Math Report

Math Report

It’s no secret within the commercial lending and investment community that retail is often the property type more institutional capital sources underweight for allocation of investment capital. While retail is notorious for tipping the scales regarding undesirable metrics like loan delinquency (the highest among core property types at 4.29 percent versus 2.98 percent for office) and value decline.

Many vacated malls, shopping centers, and big-box stores have desirable location attributes – frontage along primary commercial arterial and public transit routes, proximity to employment centers, and site configuration or building design that’s well-suited for adaptive reuse. Conversion of these buildings is ideal in meeting the ongoing demand for affordable housing, industrial warehouse utilization, off-hospital campus medical use, and even co-working office space. The central question now, however, for legacy storefronts is one of highest and best use to unlock the market value of the real estate for retail use. Both retailers and communities have a vested interest in putting these real estate assets back to productive use to recapture lost property value and return vacant buildings to new uses to property and local tax revenues.

This report is not another examination of retail’s demise, because in the immortal words of Mark Twain, “The reports of [its] death are greatly exaggerated.” Nor is it another foretelling of how the use of retail stores is morphing from a place to shop to something experiential. Retail has always been experiential – dating as far back as centuries-old seaport trading centers to the more modern development of shopping malls.

Moreover, according to a recent report by the International Council of Shopping Centers, “The Halo Effect II,” online and brick-and-mortar retail have a symbiotic relationship that produces impressive synergistic results on the bottom line.2 This halo effect increases not just overall spending by the consumer, but also the propensity to visit online and brick-and-mortar locations when a purchase occurs. For example, when a consumer spends $100 online and subsequently visits a physical store within 15 days of that purchase, the person spends an additional $131. If they start out with that same $100 purchase in-store and head online within 15 days, the average additional spend is even greater, at $167. Additionally, the consumer is more likely to visit both online and brick-and-mortar storefronts as a result of a purchase. ICSC’s research indicates that customers complete an average of 2.1 in-store transactions within 15 days following an online purchase, and 1.3 online transactions within 15 days of an in-store purchase. 

Retail success in its next iteration will be defined by alignment with services – services like hospitality, transportation centers, health care, and education. This report peels back the misconceptions behind retail bankruptcies and store closings (no, Amazon isn’t the primary culprit) and proffers where the next generation of retail is headed. Could it be that mall retail stores re-emerge in hotel lobbies, airports/transportation centers, and medical centers? Could the halo effect accelerate with retail aligned with these service offerings?

Additionally, will the next generation of real estate curriculum at university real estate centers like the Alabama Center for Real Estate or professional industry organizations such as CCIM Institute modify the long-standing axiom that all real estate is location, location, location with all retail real estate is logistics, logistics, logistics?

While this report tackles several myths, one is most germane to the predictions that follow – that Amazon and online retail have been the primary cause of store closings. The truth is, the real villain behind what many industry analysts have coined as the “Retail Apocalypse” is overleverage. Furthermore, online retail sales are still a relatively small portion of total retail sales that have yet to take a real bite out of retail store activity. Amazon merely tapped into technology to reinject growth into retail, enabling the company to dominate book and music sales and, more recently, generate a similar disruption into grocery retail.

Here are five predictions for the future of retail that debunk several primary myths behind the plethora of retail bankruptcies and store closings that occurred in the past decade.

Myth #1: Retail Bankruptcies and Store Closings Are Due to Less Consumer Spending

The fact is, total retail sales have increased at an average annual rate in excess of 4.35 percent since 1993, according to Trading Economics.3 Additionally, most retailer quarterly earnings statements – whether from Walmart, Target, Home Depot, or major grocers – report increased physical same-store and online sales (with a few exceptions identified in this report). While online sales have yet to reach 10 percent of total retail sales, the growth is on track to make a material impact by 2025, with 20 to 25 percent of total retail sales projected.

If it’s not the loss of in-store sales to online consumption or recessed consumption post-Great Recession, what’s the real culprit behind the bankruptcies and closures? Over leverage. It started in the 1980s, with a string of leveraged buyouts by private equity firms like KKR, and peaked in 2006, when CMBS debt issued for mall properties exceeded $15 billion with peak loan-to-value (LTV) ratios surpassing 70 percent.4 Retailers felt the acute pain of being over leveraged when growth slowed, the Great Recession hit, and the cost to service debt overtook revenue growth. Assets of the company were typically sold off to pay the debt when the carrying cost of the debt exceeded the leveraged company’s cash flow to service debt or when growth faltered. Moody’s retail analyst Charlie O’Shea best characterized the impact of over leverage by saying, “You can’t outrun debt.”

Myth #2: After Years of Bankruptcies and Thousands of Store Closings, Both Will Abate in Coming Year

The simple fact is that the U.S. is “over-retailed.” Research by ICSC and CoStar shows the U.S. has more than 115,000 shopping centers totaling over 7.5 billion square feet. According to PwC, there is approximately 24 sf of retail space per person in the U.S. – 50 percent more than second-ranked Canada, twice that of No. 3-ranked Australia, and nearly six times that of the U.K. PwC forecasts that U.S retail space will need to shrink toward that of Australia to rebalance – a contraction of more than 50 percent.5

Future closings will be determined first by leverage and then by technology gaffes. Look for one in four malls to close by 2022, according to research from Credit Suisse. Currently, malls are closing at an annualized rate of 75 per year. The 11 regions that will see the most mall closings and contraction in per capita retail by 2025 based on mall inventory and deteriorating performance metrics will be California, Florida, Texas, Pennsylvania, New York, Ohio, Georgia, Illinois, Michigan, the Mid-Atlantic (Virginia and Maryland), and Tennessee.

Myth #3: Online Retail Is Expanding Because It Is More Cost Effective

Alix Partners, crunching the numbers for CNBC in 2017, found that apparel retailers’ net margin from merchandise sold at brick-and-mortar stores was 32 percent, compared to 30 percent for online apparel sales. The cost to build systems, operate last-mile delivery reliant upon the current inefficient infrastructure, and process the volume of returned online merchandise (now an estimated 30 percent of all merchandise sold online) are much more capital intensive than leasing, stocking, and staffing brick-and-mortar retail stores. Keep this in mind as some iconic luxury retailers like Macy’s and Lord & Taylor experiment with rental apparel models.6 If managing 30 percent returns today is a nightmare, wait until the logistics of dry cleaning, alterations, and repairs for rental clothing are layered in. These logistics challenges, though, are not enough to reverse course and go back to shop-and-take-home retailing. A report by ICSC illustrates how online and brick-and-mortar retail feed the activity of the other. The trick is making logistics and last-mile delivery more cost effective. Look to retail prediction #3 for more details on that tricky endeavor.

Apparel Retail Margins

Myth #4: Malls Are Obsolete, and No More Will Be Built

The mall is not dead. In 4Q2019, one of the 10 largest malls in America will open in New Jersey. TruAmerica Triple Five Group, the Canadian developer that previously built two of the three largest malls in North America including Mall of America, will open its 3-msf American Dream Meadowlands. The final design and offering will be a mix of 55 percent entertainment and 45 percent retail with 500 stores. The mega-mall will offer every imaginable experience to lure traffic and generate revenue beyond rent from stores, including the first-ever indoor snow park and largest indoor water park in North America; a Nickelodeon Universe theme park; an NHL-sized hockey rink, with promotional deals in place with the New York Rangers, New York Islanders, and New Jersey Devils; and more. The mall is not obsolete – it is just going over the top on entertainment offerings.