While the retail market is undoubtedly difficult right now, the positive news is that retail is no longer the least desirable asset class. The commercial real estate slowdown has affected all asset classes, but the retail market, which faced its own difficulties prior to rising interest rates and return-to-work challenges, is somewhat less impacted. Unlike industrial and multifamily properties, retail did not see significant pricing spikes over the last few years. While cap rates are increasing on retail properties, the changes in value are not as dramatic as with other sectors.
Across US markets, the viability and value of retail properties largely depends on their tenant mix. Properties with “internet-proof” retailers such as grocery stores, services, and experiential tenants have the edge. We are still seeing decent trade volume for smaller centers, grocery-anchored centers, and some lifestyle centers with a desirable tenant mix.
Malls continue to struggle. Sustainable occupancy costs are trending downwards, so to compete for tenants, malls must reduce rents or tenant sales must increase. Since sales aren’t likely to increase dramatically, rents must trend down. Unfortunately, this is likely not a temporary condition related to the current state of the economy, but a result of the market disruption caused by the rise of e-commerce.
There is increasing interest in redeveloping mall anchors to other uses, such as medical offices or multifamily. Redevelopment efforts are often hindered by the restrictive covenants in place at malls. We are seeing a trend in which some municipalities are beginning to get involved to remove these covenants, resulting in success at some properties. However, the redevelopment of these anchors and other big box stores can be cost-prohibitive, particularly in the case of conversion or redevelopment to multifamily.
Beyond malls, landlords at retail centers everywhere are rethinking how to use their big box space. With tenants like Bed Bath and Beyond closing, is there a future for large box stores? Some landlords have been able to lease these spaces to gyms or fitness tenants. In some markets, community colleges or churches will occupy large retail spaces. More affluent markets might attract golf simulators or other experiential tenants, which not only lease large spaces but attract valuable foot traffic to the center. However, many landlords will have to invest the capital required to demise these big box spaces and create smaller spaces which command higher rents.
To undertake any of these options, retail owners must consider the potential return on capital in a capital-constrained market, which will make some potential uses infeasible. To inform their decision, they may engage a valuation consultant with retail expertise and knowledge of the local market to perform a market study. A market study provides an analysis of supply and demand within the local market and can inform income projections for the proposed use. They may also engage a qualified engineering consultant to perform a feasibility study, which includes information about the site, its infrastructure and improvements, as well as a conceptual layout, permitting requirements and costs, and an estimate of construction costs.
The retail market still faces challenges in the near- and medium-term future, but there is potential upside for retail owners as developers continue to look at retail properties as candidates for redevelopment. As this occurs, the overall inventory of retail square footage will decrease, allowing for better absorption of retail space.