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By Patrick Broome, CMI, Vice President - Property Tax, Jeremy Chitlik, Senior Director - Property Tax, and Andrea McKinnon, Director - Property Tax | May 5, 2020

How we got here and what transformations will we see.

For more than a decade, the retail industry has anticipated a “tipping point” that would create a permanent shift in the way it operates. The signs were unmistakable and experts knew it was inevitable, but no one knew what that trigger might be. Until now.

That trigger appears to be the novel coronavirus — a singular event so large and destructive that its impact will reverberate through every corner of the retail industry. In this article we explore how the retail industry’s trends over the last ten years create both advantages and disadvantages as we face COVID-19.

Going online reveals excess space

Not long after big box stores usurped the traditional large malls to dominate the retail landscape in the 1990’s, e-commerce began to take a foothold, forcing retail to turn another corner. As more consumers started purchasing goods online instead of in brick-and-mortar stores – a phenomenon often referred to as the Amazon effect – both department and big box stores reacted to the steady growth of e-commerce by enhancing their online ordering experiences and providing customers with options for delivery and in-store pickup.

Other retailers scaled back their footprints and allowed customers to try products before buying. Bookstores developed e-readers to capitalize on the availability of digital publications and many of the retailers that were slow to react to the rise of e-commerce quickly failed. Major household names like Toys R Us, Sports Authority, and Borders faced bankruptcy. Still, traditional retail managed to hold its own through 2017.

However, this vacancy was adding to a problem years in the making: Retail had been overbuilt. In 2018, the U.S. averaged 24 square feet per person of retail space. In comparison, Canada was second with 17 square feet and most of Europe and Asia averaged 3 square feet. The 2018 bankruptcy of Sears, the second largest occupier of U.S. retail space added an oversaturated market with an additional 300 million square feet. Today, as more retailers like J. Crew, Payless and Forever 21 file for bankruptcy, it is clear the problem will continue to get worse before things improve.

We do not know whether the American retail market has the infrastructure in place to re-let the massive amounts of tenant space that could be vacated nationwide. The challenges is compounded for less desirable space that is now facing a new competitive set as discussed later in the article.

Experiences are not socially distant

As the last recession eased after the 2008 financial crisis, a cultural shift began to emerge that emphasized paying for experiences instead of things. In the last decade, retail has seized on this trend by building new town centers and re-energizing stagnating malls with active retail such as mini-golf, cinemas, restaurants, indoor climbing walls, and Ferris wheels to create socially driven experiences that could not be replaced by online shopping. It encouraged customers to spend more time on the property.

In addition, efforts to support community retailers and Main Streets such as buying local and Small Business Saturday, gained popularity. However, small and local retailers, many of them located in town centers and downtowns, are disproportionally dependent on foot traffic. Often, they feature specialty, tourism, or novelty products that appeal to a narrow demographic and rely on impulse buying.

Large retailers have continued to battle decline, trying to find ways to remain relevant and profitable. These efforts to respond to e-commerce are becoming their saving grace, but those focused on adding value through experiences is leading to new problems.

  • Walmart, Target, and other retailers have enabled customers to pick up their online orders at any of their locations — a service that Amazon could not provide.
  • Kohls launched a plan to retrofit its 80,000-sq-ft stores into multiple leased spaces that would accommodate the Kohls brand as well as other businesses. Kohls also partnered with Amazon to handle their returns and bring people into their stores.
  • Macy’s outlet concept had been showing success, and its shop-in-shops concept featured smaller retailers, such as Starbucks, MAC, and Finish Line, inside Macy’s locations.
  • Sephora stores located in JC Penney locations were drawing customers and providing additional value to the traditional retail format. Store closures is straining this partnership.

Covid-19 & the unwinding of rent rolls

In March 2020, retail sales in the U.S. fell 8.7% — the largest monthly decline in history. Compared to March 2019, clothing store sales alone have dropped by almost 51%.

Brick and mortar retail everywhere, in all shapes and sizes were not prepared for what has confronted them. Today, as consumers are told to stay home, keep physically distant from others, order takeout food, and avoid large groups, and with social distancing protocols in place for months to come, the impacts to retail industry will be monumental.

Questions critical to the future of retail are being raised as consumers who had resisted e-commerce are adopting online buying behaviors: Once you must buy groceries online for months, will you return to the store when you have a choice? Can local shops pivot to online or contactless operations quickly enough? Will closed businesses come back after the pandemic or will they stay shuttered?

Shopping center owners are confronted with their own issues. Tenants that have closed their locations but intend to stay may refuse to pay rent; Cheesecake Factory, with nearly 300 locations, and the Gap did not pay April’s rent. Many of their tenants won’t survive a shutdown that extends into the summer. Landlords with less desirable locations will lose tenants as an abundance of more ideal locations become available. Tenants that could not previously afford or find vacancies in better locations will be able to move; as inventory increases, rents will decrease.

How will we value retail property in a post-COVID world?

For commercial property owners trying to understand impacts on property value, 2008 is a key reminder.

In 2008 and the years following, there were few property sale transactions. This led to a period of very little reliable data on comps and cap rates, and the transactions that did occur were distressed. This will also be true in 2020. How do you value properties when nothing is being sold? Because the cap rate is a reflection of risk, you must assume cap rates will be higher than 2019 but by how much? If you use current vacancy or rental/leasing rates, you will grossly overstate market occupancy levels and rent. Existing rents in place cannot be used as a reasonable reflection of today’s rent, and there is substantial risk associated with those leases. Tenants may leave or renegotiate their leases to a rate that is economically feasible for their business. Stated simply, when the existing leases in these centers were signed, the world was a different place.

In 2008/2009, retail owners had to wait until data became available. In 2020, it will take time to see what the market is willing to pay, although it is guaranteed to be considerably lower than 2019. Landlords will be reluctant to cut rates, but at some point they’ll need to fill spaces left vacant by those who won’t survive. Decreased demand will drive rents down, but retailers will still struggle to afford them and there will be a delay before retailers vacate properties.

Owners will have to conduct tenant-by-tenant analyses to answer tough questions. Prior to COVID-19, which tenants were behind on their rent and sought rent relief or a reduction? Which tenants operate at low margins and must have high volumes of foot traffic to survive? For national tenants with locations throughout the country, what was their financial strength before 2020? Did they have strong balance sheet? If many of those tenants may be gone in six months, then who is left — who are the strongest tenants?

The new retail climate

Relief will come to the market, but when, and in what form? What will the new retail climate look like? What reasonable assumptions can we make?

These are uncertain times, but a few facts are uncontested:

  • Retail has changed forever. We can start to understand the degree of change by tracking the increase in online versus brick-and-mortar sales. For example, analysis by Altus Group showed that, from 2009 to 2018, Walmart’s e-commerce sales increased by 545%; Macy’s increased 511%; and Target’s increased 406%. It’s clear that all retailers must ensure their online services are efficient and easy to use to maintain or establish consumer connections.
  • The retail market must correct for multiple issues, not just the recession. There will likely be long-term changes in consumer behavior. The most critical of these may be the extent of the psychological repercussions that results from economic insecurity, health concerns, and isolation; these will not become clear until long after the worst of the pandemic is over.
  • Retail experience from the last decade is not relevant to the current situation. The anchors on which retail relied before COVID-19 — restaurants, fitness centers, big box, theaters — will be unreliable in the future, and we don’t yet know what type of new tenants may fill that void. Retail must adapt by designing smaller spaces and adjusting for lower property values. A reduction in property taxes will provide relief and every dollar saved will go further than it did last year, but in the short term, the deficits owners face will exceed the benefits.

This is what we know. Of course, much more remains unknown.

Because the situation is fluid, it’s difficult to get a true sense of the future of retail, and numerous factors are hitting this market segment at one time. But after assessing key indicators, we can propose some likely scenarios:

  • The physical retail market will survive, in a different form. For example, warehouse stores like Costco or drive-through retail are viable possibilities. The availability of order pickup at brick-and-mortar stores offsets some of the loss of foot traffic. It will, however, have a negative effect on retail that is dependent on impulse purchases. And we must make market corrections. As noted earlier, the U.S. has a tremendous oversupply of retail space; it more than doubled from 1980 to 2010, from 3.3 billion to 7.2 billion square feet. To stabilize the market, we must reduce that space until the economy levels off.
  • In the short term, physical distancing is the new normal for restaurants and shops. As occupancy for in-house dining is reduced, the loss in total patrons may be offset with a per patron increase in menu prices. From discussions with our clients, this increase could be as much as 25% depending on location. Similarly, outlets and other stores that feature narrow aisles and racks and shelves crammed with products will initially have less appeal. Stores must incorporate more open space into their designs, which will mean fewer products to sell per square foot.
  • When a vaccine for the novel coronavirus is approved, retail will start to recover. We can find a precedent in the 1950s, when the impact of the polio epidemic eased after a safe vaccine was developed. But that scenario is still many months, if not years, away, and retail will first need to be recapitalized and money must start flowing back into economy.
  • The new anchor store is yet to be discovered. Unless the fitness centers, entertainment venues, and restaurants that currently anchor shopping centers have deep pockets, they won’t last in the short term. There is some speculation that grocery stores may become the sole reliable anchor in the near term. This could cause retailers to flock to centers with grocery anchors.
  • Competition for office space may arise from industrial and retail. Some regional malls have successfully retrofitted their spaces to accommodate local government tenants. Small businesses, nonprofits, or call centers looking for office space may find the former town center or strip mall an ideal new location, with its availability of parking and accessibility to public transit.
  • There is real potential for permanent change to the retail fitness concept. These were some of the first venues to close during the pandemic, and at least one national fitness chain announced that most of its locations will not reopen. A few fitness centers did reopen in late April, however, adhering to their own distancing, occupancy, and sanitizing procedures. It’s too soon to predict when or whether consumers will return in the numbers necessary for these centers to stay viable.

There’s no doubt that the current picture is bleak. The retail market had already been struggling before COVID-19. With the current social implications combined with an oversupply of retail space and other issues, it’s clear that a market correction is not only inevitable, but will be fast tracked. We now know that many of the trends we had been following industry wide — including experiential retail, shopping locally, and town centers — will hasten greater losses. And although the economic fallout caused by the pandemic will affect how and why consumers spend, the retail market is not going away. But past experiences and emerging data are starting to create a path forward and will eventually help us find our footing during this difficult and unsettling time.

Whatever new form the market will take, Altus Group will be tracking it and providing retail property owners with the guidance they need, throughout the remainder of 2020 and beyond.

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