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August 19, 2017

Are Online Shoppers Hurting REITs?

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Are Online Shoppers Hurting REITs?

As retail activity shifts increasingly to the online world, experts identify some real estate investment trusts that stand to benefit. But others may have a bumpy road ahead.
Vacant store

The surge in internet retail sales is proving to be a boon for industrial real estate investment trusts, as online retailers need space to store and distribute their goods. But the same can’t be said for Class B and C mall REITs; the ever-increasing portion of consumers doing their shopping online is putting a dent in the revenue of mall tenants, which is in turn harming the investment vehicles that rely on them.

Online retail sales grew 15 percent last year to $341.7 billion, according to the U.S. Commerce Department. That dollar amount represented 7 percent of total retail sales in 2015. “And we only expect that to rise in the future, especially as millennials who grew up with e-commerce take over the big portion of spending,” says Edward Mui, a REIT analyst at Morningstar, a research firm in Chicago.

The bifurcated effect on industrial and retail space is evident in REIT performance. Industrial REITs in the FTSE NAREIT US REIT index have returned a whopping 21.8 percent so far this year, compared to 9.9 percent for REITs overall. Meanwhile, mall REITs are lagging behind with a 6.9 percent return.

Prologis, the largest industrial REIT, has calculated that every dollar of online sales requires three times more distribution and warehouse space than a dollar of sales at a brick-and-mortar store. That’s because when goods are shipped to a brick-and-mortar retailer, the shipment usually entails a large amount of goods delivered to a limited number of stores. But internet sales routinely involve the delivery of a single package to anywhere in the country and beyond. Oftentimes these goods travel long distances before reaching their end point and must be stored in industrial facilities along the way. Mui says that’s part of the reason why the online shopping trend “seems to be an unalloyed benefit” for industrial REITs.

Steve Brown, a real estate fund manager at American Century Investments, agrees. He says that, as a result of the high demand for this type of industrial space, rents and occupancy rates are rising: “We think that trend will continue along with the growth in online sales.”

Online retail goliath Amazon is naturally a huge user of industrial space. But so are Wal-Mart and Target, which are both building out their online presence, according to Jonathan Miniman, a portfolio manager at CBRE Clarion Securities in Radnor, Penn. He says online sales will be a “fundamental tailwind for the foreseeable future” in the industrial REIT space and adds that these companies demand high-quality spaces: “Online retailers need the newest and best assets—bigger floor plates and higher ceilings.”

Amazon in particular demands unique design and capacity for its distribution centers and warehouses, which means rethinking the relationship between industrial tenants and real estate professionals. “That requires innovations from landlords, making landlords their partners,” Mui says. “That trend will continue.” Amazon is also trying to cut down on its delivery time, and it will take the right kind of real estate to do that. So Amazon’s relationship with its landlords will only grow closer, Mui says, and for REITs that feature buildings with truly effective landlords, the growth of online sales could be a boon, he says.

But online sales aren’t a benefit to all. On the retail front, falling sales at retailers such as Sears and J.C. Penney are causing pain for some malls. “While [Class] A malls are still putting up good numbers, B and C malls have flat to falling occupancies and rents,” Brown says. “The A malls have restaurants and popular tenants like Tesla and Apple.”

That’s not to say that the retail REIT sector as a whole is underperforming. It has returned 10.7 percent this year—better than the overall REIT average—propelled by strength in certain types of shopping centers. Some retail trends that reach beyond commercial class type and indicate diversification can lead to better outcomes for shopping centers. Miniman notes that shoppers at brick-and-mortar stores are spending more on durable goods, such as home-improvement items, than on nondurable goods, such as apparel. They’re also looking for more experiential options, such as restaurants and movies. “Retailers are trying to figure it out, and the better ones will,” he says.

Omnichannel retailing, which mixes brick-and-mortar with online, is the most profitable, Miniman says. When a customer orders a product online and picks it up at a store, the company doesn’t have to pay a sales commission. Additionally, when online shoppers come to pick up their orders at the store, they’re confronted with yet another chance to buy.

Also, this trend of mixing online sales with physical locations means retailers can use their stores as warehouse and distribution centers. For example, big department stores may not be able to complete deliveries within hours of ordering, but they can be more convenient for shoppers picking up last-minute items on the way home. “If you’re Macy’s, you can’t compete with Amazon,” Miniman says. “But you have 500 stores, and you’re close to the last mile for consumers.”

Unlike some mall REITs, shopping center REITs have thrived this year, returning 16.8 percent. They are benefiting from the strong sales numbers put up by tenants such as Home Depot, Lowes, Wal-Mart, and Target, as these retailers are faring better than department stores. “Strip centers are seeing a rise in occupancy because of the improvement in the economy,” Brown says.

But at the most basic level, the strip centers are facing the same issues as malls. While gross domestic product has grown about 2.1 percent annually since the recession ended in 2009, that hasn’t been strong enough to boost Class B and Class C retail in malls or shopping centers, which have both suffered as income has stagnated for the nonwealthy. But for both types of REITs, Class A properties will continue to shine, analysts say. “That’s where the retailers want to be,” Miniman says.

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