How Retail Continues to Roll With The Punches

Retail’s transaction volume declined 41% in 2023 from 2022 as macroeconomic pressures have thrown water on the previously scorching market, but it has retracted less than any other sector. This relative outperformance resulted from boosted deal activity at the entity level in Q3 2023, the second strongest year ever recorded for entity level sales at $5.3 billion and a dedicated private buyer pool. Despite transactions declining, pricing adjusting, and cap rates increasing, investors consider the sector a safe haven. This report dives into why retail is in high demand.

Retail Market Performance

Since the pandemic, retail has demonstrated notable growth. This is attributed to consistent demand, adaptive strategies, a notable reduction in store closures, and limited new supply. With the current market conditions, few retail opportunities are available for buyers, and pricing is stabilizing quicker than the broader commercial real estate market due to the sector’s low-risk profile.

While pricing is adjusting, it’s insufficient to push investors’ aggressive investment strategies like in 2022. The spread between borrowing costs and cap rates is impacting transaction volume. On the private client side, cap rates have adjusted 50 to 100 basis points higher. Well-located assets boast longer lease terms and great credit tenants can find cap rates in the 6.00% range.

In 2023, the merger of global net lease and the necessity retail REIT (464 retail assets) and the acquisition of Urstadt Bibble Properties by Regency Partners (66 retail assets) occurred.

Net Lease Demand

A tight labor market, expectations for a pause in rate hikes, and historically low single-tenant vacancy continue to attract active buyers to the retail market. Private buyers have been the largest group of investors, but institutional investors also eye the sector as they have dry powder to deploy. Investors like the stability, steadiness, and ability to increase cash flow and pass-through tax benefits.

While there was a definite slowdown in transactions in 2023, the market is coming off all-time highs. Single-tenant net lease transaction volume for 2021 surpassed $5.4 billion, and 2022 rounded out at $6.3 billion. As of November 2023, transaction volume recorded $2.8 billion, which is still in line with pre-pandemic levels, noting that retail will remain resilient moving forward. According to GlobeSt., investment in retail properties nationwide increased to $11.86 billion in Q3 2023, 34% higher than the $8.84 billion recorded in Q2 2023.

In Q3 2023, the Southeast led in investment sales volume, recording $3.04 billion, followed by the Northeast ($2.87 billion), West ($2 billion), Midwest ($1.8 billion), Southwest ($1.65 billion), and Mid-Atlantic ($1.01 billion).

This volatile climate has paved a path of robust growth and recovery for the sector. Shopping center vacancy rates have been the lowest in decades, retail rents have increased, and with over three-quarters of new development having a tenant in place at delivery, the retail market has faced little to no threat from new supply.

Retail By The Numbers | 2023 | Source: CoStar Group

• Deliveries in SF: 50.4M
• Vacancy Rate: 4.1%
• Net absorption in SF: 51.7M
• Rent Growth: 3.4%

Low Vacancy Rates

In Q3 2023, demand for space grew by almost 12 million square feet, the 11th consecutive quarter of rising demand and minimal new supply, according to CoStar Group. This has contributed to an unprecedented decline in shopping center vacancy rates. Asking rents have increased 3.4% over the last 12 months to a new record high of $25 per square foot. Sunbelt markets have experienced the most extensive rent growth, attributed to the region’s substantial population and buying power. Once rents stabilize, the market is expected to revert to normal transaction levels.

Rent collection trends for the first three quarters of 2023 outpaced 2022 numbers in the same period. – Source: CoStar Group

After nearly reaching a balance in 2021, net store openings reached their highest point in nine years in 2022, and this positive trend persisted through 2023. The prevalence of store openings surpassing closures in 2022 and 2023 underscores the robust demand for retail space.

Retail tenants leased just under 59 million square feet in Q2, the lowest amount of space signed in a quarter in over two years. Just 4.9% of total retail space is available for lease as of September 2023, a more than 1.5% decline from the pandemic-era peak and the prior 10-year average for retail availability, according to CoStar Group.

The 10 consecutive quarters of demand growth have pushed the retail market into its tightest position in nearly 20 years, there is less space available for lease now than at any point since national tracking began in 2006 – Source: CoStar Group

The anticipated risk of new supply will remain low for the foreseeable future. As of Q4 2023, about 58.2 million square feet of retail space is in progress nationwide. Additionally, new construction projects have declined across the U.S. due to rising construction financing costs and record-high land and labor costs. New retail space is expected to be limited over the next year, keeping prices high in primary locations for the foreseeable future.

Despite several prominent retailers filing for bankruptcy over the past year, there is still healthy demand, and landlords remain optimistic they can fill vacancies quickly and push rents higher. – Source: Deloitte

According to Mark Sigal, CEO of Datex Property Solutions, the lack of new retail inventory, amplified by a repositioning of enclosed malls that are no longer economically viable, has created increased demand for open-air retail.

While economic forecasts have indicated a minor recession in the coming months, retail fundamentals are expected to remain balanced.

1031 Exchange Investors

Many investors in the net lease retail segment are 1031 exchange buyers who want to get out of management-intensive assets like multifamily or office. Net lease investments are attractive because they provide long-term structures, steady cash flow, and depreciation benefits. Currently, there is a lack of 1031 exchange buyers, creating a void in the market, especially for products in the $2 to $10 million range. However, there has been an uptick in the $10 to $30 million range, sometimes as high as $50 million.

Segmentation in Retail

Retail has undergone several strenuous periods, from an abrupt shutdown of physical stores in 2020, supply chain issues, increasing operating costs, constantly evolving consumer preferences, an insufficient workforce, and constant rate hikes. As such, the net lease retail market has become very segmented. While cap rates have increased, certain property types remain in high demand.

These property types include but are not limited to: 

• Gas and Convenience Stores
• Dollar Stores
• Grocery Stores
• QSR
• Healthcare

A strong flow of capital has poured into these net-lease spaces, primarily through 1031 exchanges. There are various reasons this influx of capital continues; most specifically, net-lease properties offer limited owner responsibilities, long-term leases, strong credit, and attractive rental increases.

Spotlight On Discount Stores

The recent success of the retail sector can be heavily attributed to the rise of discount retailers. This includes Family Dollar, Dollar Tree, and Dollar General. These three stores alone account for a third of openings in 2023, adding over 16 million square feet of occupied retail space. The sector’s ability to sustain its visit gains from the pandemic period is a clear indication that discount stores have become a crucial part of the regular shopping habits of many consumers.

Nationwide Visits | 2023 | Source: Placer.ai

• Dollar Tree: 1.12B
• Dollar General: 993.84M
• Family Dollar: 323.18M

Retail stores and shopping centers are evolving to cater to the consumer preference for a seamless experience.

The Resurgence of Retail | Impact Of Consumer Spending

The vitality of the retail market hinges on consumers’ capacity to spend money and shop at physical retail stores. Once viewed as the cause of retail’s inevitable downfall, e-commerce may be the key to keeping up with rising demand and evolving consumer preferences. Physical retail stores can utilize the benefits of both online and offline channels by effectively incorporating e-commerce into their business models. This will result in a more dynamic and resilient retail environment.

A report from Coresight Research revealed that over 75% of American consumers engage in both online and in-person shopping within two weeks. This percentage is notably higher among individuals under the age of 45 and those with an annual income exceeding $100,000. In the context of discretionary spending, a mere 7.7% of consumers limit their purchases exclusively to online platforms. This highlights the essential role of physical retail stores in the overall consumer experience. The findings further reinforce the notion that brick-and-mortar stores and shopping centers are more effective in encouraging larger shopping cart sizes compared to online marketplaces.

Multi-Tenant Retail Sales Skyrocket | Investor’s Choice

Overall, the outlook continues to look promising for commercial real estate investors. Several junior and big-box anchor stores and grocery operators have disclosed their intentions for expansion. Owners of current multi-tenant retail properties can capitalize on the chance to attract these brands and elevate the value of their centers. Well-situated properties, whether unanchored strip centers or open-air power centers featuring national anchor tenants are expected to remain appealing investments.

Most recently, there has been a strong push for shopping center owners to unlock hidden value by monetizing outparcels. This is possible by subdividing outparcels on existing shopping centers, which tend to be net lease and trade at a premium. This can occur by signing new outparcel leases or utilizing parking lot space for pickup/ delivery in larger parking lots.

Retail Outlook

Retail real estate has become a focal point for investors seeking opportunities during retail’s transitional phase. The stabilization of interest rates is a crucial factor that will pave the way for enhanced deal flow in 2024. The shift in the financial environment has the potential to shape a new normal in the minds of investors. This will foster a climate of increased confidence in asset pricing and yields.