Much of the retail sector was already gasping for air pre-COVID-19, with climbing retail bankruptcies and store closures.
Add in a global pandemic that could permanently change how people shop, work and live, and the outlook appears even more risky for many retail real estate investors.
The pandemic-induced lockdowns and social distancing requirements have hindered consumer spending at bricks-and-mortar retail locations while accelerating online shopping. Many non-essential retailers—particularly department stores and apparel stores—have been struggling to pay their rent.
With all of the uncertainty around COVID-19, the economy and the future of retail, investors hit the pause button on new deals as investment activity plunged further. Retail investment sales volume was already weak in 2019, when it experienced the biggest drop of any major property type.
In the second quarter of 2020, retail investment sales plummeted 73 percent year-over-year to $4.6 billion, according to data firm Real Capital Analytics (RCA). That represents the worst performance by the sector for any second quarter. RCA tracks retail properties priced at $2.5 million and more.
The pandemic is accelerating the retail sector’s pain
“It’s kicking a man when he’s down,” says Jim Costello, senior vice president at RCA. “Retail was already challenged. It’s the case of the patterns of consumption changing with a slow, steady drumbeat of more online sales every year as a portion of total consumption. So, retailers are facing an uphill battle, and then while that’s happening, this pandemic hits and people can’t go to the mall, so the whole rationale of those stores being there has changed. It’s just creating havoc for owners, investors and retailers.”
This year is on track to set a record number of retail bankruptcies with 44 so far, according to S&P Global Market Intelligence. Recent victims include Stein Mart Inc., Le Tote Inc., Ascena Retail Group Inc. and Tailored Brands. More filings are anticipated.
For most of the retailers faltering, the pandemic is the “final straw that broke the camel’s back,” says Scott Holmes, senior vice president and national director of the national retail group at real estate services firm Marcus & Millichap. “They’ve been limping along for a long time.”
Unfortunately, many have gone the private equity route, which means more leverage and more debt, Holmes notes.
“When you get over-leveraged, that ties your hands and you have less flexibility to make changes and adapt, because you’re too busy keeping up with your debt service,” he notes.
Plunge in investment sales activity
The pain doesn’t appear to be ending any time soon for the retail sector. Reports of potentially distressed retail assets jumped in the second quarter, totaling $29.4 billion for the first half of the year, RCA reported.
Additionally, the number of terminated retail contract deals in June increased by 2 percent, up from 1 percent posted in both April and May.
“Investors don’t like doing that stuff, because if I’m in the middle of negotiations and back away, people have long memories, but in a case like this, it can be worth it to trade that reputation and avoid making a really bad deal,” Costello says.
Also noticeably absent in the second quarter were portfolio and entity-level transactions, RCA noted. Deals of these structures dropped by 89 percent.
“There were a few portfolios, but no entity-level transactions,” Costello says. “You’re not seeing somebody say, ‘I’m going to buy this other company and roll their assets into my portfolio.’ That type of activity just doesn’t make sense in the face of all the uncertainty.”
Deal size is also shrinking. The average deal in the second quarter averaged $7.7 million, down from $10.8 million a year ago.
Other firms weigh in
Second quarter was where nearly all the decline happened, Marcus & Millichap’s Holmes notes. Transactions were down 65 percent year-over-year. Dollar volume fell 73 percent compared with second quarter 2019, to $4.6 billion. Holmes says the average price per sq. ft. was $247, and the average cap rate fell 20 basis points to 6.5 percent.
Pre-COVID-19, investment sales activity was actually increasing, he notes. “In January, February and the first half of March, we came out of the gates roaring and were on pace to be way ahead, and then the second half of March is when things really started to shut down and a lot of transactions got delayed that would have closed in the first quarter, or were cancelled entirely,” Holmes says. “People were just too nervous going forward not knowing what the future was going to hold.”
The supply side is also down significantly as many sellers decided to pull properties off the market or not go forward on deals, he adds.
Retail ‘hit especially hard’
Research firm CoStar Group reported that second quarter retail investment sales volume totaled $10.2 billion, down from $23.6 billion in the first quarter of 2020 and $24.9 billion in the second quarter of 2019.
“The pandemic has caused overall commercial real estate transaction activity to slow, though retail has been hit especially hard,” says Alexander Levy, a CoStar Group consultant.
Pricing for retail assets is lagging. Pricing in its Commercial Property Price Index fell more in the second quarter than in any of the four main property types (also including office, industrial and multifamily), according to CoStar. Lockdowns and social distancing intensified what was already a challenging environment for bricks-and-mortar retail, and retail saw the sharpest quarterly decline of 1.9 percent among all four major property type indices, CoStar data showed.
“We expect retail investment to stay at reduced levels for the near term as states are still rolling out reopening plans and [COVID-19] cases continue to rise in some areas,” Levy says. “There may be an increase in the share of distressed retail transactions, but we expect high-quality, well-located retail to hold up relatively well and to continue to see outsized investor interest.”
Some brighter investment spots
Necessity-based retail, including grocery-anchored shopping centers, continued to see stronger investor interest, while regional malls and other retail centers with a high exposure to competition from e-commerce experienced the most significant drop in pricing. Investment in grocery-anchored shopping centers accounted for 24 percent of transaction volume for the quarter, RCA noted.
“Multi-tenant shopping centers that have continued to perform well are the grocery-anchored and drugstore-anchored centers—those providing needs-based, less discretionary income types of things,” Holmes says.
He adds that the single-tenant net leased business remains robust as well. For example, the sale of drugstores—including CVS and Walgreens—was up 8 percent in the second quarter over the second quarter of 2019, Holmes says. There’s also significant interest in drive-through restaurants and dollar stores. These businesses remained open, are recession-resistant categories and continued paying rent through the pandemic, Holmes notes.
Secondary markets gained steam
Investors who did put capital to work in the second quarter did so in secondary and tertiary markets and in smaller amounts than during previous periods, RCA reported.
“In March, April and May, it seemed as if secondary cities were going to be safer, so investors were less fearful, less cautious in those areas,” Costello notes. “But now it’s clear that this virus is everywhere. It will be interesting to see how investor perceptions change.”
Meanwhile, suburbia opportunities could be on the rise. “Ironically, it’s probably going to be the non-urban areas that are going to be the greatest opportunities in the next couple of years,” says Scott Stuart, CEO of the Turnaround Management Association, which focuses on corporate restructuring. “Even though that will come back at some point, the suburban areas around the urban centers are actually becoming more attractive, because people as a result of the pandemic, don’t want to be in urban centers.”
“From a speculation point of view, there could actually be more opportunity for investment in the areas where populations are moving to as opposed to the traditional go-to areas like a Michigan Avenue in Chicago or Fifth Avenue in New York,” Stuart adds.
What does the future hold for retail investment?
The retail world was in distress before the pandemic, and the sector continues to try to figure itself out, Stuart notes. “It’s kind of no-man’s land in retail investment right now.”
However, that won’t last forever. “I think it’s 2022 when you will have more solid answers,” Stuart says.
For the moment, there’s excess inventory and huge investment opportunity for retail investors that willing to take a risk.
“The other way that you can look at investment is there’s desperation out there,” he notes. “People who have money and want to invest in a desperate time will look at it as an opportunity that they can sit on, knowing that come the other end, there will be something that’s going to come out of it. But it’s definitely more of a speculative investment than it probably ever was.”