Now that most retail REITs have reported their third quarter results and provided an outlook for 2016, one thing has become very clear—tenant issues are accelerating, creating a more challenging environment for the sector looking forward.
“Space lost to tenant bankruptcies and other store closings has gathered momentum, and, similarly, lease termination income rose for a number of companies in the space,” according to RBC Capital Markets’ analysis of retail REIT performance for the third quarter.
The current level of tenant issues, specifically bankruptcies, is still not as high as it was before the recession. “We are returning to a period where tenants come and go, and that’s how it should be,” says Rich Moore, a REIT analyst with RBC.
More bankruptcies equals more new concepts
Retail REITs’ operating metrics remained healthy during the third quarter, although there has been a bit of softening, according to the RBC report. By and large, net operating income (NOI) growth exceeded 3 percent, occupancies continued to rise and leasing spreads were in the mid-to-high single digit range. REIT balance sheets remain healthy, although some are starting to deal with outstanding rental debt.
“For a long period, nearly every retailer was paying its rent,” Moore says, adding that under normal circumstances, retail REITs must deal with at least a few tenants that get behind. “And that’s what they’re starting to deal with again.”
Moore contends that increasing tenant issues are a sign that the retail REIT sector has returned to a more “normal state” that it has seen for the past few years. “Before the recession, there was certain amount of bankruptcies that occurred on a regular basis, and no one really worried about it much because it’s the nature of the business,” he says. “The recession wiped out most of the weaker retailers. If you made it through the recession, you were a pretty healthy retailer. As a result, we’ve seen very few bankruptcies until recently.”
Tenant bankruptcies and resulting occupancy loss among the mall REITs rose in 2015 compared to the prior four years, according to Matthew Werner, a portfolio manager/analyst with Chilton Capital Management LLC, a Houston-based firm that specializes in REITs. American Apparel, Jones New York, and Forever 21 are just a few of the retailers that are shrinking their footprints, adding to last year’s list of high profile declining retailers, including Coldwater Creek , RadioShack and Wet Seal.
But Moore isn’t concerned about the increase in bankruptcies. If anything, he’s reassured by it.
“The reason we weren’t seeing any bankruptcies was because no one new was starting up—there was an absence of new concepts,” he says. “As the retail sector improved, people decided to jump in with new concepts. That’s why we’re seeing bankruptcies: not everyone is going to win.”
Power center concerns
Of all the retail property types, the outlook for power centers is the most challenging, experts says. With the exception of DDR, which has positioned itself as the ultimate power center REIT, other REITs with mixed portfolios are spending more time talking about non-power center assets, Moore says.
“There was a time when power centers were cool and that’s what the REIT management teams wanted to talk about,” he notes. “Now they’re talking about other property types.”
The shift reflects a greater concern about the sector and its tenants, he adds. Because the tenants that occupy these centers are built around convenience and selection, they are the most vulnerable to competition from e-commerce players, which offer a similar level of convenience and selection.
“Power centers aren’t places where shoppers browse,” Moore says.
Moreover, big-box chains aren’t expanding at the pace they once were. Many are downsizing their store prototypes and their overall footprint instead.
“The power center business has definitely gotten tougher,” Moore notes. “There’s a concern about what tenants will fix the space if a big-box tenant leaves.”