Retail and Retail REITs are at a Turning Point

Written by Greg Fierros

Is retail in a cyclical bear market? Is it permanently doomed? Or is a technological disruption in retail leading it to the verge of a renaissance? What do the retail sector’s struggles mean for retail REITs? How can REIT investors best position themselves for what may lie ahead? The recent struggles of retail have made the sector the “topic du jour” amongst many investors, and its future and how that will spill over into REITs is the subject of much debate. The factors affecting the subsector are both numerous and complex and have can have multi-faceted effects which have positive and negative impacts on properties in the sector. The fate of the sector appears to be at a crossroads, leading to several very divergent scenarios.

Scenario 1: Cyclical Bear Market

There’s an old adage in investing that is usually attributed to Nathan Mayer Rothschild. It goes something like, “Don’t buy until there’s blood in the streets.” It is believed that Rothschild made the comment in reference to investing in what is the modern day Netherlands during the Battle of Waterloo against the Napoleonic army. If there’s any truth to the saying, the brawls in lines during recent Black Friday shopping events could be an attractive contrarian indicator for the retail sector and retail REITs. Many see the recent troubles in retail as a natural cooling down of a sector that has bested most other asset classes in performance in recent years.

After all, considering the fact that REITs, and in particular retail REITs, have enjoyed stellar performance coming out of the 2009 financial crisis, a slowdown in the subsector during 2015 and 2016 shouldn’t come as too much of a surprise. In fact, retail REITs outperformed the healthcare, apartment, office, and industrial REIT sectors and the S&P 500 as a whole over the five-year timeframe ending Dec 2014.1 According to a study by NAREIT’s Economic Outlook released in January 2017, REITs, including those in the retail subsector have shown positive rental growth YoY, even in the face of recent store closures and bankruptcy filings. In addition, the study pointed to several positive fundamentals. Retail REITs have led the REIT sector for occupancy rates entering 2016, and have exhibited declining vacancy rates, in fact, among the lowest of all REIT subsectors, indicating fundamental strength for the subsector relative to other REIT types.2

Scenario 2: Transition to “New Normal” for Retail

Reports of store closures and even Chapter 7 and 11 filings seem to be hitting the headlines with increased regularity, including for well-known name brands like Macy’s, Sears, Wet Seal, and Gander Mountain. In fact, Q1 of2017 bankruptcy filings from retailers were equal to all of 2016’s retail bankruptcy filings.3 Many investors point to a weakening consumer as an indication of an end to the trademark American industry of malls which began in the 1950’s. Some investors believe that close to a decade of ZIRP has led to an overextended consumer and an outlook of under-consumption for the foreseeable future.

Scenario 3: Amazon Effect and Technology Drastically Transforms the Retail Landscape

The momentous growth of Amazon has had serious consequences for brick and mortar retailers. While brick and mortar retailers’ stock prices have experienced a reckoning over the past ten years, Amazon’s business model for retail distribution has led to explosive earnings growth resulting in 1,934% return on its common stock for that same ten-year period (period ending December 2016). Over that same timeframe, Amazon’s market value grew from being one of the smaller companies in the market to being greater than Walmart, Target, BestBuy, Macy’s, Kohl’s, Nordstrom, JCPenney, and Sears combined. The heightened efficiency of online retail is forcing brick and mortars to step up their game in value creation. Brick and mortar retailers are now looking to create unique one-of-a-kind experiences for consumers at their physical stores in order to counter the onslaught brought on by online retail.

While not much is known about how retail might evolve based on this dynamic, the potential also exists for a “click-and-mortar” revolution which draws upon the strengths of both online retail and brick and mortar. The disruption in retail poses some potentially exciting opportunities for innovative companies, and for astute investors able to identify value.

Ways to Play the Retail REIT Sector

Woes of retail during 2016, and so far in 2017 are cause for concern in retail and retail REITs, but as the saying goes, it’s happy hour somewhere. Emerging markets could offer an escape from the stresses of retail in the domestic markets. China has been enjoying a burgeoning retail sector in recent timeframes. According to PwC, China went from having four consumer goods companies in the top 100 retail and consumer companies by market cap globally (as denominated by €) to having seven companies in the top 100.4 Furthermore, the paper went on to mention that the collective market cap of these Chinese companies increased significantly over the timeframe of 2009 to 2015, from €30b to €378b. FDx Advisors’ approved fund, the Third Avenue Real Estate Value Fund (TAREX) is a good tool to gain exposure to Chinese real estate. Although the management team has a favorable view of domestic retail, the fund had a 31.06% exposure to Asia ex-Japan markets as of 6/30/17, offering investors who wish to avoid downside risk potential in domestic markets an excellent opportunity to access Chinese retail REITs. For those investors taking a more cautious approach, the Salient Select Income Fund (KIFAX) has a lower exposure to common stock, investing more in securities higher up in the capital structure. The managers of the fund draw a distinction between regional malls which tend to be highly discretionary in nature, and shopping centers which tend to lend themselves to brick and mortar distribution, and have a more non-discretionary leaning. Furthermore, Senior Analyst on the fund John Palmer mentioned that the mall REITs are spread out somewhat in terms of quality, with about three higher quality names, and three lower quality names. The fund, KIFAX, invests in these higher quality mall REITs, making the fund a viable option for investors seeking shelter from volatility in the retail sector.

This blog post was written by Greg Fierros, CAIA, Investment Research Analyst