The REIT Newsletter for Advisors • Fall 2024
Retail REITs in Broadly Positive Position at Mid-Year
Fundamentals for retail real estate appear favorable at mid-year, supported by supply constraints and retailers’ continued commitment to brick and mortar stores as an essential distribution channel. Analysts are watching pockets of consumer stress but remain generally positive that leasing volumes and pricing power will trend higher for real estate investment trusts (REITs) during the rest of the year and into 2025.
Advisor Access spoke with sector analysts Michael Gorman at BTIG, LLC, RJ Milligan at Raymond James, and Linda Tsai at Jefferies, LLC, for their outlook on REITs that own retail real estate.
Advisor Access: How would you describe retail real estate fundamentals at mid-year, and what are you expecting for the rest of 2024?
Michael Gorman: As we sit at mid-year 2024, retail real estate fundamentals for strip centers are quite strong. Retailer demand is some of the strongest we have seen, certainly in the past 15 years. Coupled with a lack of new supply over the past decade, REITs in this space are seeing great leasing volumes and solid pricing power as a result. This should ultimately lead to stronger same store NOI (net operating income) in the back half of this year and into 2025 as the new leases come online and the gap between signed and occupied space shrinks.
The one hold-up on the fundamental front that is getting increased attention is the capex required for backfilling vacant spaces in retail portfolios. That would moderate some if occupancies stabilize, but it is a focus right now.
RJ Milligan: Retail real estate fundamentals in the net lease and shopping center space are as good as they have been since the Global Financial Crisis (GFC). COVID-19 was really the big turning point as retail real estate headwinds turned into tailwinds when retailers saw the value of having a brick-and-mortar presence. Concerns about tenant fallout have mostly been overblown, and thus far this year we’ve seen minimal bad debt write-offs, which has resulted in slight increases to guidance.
We expect more of the same for the rest of the year and investors have really pivoted to looking to 2025, as all of the leasing done over the past several years finally drops to the bottom line, resulting in accelerating FFO (funds from operations) growth.
Linda Tsai: Given year-to-date stock underperformance, low supply, and contained tenant store closures, shopping centers look attractive in the second half of 2024. Expectations for 2025 earnings growth are lower for shopping centers versus other REITs, but the year-on-year improvement in earnings growth is higher, underscoring favorable valuation.
The transaction environment has been muted overall. REITs have been challenged to issue equity, hamstrung by weak stock prices trading at discounts to NAV (net asset value). That said, we expect improvement from here, given a lower inflation point and a greater likelihood that interest rates are coming down. Shopping center REITs’ eagerness to acquire underscores confidence in the tenant/retailer demand environment, unlike the years leading up to the pandemic, when REITs were net sellers.
AA: What are the most prevalent trends you are seeing in consumer spending?
Gorman: We are seeing lots of conflicting trends right now in the consumer space. Macro data is showing record credit card debt at the consumer level, but also still record checkable deposits. Real wages have started to decline, but consumer sentiment remains elevated off of the lows of 2022. All of the cross currents at the macro level aside, we are seeing and having more conversations about consumer stress, especially at lower income levels, and trading down behavior. We are also seeing a greater focus in our conversations on portfolio quality, income demographics, and also non-discretionary tenant exposure. This certainly has a more defensive feel to it.
Tsai: The consumer has held up, but pressure around the low- and middle-income consumer has increased. We’ve seen this in the types of retailer restructurings (Rue 21, Express, JOANN, 99 cents Only) and store closure announcements (Family Dollar, Walgreens). First quarter credit card delinquencies rose 8 basis points quarter over quarter to 3.16% but remain below the long-term average of 3.7%. The personal savings rate as a percentage of disposable income, 3.8%, remains below the long-term average of 6.1%, having hit a pandemic high in 2020 of 24.5%. Even if the consumer is slowing though, the main story for retail real estate is lack of supply and retailers’ commitment to brick and mortar as the most profitable distribution channel compared to ecommerce alone.
Milligan: We’ve seen some weakness for lower-end consumers, but the good news for REITs is that they really aren’t their core customers. Remember, REITs own the highest quality retail real estate with the best tenants. Retailer demand for space remains very strong.
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AA: Where do you see the strongest pockets of opportunity within retail real estate?
Tsai: Net lease has been the underperformer within retail and the ability to grow more accretively again through acquisitions should be well received. We are constructive on shopping center fundamentals. Malls, we are more hesitant towards, given some of the store closures in apparel that focus on the middle-income consumer, challenges around bigger boxes like F21, and continued consolidation of department stores (Saks/Neiman), which point to an ongoing supply/demand imbalance that benefits discounters and luxury more in the open air and high street retail.
Milligan: One of the biggest opportunities is upgrading tenants to drive more traffic. With such a limited amount of space available left to lease, the landlords have meaningful negotiating power for higher rents, but also for the best tenants that will drive traffic and increase the value of the overall center.
Gorman: Based on the conversations that we have been having lately, it seems as though there could be more investment opportunity with larger deal sizes both because the buyer pools are smaller and also because there are likely more levers to pull in favor of value-add. We are also seeing institutional landlords use their tenant relationships to take advantage of investments that perhaps have nearer-term lease expirations where they have additional confidence. That said, given some of what we are seeing on the consumer side, we are more skeptical of any “opportunistic vacancy” or “leasing upside” in the market right now.
AA: Is there anything else you expect to be watching as you monitor the retail real estate sector going forward?
Gorman: The traditional real estate fundamentals of supply/demand dynamics clearly favor retail landlords at the moment. However, we are watching for discussions about where those strong fundamentals run into the upper bounds of retailer business models. Perhaps the fundamentals support a certain rent level, but the occupancy cost that rent implies for the retailer is unsustainable.
We are also watching the WFH (work from home) trends as well, as neighborhood retail has certainly been a beneficiary of population trends. Finally, tech continues to be a major player in the retail space. The omni-channel environment continues to evolve, and various tech platforms are increasingly playing a role both for landlords and tenants for determining optimal site selection.
As we get more dovish signals from the Fed and inflation data, we are watching the interplay between the potential relief on landlords from financing headwinds with the risks that the reason for the rate relief is a slower consumer and economic environment.
Tsai: It will be interesting to see how Curbline Properties Corp., the spin-off of SITE Centers Corp.’s (NYSE: SITC) convenience centers, trades this fall. Rates coming down for a smaller cap REIT will be fortuitous, even though they will spin out as a separate entity, debt free. Besides having a higher growth profile from higher embedded rent bumps and lower capex spend, demand is far greater for spaces that are 2,000-5,000 square feet versus big box spaces.
While CURB is convenience center focused, the higher rent bump and lower capex model also supports Acadia Realty Trust (NYSE: AKR), a name we like a lot, as its street retail portfolio has these characteristics too, resulting in a longer runway for above average NOI growth.
Milligan: Capex remains elevated due to large signed-not-open pipelines and the backfilling of the vacant Bed Bath & Beyond Inc. (BBBY) boxes. With less space to lease, and the better-than-expected progress of the BBBY re-tenanting, we expect leasing costs to come down materially as we move through 2025.
Thank you for your insights.