The Repurposing of Retail Has Begun: Opportunistic Buyers Target Under-Performing Shopping Centers
JUNE 13, 2019 | DREW MYERS
CoStar Insights: Composition of Shopping Center Sales Reveals Retail Space Rationalization is Ramping Up
In 2016, CoStar Market Analytics made the call that, in today’s overbuilt and multichannel retail environment, 1 billion square feet of store space must be rationalized, repurposed or removed from the market to return retail real estate to normal levels of productivity.
Certainly, some vacant big boxes have been demolished and portions of unprofitable shopping centers redeveloped here and there, but today, more investors are thinking critically about the weaker-performing retail assets in their portfolios and opportunistic buyers are capitalizing on under-performing, yet affordable sites ripe for repurposing or redevelopment.
Excluding bulk portfolio deals, shopping center pricing across the U.S. is down more than 14% on a per square foot basis since the cyclical high in 2016. And over the course of a year, sales of retail centers remains 27% below 2015-2016 peak, as shown in the first chart below.
Indeed, ongoing pricing declines reflect investor concerns surrounding the retail sector. However, it’s critical to peel back the layers of the investment market, as it’s really the composition of buyer that is driving the declines. In particular, CoStar is tracking an uptick in opportunistic buyers willing to scoop up retail sites for little more than the value of the land parcel itself, an indication that some sites below the necessary threshold of productivity are finally changing hands to be repurposed.
It’s important to keep in context the strong performance of high-quality retail while diving deeper into some of the distressed asset trends. Pricing among the top 10% of retail trade area locations nationwide remains more than 20% above prerecession peak, and the shape of the pricing curve over time does not show the same downward trajectory as the broad market.
Furthermore, dense urban sites and core grocery locations have attracted more institutional investment capital due to their continued retail success. In fact, retail centers located in the primary path of densification this cycle have returned outsized average annual pricing gains to investors compared with low-density growth sites, even in good quality locations. But today, the frequency of these high-quality deals has declined.
At the peak of the previous cycle, 14% of shopping center property sales occurred in the Tier I (core) markets, which include Boston, New York, Chicago, L.A., San Francisco and Washington D.C. Meanwhile, over 55% occurred in Tier II markets, such as Las Vegas, Atlanta, San Jose, Miami, Honolulu, Houston and Minneapolis. As a result, less than 31% of deals occurred in tertiary markets.
But today, more than 43% of retail center trades occurred in tertiary markets, while just 10% occurred in core markets. Similarly, the composition of trades skews to the lower end of the location quality score spectrum based on CoStar's proprietary geospatial analysis to gauge the retail sales potential of every location, independent of current use or building quality.
For the first time on record, the weakest half of the market by trade area quality has made up more than 30% of transactions in 2019. In 2006, just 18% of deals were in these lower-productivity sites.
This trend is not fully unique to retail, as CoStar is tracking a push among apartment buyers moving out to secondary and tertiary locations in the search for higher investment yields. And many owners of high-quality retail centers are locked in a long-term hold or simply do not wish to get off the sidelines at this point in the cycle. However, the number of trades today is comparable to cyclical highs, which means that enough buyers are out there to keep the market active.
The key difference is that opportunistic retail buyers are pouncing on distressed assets. In fact, 1.2% of deals so far in 2019 were made solely for the value of the underlying land, as shown in Exhibit 3.
Also, the total number of below-market trades attributed to foreclosures and financially distressed owners rose by 36% in 2018 as compared to 2015-2016. In essence, retail centers deemed uncompetitive because of vacancy rates above a certain threshold possess slim odds of recovery outside of significant capital or leasing investments.
REITs, in particular, have been net sellers of late, offloading weaker-performing centers to fund capital investment costs associated with upgrading or enhancing other assets in their portfolios.
Some firms targeting these distressed sites have found initial success by employing creative repositioning and cost reduction strategies on a case-by-case basis. Furthermore, 27% of the under-performing assets possess 50,000 or more households in the local three-mile trade area and 42% possess median incomes above $75,000, density and income thresholds that likely support retail or other income-producing real estate uses.
While the number of land-value trades has doubled from earlier in the cycle, the amount of retail space projected to be demolished or redeveloped is still just a small chunk of the necessary rationalization. Many core investors remain content sitting on stable, high-quality retail property for the long term. And many of the under-performing retail sites that have been listed for sale possess reasonable demographic characteristics that may persuade buyers to keep the current use in place.
Accordingly, it’s worth monitoring the success rate on these land value deals and the strategies deployed, as they are likely to remain a prominent portion of near-term deal flow in the retail space.
Drew Myers is a senior consultant for CoStar Group based in Boston.