patternAugust 21, 2024

While Trends Bode Well, Areas of Risk Remain

Market Insight
Blaire Butler
From The Colorado Real Estate Journal, August 2024
By Blaire Butler

When it comes to real estate investing, higher risk equals higher reward. When it comes to real estate lending, the mindset shifts a little. It’s valuable to be able to understand a lender’s perspective and present opportunities in a way that anticipates and mitigates their concerns. There are some key consistencies occurring in the retail sector as a whole, from my perspective.

Adapted, relevant While the office sector may be in the midst of its midcentury crisis, I would argue that retail has already experienced this cycle. The creation and rise of e-commerce brought about a fundamental shift in the way consumers acquire goods. Headlines surrounding the “death of brick and mortar” lined publications for years followed by continuous announcements of bankruptcies and store closures. Per CoStar, store moveouts impacted over 400 million square feet per year in 2018 and 2019 before peaking at nearly 420 million sf in 2020. Since 2020, however, the store closure volume has decreased and, while there are still some retailers downsizing their physical footprint, it feels as though the big wave has passed. To a large degree, retailers have adapted to the shift, and the real estate that remains is relevant, thoughtfully located, destination-oriented and high performing.

Balanced economics The supply and demand story we all learned in Economics 101 is playing out in real time in the retail sector. Steadily rising demand from new and existing retailers, a reduction in tenant bankruptcies and store closures, and limited new supply have created a balanced market that bodes well for real estate investment. Per CoStar, only 4.7% of retail space across the country is currently available for lease; this is the lowest level since CoStar began tracking the national market in 2006. The national reported vacancy rate is just 4.1%, with Denver reported even lower at 3.8%. While consumer demand remains strong, the other part of the equation is supply. Fewer tenants are moving out, experiential, and food and beverage retailers are driving more demand, and minimal new construction is being built. Per CoStar, deliveries totaled just 35.7 million sf over the past 12 months, which is less than half of the prior 10-year average. Most retail construction activity comprises single-tenant build-to-suits or smaller ground-floor spaces in mixed-use developments. Minimal new construction is anticipated to continue for the foreseeable future, given high construction costs and financing costs. In many cases, the rents needed to achieve an adequate return on a new development project are not feasible. Retail tenants already are absorbing higher costs for insurance and real estate taxes; there’s only so much room to push rents before it becomes too difficult for tenants, particularly those locally owned, to stay in business. The supply trends in retail real estate could lead to several more years of strong fundamentals. While these trends bode well for retail, there are certainly still areas of risks. Specifically, each subsector of retail possesses nuances that drive how lenders perceive and mitigate risk.

Anchored retail Neighborhood retail with a strong grocery anchor continues to be the favorite in lenders’ eyes, presenting the least risk. This was further confirmed through COVID-19, with the Centers for Disease Control and Prevention deeming which businesses were “essential” for society. A well-located property with a top grocer undoubtedly performs well, in good times and bad. The key to achieving the most aggressive financing is providing tenant sales figures. If that’s not available, data on consumer traffic and behavior, from a source such as Placer.ai, can fill in to demonstrate a center’s viability. Shadow-anchored properties receive similar treatment from lenders. If you’re looking to finance an anchored retail property, you can anticipate strong interest, 60%-65% leverage, 150-180 basis point spreads, and lengthy interest-only periods. Perceived Risk Level: Low

Strip retail Lenders tend to view strip retail as a riskier grouping, largely because there’s not a strong anchor to drive traffic. Additionally, neighborhood strip retail centers are more often comprised of “mom-and-pop” type tenants that are not as resilient in challenging economic times. While that viewpoint is not obsolete, there has been a renewed interest in lending on strip retail. Multitenant properties with diverse rent rolls protect against vacancy risk. One vacancy doesn’t disrupt the property’s cash flow as much as a large-box or anchor tenant, plus there’s a higher number of these operators to backfill one that goes out of business or moves locations. Further, the accessibility to consumer data has enabled businesses, even at the “momand-pop” level, to make more strategic decisions on locations and capitalize on synergies with other retailers. With the resiliency of this subsector through COVID-19 and the lack of new supply coming on line, lenders are bullish on its continued success. If you’re looking to finance a strip retail property, you can anticipate strong interest, 55%-60% leverage, 190-220 bps spreads and moderate interest-only periods. Perceived Risk Level: Moderate 

Large-format retail Large-format retail properties (think power centers and malls) are considerably harder to finance, given lenders’ perceived exposure to vulnerable tenants. While there are still some strong performers, landlords have also experienced vacancies, with a smaller pool of tenants to replace them. While there is a surge of experiential retail absorbing large-format space, often these are newer concepts that lack the financial strength to materially overcome the perceived risk. These properties are also more inclined to have leases with co-tenancy clauses, which presents a hard downside scenario for lenders to mitigate. That being said, there is liquidity in the market for well-located properties with a long history of strong performance owned and operated by best-in-class sponsors. Another trend within this subsector is repositioning. Investors are recognizing that there is opportunity to repurpose some large-format retail centers to bring new uses, more density and various demand drivers to a specific location. These are often complicated, large and risky transactions, but certain lenders are willing to lean in. Financial wherewithal and liquidity of the Sponsorship is vital, as are conservative assumptions. Perceived Risk Level: High 

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