part of most retail transactions, and the current environment is impacting deal flow and pricing. Eventually, the market will improve, but until that point, investors improve their odds of a successful transaction by bringing more equity to the table and targeting smaller deal sizes. Most retail transactions happen in this space, creating a unique advantage for private buyers who typically have greater access to cash, and strong local and community banking relationships to access debt for smaller transactions. More than three-quarters of investors we surveyed expect to be net buyers of retail in 2024, with the bulk of those coming from private capital groups targeting grocery-anchored neighborhood centers and unanchored strips in Southeast markets.
From leasing fundamentals to relative pricing and capital structure, the stars seem to be aligning for retail investment to outpace its recent performance in the upcoming investment cycle. While the sector is unlikely to experience the type of frenzied growth that other asset classes have experienced in the past, the case for retail as a relatively stable investment on a risk-adjusted basis is favorable. Private and institutional funds alike will have increased opportunities for value-add plays, as pricing continues to adjust and forced sales come to the market. Now is a good time to sharpen the pencils for opportunities across the retail sector.
