Retail Real Estate

STEPSTONE | Retail Real Estate: Clean Up in Aisle Six, or Heading to Chapter-7? 1

Retail Real Estate: Clean Up in Aisle Six, or Heading to Chapter-7?

With Amazon's recent acquisition of Whole Foods, and the near daily announcements of store closings, much has been written about the death of retail. Perhaps too much. After all, US consumers touch retail daily. The newsstand, coffee shop, lunch spot, supermarket, drug store, dry cleaner, fitness center, movie theater, take-out dinner place and frozen yogurt bar all occupy retail oriented real estate. Chances are that unless one falls within a narrow demographic and geographic segment, most of what is worn or eaten comes via brick and mortar locations. And given that people are likely to continue getting dressed and eating every day, demand for retail will persist.

Will evolving consumer shopping patterns impact retail oriented real estate? Of course. Just as malls took retailers from Main Street in the 1970s and category-killer power centers took shoppers away from malls in the 1990s, the Internet has transformed the way the world shops. The issue that investors will address over the coming decade is the extent to which these changes in buyer behavior result in obsolescence or opportunity.

"First there was books, then music and video...Now Amazon.com is placing its bets on the fledgling grocery business."

– The New York Times, 19 May 1999

February 2018

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E-commerce Sales Growing Fourfold Over Retail SalesIn 2007, 5.2% of retail sales (excluding spending on autos and gas) occurred online. Today, that figure is 13.2% with e-commerce spending growing at an annualized 12.8% over the past decade compared to just 2.7% for overall retail sales. Projecting these trends out over the next decade suggests that one-third of retail sales could occur online by 2027 (Figure 1).

The trend toward e-commerce is leading to a record number of store closings projected for 2017; retailers such as HH Gregg, Sports Authority, Gander Mountain, Radio Shack, Payless Shoes, The Limited and Toys 'R' Us have all announced closings and/or bankruptcy protection. This is on top of the weakness seen at general merchandise retailers where closures are planned at Sears/Kmart (150 locations), J.C. Penney (138) and Macy’s (68). The 8,640 stores projected to close in 2017 is up fourfold from the 2016 levels and a 40% increase over the global financial crisis (GFC) level of 6,163 in 2008 (Figure 2).

At the same time that there are a record number of stores closing, there are interesting new entrants into the physical retail space; formerly online only operators such as Bonobos, Warby Parker, Fabletics, Athleta and Boston Proper have all begun to open brick and mortar outlets to create omni-channel distribution options for their consumers. Even e-commerce pioneer Amazon has begun to test unique store concepts for books and convenience food while finalizing designs for an ‘Apple-esque’ showroom for its line of tablets, e-readers and wireless speakers. The less encouraging aspect of the entrants is that a Bonobos, Warby Parker, or Amazon store is substantially smaller than a J. Crew, LensCrafter, or Barnes & Noble store given that the new entrant is mostly a showroom with almost no inventory. Mall owners are leasing to these new entrants to fill storefronts, but are in effect getting paid for one-third of the space, leaving a large portion of dead space behind newly erected dividing walls. Another change in the retail landscape is that off-price retailers such as Burlington, Dress Barn and TJX are all opening new stores as consumers have become thriftier since the GFC.

1 Dudley L. Poston and David Yaukey, The Population of Modern China (New York: Plenum Press, 1992), 15.2 Richard Jackson, “The Aging of China,” Center for Strategic and International Studies: Critical Questions, April 2016.3 Chen, W., Zheng, R., et al (2016), Cancer statistics in China. CA: A Cancer Journal for Clinicians, 66: 115–132.

FIGURE 1 | E-COMMERCE AS % OF US RETAIL SALES (EXCLUDING AUTOMOBILE & GAS STATION SALES)

FIGURE 2 | ANNUAL RETAIL STORE CLOSINGS

1975

4475

3081

2003

2645

17041343

2795

6163

44423917

24802140

1766

3084

5077

2056

8640

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

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2016

2017

(f)

Source: Credit Suisse.

Source: US Census Bureau June 2017, StepStone.

0%

5%

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15%

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30%

35%

40%

Projected

20075.2%

201713.2%

202733.7%

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Creative destruction has been at work for over a century in the retail space as new entrants, new formats and new technologies have altered the landscape from Main Street to malls to power centers to omni-channel. To a large extent, the pain felt by the retail sector is more of a story about corporate strategy than a real estate story.

The concern over retail business strength is most evident in the real estate investment trust (REIT) market where investors can express their fear or favor daily. The listed real estate market was introduced to investors in 1991 when the open-air shopping center owner Kimco Realty became the first publicly traded REIT. Given that provenance, and the concentration of high value malls in the publicly traded REITs, retail is the largest sector within the NAREIT Equity REIT Index at 16.9%.

Through September 2017, retail REITs were down 10.8%, the only sector to post a negative return for the period (Figure 3). This compares to a 6.0% gain for the broader index and is considerably lower than the strong returns posted in Data Centers (28.0%) and Industrial (18.5%).

Grocery anchored REITs such as DDR (-40.3%) and Brixmor (-23.1%) were down even more than the retail sector given concern over e-commerce entrants.

The US grocery market is extremely fragmented and regional. Whole Foods is one of only a few national chains, but even with 460 stores the chain represents only a 1.7% market share. Add to that level the 0.8% share that Amazon garners and you have the seventh or eighth largest purveyor of groceries in the country (Figure 4). The market is split on whether the Whole Foods acquisition will mark the beginning of the end of grocery anchored retail, or a capitulation from Amazon that losing money on delivery was unsustainable and therefore a move into physical stores would lower operating expenses by having consumers pick up goods from a centralized location.

It is worth noting that the grocery business is a very low margin business dependent on high volume to turn a small profit. The business model is being challenged by demographic shifts. Millennials are delaying marriage and parenting. They also prioritize experiences over possessions; in the age of celebrity chefs and Instagram, dining experiences are high on their bucket list. Both young and old are migrating to urban apartments rather than suburban homes. All of this means that there has been a shift to dining out.

FIGURE 3 | REIT SECTOR RETURNS & WEIGHTS

(15%)

(10%)

(5%)

0%

5%

10%

15%

20%

25%

30%

Returns YTD Sector WeightNA

REIT

Index

Indus

trial

O�ce

Reta

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Resid

entia

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Dive

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Lodg

ing/R

esor

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Healt

h Care

Self S

torag

e

Timbe

r

Infras

tructu

re

Data

Cent

ers

Spec

ialty

Source: NAREIT as of September 2017.

FIGURE 4 | GROCERY SECTOR MARKET SHARE

17.3%

8.9%

5.6% 5.1%

3.4% 3.4%2.5%

1.9% 1.7% 1.7% 1.7% 1.5% 1.5% 1.3% 1.2% 1.1% 1.0% 0.9% 0.8% 0.8%

Walm

art

Krog

erAl

berts

on’s/

Safew

ayCo

stco

Sam

’s Club

Publi

x

Ahold

HEB G

roce

ry

Who

le Fo

ods

Delha

nize

Shop

Rite

Targ

et

Meije

r

Aldi

Sout

hwes

tern

Groc

ersTra

der J

oe’s

Hy-V

ee Fo

od St

ores

BJ’s W

holes

ale Cl

ub

Weg

man

sAm

azon

Source: Statisdata 2016.

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In 1992, households spent about US$162 at grocery stores for every US$100 spent at restaurants (Figure 5). Over time, spending at restaurants gradually increased to the point that in 2015, retail sales at restaurants were actually higher than retail sales at grocery stores. Operators of retail centers have identified this trend and have increased the food and beverage component of their tenant mix in order to provide the experiences that cannot be replicated online.

The Move to Omni-channel Is Bi-directionalAt its core, a retail store is a distribution center in which the items are selected by the consumer who then bears the burden of last mile delivery (i.e., they take their purchases home). Amazon has already announced an arrangement with the department store Kohls whereby customers wishing to return goods received via delivery can return incorrect items to a local Kohls store. This reduces the overall delivery cost for Amazon, increases customer satisfaction and therefore purchase activity, and potentially leads to an up-sell opportunity in which Kohls might be able to entice Amazon customers to make a purchase during their visit. There are rumors currently that Amazon will deepen this relationship by acquiring Kohls, which would signal a confirmation of the importance of omni-channel operations in the evolution of retail.

Studies have indicated that the benefit to the retailer from having an omni-channel operation can be significant given that as many as 35% of all online orders are returned, at significant expense to the retailer. By directing returns to a store location, the retailer is able to up-sell the customer three-quarters of the time, meaning that net sales rise from 65% to around 90% (Figure 6).

The move to omni-channel has been bi-directional with e-commerce players acquiring brick and mortar retailers, and vice versa. In the past 12 months Walmart has acquired Jet.com and Bonobos; PetSmart has acquired Chewy’s; Nordstrom has acquired Trunk Club; and Saks Fifth Avenue has acquired GILT Groupe. The US$6.5 billion paid by the retailers in these transactions marked a significant investment in building out an online presence to complement their physical presence, as well as the acquisition of technology and technologists that will be crucial in the retail landscape of the future.

There has only been one mall built in the US in the past decade.

FIGURE 5 | MONTHLY SPEND ON FOOD & BEVERAGE BY VENUE

Source: US Census Bureau, October 2017.

$0

$10,000

$20,000

$30,000

$40,000

$50,000

$60,000

Jan-

92Ja

n-93

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thly

Sal

es (U

S$ m

illio

ns)

Grocery Restaurant

FIGURE 6 | BENEFITS OF OMNI-CHANNEL OPERATIONS

Source: Shop Visible.

35%Return Rate

ONLINE ONLY

= 65%Net Sale

35%Return

Rate

75% in-store purchase during

return visit

= 90%Net Sale

OMNI-CHANNEL

Little Warehouse on the PrairieImagine a time when consumers would have to go to a store, select among a limited number of offerings, and then pay whatever the merchant demands because competition is relatively low. Think then if technology brought a new entrant into that consumer’s world whereby the buyer could select from a seemingly infinite number of items in all sizes and colors, and then, as if by magic, have their purchases delivered to their home. Surely this would be the end of stores. Right?

At the end of the 19th century, most Americans shopped at a general store that carried 100 to 200 items. In contrast to the drab physical shopping experience, technology in the form of the 1886 Bloomingdales catalog featured 1,700 items with illustrations and enticing prose. The Sears catalog of 1895 had 583 pages of merchandise that rural people didn’t know existed or know that they needed, but once they saw it, they sure did crave it.

Ponder the competitive advantage these new entrants enjoyed with their ability to reach customers in far f lung locales, present them an endless assortment of goods and ship to them directly. Clearly this technology-enabled competitor would lead to the extinction of local stores with their limited inventory and legacy cost structures. Not exactly. In fact, rather than rely solely on the catalog, Sears built on the success of the mail order business by opening brick and mortar stores around the country. In 1931, 50 years into the company’s existence, Sears' in-store sales volume eclipsed the catalog business for the first time, and forever thereafter. Retailers of the late 19th century pioneered omni-channel with their recognition that physical stores can complement technology to provide a broad set of purchase opportunities for their consumers. Technology-enabled competition is once again reshaping the retail landscape. Will brick and mortar survive? Will omni-channel once again be the winner?

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Half of US Malls Could Close Within a DecadeThe typical mall anchor department store was on life support after the pain inflicted from power centers in the 1990s. Just before these companies went under, private equity and hedge fund buyers were attracted to their cash flow potential and snatched them up in flurry from 2000–2008. The new owners levered the operations to the point that debt service costs prevented them from investing in e-commerce technologies and distribution capabilities that would have helped them weather the threat from online competitors. As a result, these anchors are in dire financial condition and are no longer drawing in the foot traffic needed to make the enclosed mall ecosystem viable. Anchors had been given extremely low rental rates for their large footprint stores on long term leases. The idea was that four or five of them on the outer spokes of a mall would draw consumers through the mall and into the inline merchants. These merchants would be willing to pay a much higher rental rate provided foot traffic was sufficient to ensure higher conversion.

As the anchors fail, however, the mall operator is left with a large format box that is hard enough to fill in the first place, let alone repurpose. These dark boxes at the end of the mall also diminish the consumer flow to the inline stores, which leads to a downward spiral in rental rates, occupancy and merchant credit quality.

According to Green Street Advisors, there are approximately 1,100 malls in the US, of which about 250 are Grade A or better. Within this stratum there are around 100 “trophy” or “fortress” malls that are the dominant center in their respective markets and are not likely to lose significant foot traffic to e-commerce in the near term given their strong market demographics and unique merchant mix. The trophy malls tend to be closely held by a small number of REITs, core open-ended funds, pension funds or sovereign wealth funds. They rarely trade hands. Given that there has only been one mall built in the US in the past decade, the number of fortress malls is not likely to grow.

The more likely scenario is that the lower grade malls begin to be decommissioned. Doing so may have a major impact on the markets that rely on these centers, but is not likely to have a large impact on the investable universe; even though the malls rated B or lower represent 60% of the number of malls, they are only 18% of the market value for US malls (Figure 7).

Land parcels with decommissioned malls are being razed and repurposed as multifamily communities, single family neighborhoods—or warehouse distribution centers for e-commerce operators.

Seeking the Hole in the DonutConverting former retail sites into distribution centers—or in the case of the Amazon / Whole Foods deal, repositioning existing retail into distribution centers—solves the challenge of getting goods closer to their ultimate destination. For most of the 20th century, that ultimate destination for goods coming

FIGURE 7 | US MALLS BY GRADE

Source: Green Street Advisors.

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Market ValueCount


from an industrial warehouse was a retail store located around the central business district (CBD) somewhere between clusters of single family neighborhoods or multifamily communities (Figure 8). Delivering goods to these stores was aided by a highway system that developed ring roads to keep commercial vehicles from traversing residential surface streets. Now that the ultimate destination for goods ordered online is a home address, e-commerce operators are likely to continue to seek physical locations from which to manage logistics. These logistics include everything from traditional home delivery and returns processing, to hybrid click-and-pick scenarios where the consumer orders the items online for in-store retrieval or where a consumer fills a virtual basket of goods online and the store employees pick the physical basket of goods to shopper’s specifications. In the latter scenario, the shopper can set a time to pick the order up, or the merchant might facilitate home delivery from a variety of gig-job services such as InstaCart or TaskRabbit.

Buy Now, Or Wait for the Sale?With all the creative destruction that has occurred over the past few decades, one might assume that retail oriented real estate has been a volatile investment. However, the retail sector has been the best performing and least volatile sector among the primary property types over the past 20 years (Figure 9). As the second largest sector in the NCREIF Property Index, with a 22.3% weighting, retail has generated annual returns that are 100 basis points above the broader index with 11.0% and 10.0%, respectively (Figure 9). The standard deviation of retail returns is more than 200 basis points below that of office.

Granted there have been rapid developments in the retail landscape over the last 20 months that may cause some to dismiss the return profile of the preceding 20 years, with the common refrain that "past returns are not guarantees of future results." However, those developments have yet to lead to significant changes in retail valuations or fundamentals.

FIGURE 8 | 20TH CENTURY URBAN PLANNING

Source: StepStone Group.

Retail

Single Family

Suburban O�ce

CBD O�ce

Industrial

Multi-family

FIGURE 9 | 20 YEAR RISK/RETURN FOR PRIMARY PROPERTY TYPES

Source: NCREIF.Note: Size of circles corresponds to to sector weight within NCREIF.

9.0%

9.5%

10.0%

10.5%

11.0%

11.5%

7.5% 8.0% 8.5% 9.0% 9.5% 10.0% 10.5%

Tota

l Ret

urn

Standard Deviation of Annual Returns

Retail

Industrial

All Properties

Multifamily O�ce

8

2 The gross to net spread is 0.3x (2.0-1.7) and 660 basis points (26.0% - 19.4%).

The Real Capital Analytics cap rate for retail real estate ended the third quarter of 2017 within six basis points of the all-time low of 6.46% seen in 2007. On a price per square foot basis, retail is 16% over its long-term average and right on top of the 2007 levels (Figure 10).

Cap rates and prices are holding steady because the real estate fundamentals remain supportive of investment with supply low, vacancy in check and rents growing for 23 straight quarters (Figures 11 & 12). These strong fundamentals controvert the weakness in the retail REITs, suggesting that individual investors may be more spooked than institutional asset owners.

The Future of Omni-channel RetailAs stated above, not all sites will continue to be functional as retail given physical or market challenges with the asset. Some of these sites will be scrapped; others will undergo significant repositioning to include new multifamily developments, medical care facilities, and offices.

In 2017, Walmart started a program in which shoppers can make purchases online, have those orders filled from a local store, and have the goods delivered by a Walmart associate on their way home.

FIGURE 11 | RETAIL SUPPLY & DEMAND

Source: REIS.

4%

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12%

(5)

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Vacancy (%)

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re F

eet (

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ions

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10 Yr Avg New Supply VacancyDemand Supply

FIGURE 12 | RETAIL SUPPLY & DEMAND

Source: REIS.

(5%)

(4%)

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(2%)

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$15.5

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Year-Over-Year Change in Rent (%)

Rent

(US$

/SQF

T)

Rent Y-O-Y Growth

FIGURE 10 | VALUATION METRICS FOR RETAIL REAL ESTATE

Source: Real Capital Analytics.

$188

$100

$150

$200

$250

$300

3%

4%

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Price Per Square Foot

Cap

Rate

Cap Rate $/sf

6.46%

$190

6.52%


FIGURE 13 | 20TH CENTURY DISTRIBUTION MODEL


RetailSingle FamilySuburban O�ce

CBD O�ce

Industrial

Multi-family

FIGURE 14 | E-COMMERCE MODEL



CBD O�ce

Industrial

Multi-family

FIGURE 15 | OMNI-CHANNEL MODEL



CBD O�ce

Industrial

Multi-family

The geographic positioning of many retail locations can make them attractive hubs for the distribution of goods; most are likely to continue to serve that function as the consumer shopping model evolves from brick and mortar (Figure 13)or e-commerce (Figure 14) to omni-channel with brick and mortar and e-commerce (Figure 15).

ConclusionsObservations based on national valuations for a broad category of real estate is of marginal utility given the wide variations from market to market and among property types (i.e., malls, power centers and grocery anchored sprint centers). It is also of marginal value to view headlines regarding tenant weakness as an indication of the value of the real estate they occupy.

As with all real estate, location matters and this is particularly true for retail oriented real estate given that the trade area demographics will determine whether the center will draw sufficient consumer spending to support the tenant mix. If the trade area and location are supportive of omni-channel retailers, or experiential retail, then there will likely continue to be value in the real estate.

StepStone Real Estate believes that investors should be simultaneously cautious about the potential value erosion that is likely to occur at certain retail properties and opportunistically positioned to take advantage of the re-pricing to gain exposure to assets that are well positioned to participate in the next generation of retail real estate. Specific risk factors that will drive the re-pricing are the smaller store sizes required by inventory-lite retail concepts, the functional obsolescence of certain configurations, and the reduced foot traffic caused by home delivery. One risk that investors should not fear is the risk of being too late. This re-pricing will take time so investors will be rewarded for sagacity and prudence.

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This document is for information purposes only and has been compiled with publicly available information. StepStone makes no guarantees of the accuracy of the information provided. This information is for the use of StepStone’s clients and contacts only. This report is only provided for informational purposes. This report may include information that is based, in part or in full, on assumptions, models and/or other analysis (not all of which may be described herein). StepStone makes no representation or warranty as to the reasonableness of such assumptions, models or analysis or the conclusions drawn. Any opinions expressed herein are current opinions as of the date hereof and are subject to change at any time. StepStone is not intending to provide investment, tax or other advice to you or any other party, and no information in this document is to be relied upon for the purpose of making or communicating investments or other decisions. Neither the information nor any opinion expressed in this report constitutes a solicitation, an offer or a recommendation to buy, sell or dispose of any investment, to engage in any other transaction or to provide any investment advice or service.

Past performance is not a guarantee of future results. Actual results may vary.

Each of StepStone Group LP, StepStone Group Real Assets LP and StepStone Group Real Estate LP is an investment adviser registered with the Securities and Exchange Commission (“SEC”). StepStone Group Europe LLP is authorized and regulated by the Financial Conduct Authority, firm reference number 551580. Swiss Capital Invest Holding (Dublin) Ltd (“SCHIDL”) is an SEC Registered Investment Advisor and Swiss Capital Alternative Investments AG (“SCAI”) (together with SCHIDL, “Swiss Cap”) is registered as a Relying Advisor with the SEC. Such registrations do not imply a certain level of skill or training and no inference to the contrary should be made.

Manager references herein are for illustrative purposes only and do not constitute investment recommendations.

StepStone is a global private markets firm overseeing more than US$135 billion of private capital allocations, including over US$35 billion of assets under management.

The Firm creates customized portfolios for many of the world’s most sophisticated investors using a highly disciplined, research-focused approach that prudently integrates fund investments, secondaries and co-investments.


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