Several months ago, this column introduced you to my colleague Burland East, a real estate maven who shared his unique real estate investment strategy. His “off-index” approach focuses on monopolistic landlords and their “sticky tenants” — renters who for one reason or another are unable or unwilling to move. That gives their landlords more flexibility to raise rents. Data centers and cell phone towers are prime examples in East's current portfolio.
As East implied, large retail stores like Macy's, JCPenney and Sears are just the opposite of sticky tenants. If anything, the landlords of shopping malls can't raise the rents of those tenants because sales are falling. Across the country, some shopping malls are becoming our new ghost towns. (Predictably, there's a website — DeadMalls.com — tracking their demise.)
Since my last column, East has drilled deeper into the retail sector and found that conditions are worsening faster than he anticipated. He also uncovered what he believes are compelling reasons why — and they go beyond the Amazon effect.
A series of demographic and technology-related trends have changed customer desires in ways that are proving difficult for retailers and their landlords to adapt to. As a result of these changes, retail and shopping center (malls and open-air centers) stocks have seen large declines in values and share prices. Indeed, retail real estate investment trusts have lost more than a quarter of their value from September 2016 through mid-August 2017, as measured by the Dow Jones U.S. Retail REITs Index.
Start with demographics. Anecdotally, East notes, millennials seem less interested in the purchase of things for the “sake of shopping.” The “shop ‘til you drop” attitude of the baby boomers has been replaced by less interest in buying and more interest in experiencing. There is not a lot of hard evidence to back this up, but every conversation he has suggests it's true. As a result, shopping patterns have changed. A Goldman Sachs’ report on millennials concluded that this cohort of 81 million children born between 1982 and 2002 have different priorities from their parents. They are delaying marriage and homeownership, are burdened with student and credit card debt, have less money to spend, are social and connected, and are the first digital natives.
As East points out, these demographics drive the technology trends to a large extent. Digital skills and social connectedness drive price discovery and comparison shopping, made necessary by millennials’ constrained budgets.
“It's simple in hindsight to see how this all fits together. Malls, open-air centers, the logistics and manufacturing chains and how retailing works were not built for this [generation]. Malls were built in the wake of World War II, alongside the interstate system and boomers’ desire for housing and the middle-class lifestyle,” observes East, adding that as time went on, retail became more efficient as the U.S. sourced products in markets with lower labor costs.
The effect on retail is like a hurricane that starts as a Category 3 and keeps getting revised higher as it approaches landfall. “Four-wall profit,” which is money made on the premises as opposed to online or by telephone, peaked in the period between 2012 and 2014, reflective of the fact that department stores are largely irrelevant as everything they sell is sold somewhere else for less or with better service. The hurricane of e-commerce threatens vast amounts of real property. When you consider that Sears, JCPenney and Macy's have about 3,130 locations and about 300 million square feet between them, the scope of the problem comes into sharp focus.
East says that until the advent of e-commerce, U.S. retail sales minus inflation grew about 2% a year for the past 20 years, underpinning the value of stores as tenants. Indeed, retail was a major contributor to the performance of REITs over that period, during which they returned an annualized 11.23% through June 2016, according to Bloomberg. (Obviously, past results are no guarantee of future ones, especially now.)
East's analysis leads him to believe that e-commerce will continue to grow at 15% annually from the 9% of total retail that it represents today. Store sales, he calculates, may decline 16% in real dollars over the next decade.
The dim outlook presents a challenge to investors looking to the REITs index to hedge against their equity and bond portfolios. Perhaps the best idea is to do as East does and look for tough landlords with pricing power and their sticky tenants.
--- Read Managed Futures and Managing Expectations on ThinkAdvisor.