No where have the economic forces of creative destruction been harder at work than in the U.S. retail market. Lately the sector has been a case study in contradictions, marked by the growing demand from an emerging set of new retailers that have added hundreds of new stores across the country, even as many established chains in the old order scale back, close stores or go bankrupt.
Looking at the national retail occupancy numbers, one would consider the recovery in the retail property sector to be complete. Retail vacancy rates across the country are well below those of the previous cycle and continue to trend lower. Shopping centers and malls absorbed another 25 million square feet in the second quarter, more than twice the amount of new retail space added to the market during the same period, according to CoStar’s Midyear/Second Quarter 2016 Retail Market Review and Forecast.
And yet on the other hand, the tepid rate of rent growth, which has has held stubbornly at about 2.8% annual growth since 2014, has kept retail bottled up as the last CRE property sector still shy of its pre-recession rent peak.
One nagging factor in retail’s ongoing store closures, which have been rising again since the beginning of the year following lackluster holiday sales. Most recently, Office Depot disclosed it has added 300 more stores to its store closure list set to shutter by 2019. They are in addition to the 400 stores already slated to close this year as part of cost-cutting move following its failed merger with Staples. The Sports Authority bankruptcy and closures by Sears and other department stores have left vacancy holes in many shopping centers.
Casualties in the apparel sector have also plagued landlords. Luxury brand Coach will shutter 250, or 25% of its North American stores. In June, Ralph Lauren announced the closing of 50 stores across the U.S. Japanese apparel maker Uniqlo has scrapped its second American expansion, closing five stores.
Despite this, the U.S. retail vacancy rate shrunk to 5.7% in the second quarter of 2016, its lowest level since the recession in 2007, thanks to robust expansion by trendy food stores and all types of restaurants.
“From a high-level perspective, the fundamentals outlook indicates the market is quite healthy,” said senior real estate economist Ryan McCullough, who joined Suzanne Mulvee, director of U.S. Retail Research for CoStar Portfolio Strategy, in presenting the second quarter and midyear update.
Disciplined Construction Drives Improving Retailer Productivity
The contradicting nature of the changes roiliing the retail sector have largely kept developers on the sidelines. Only 12 million square feet entered the retail inventory across all shopping center types in second-quarter 2016, less than half of the 25 million square feet of total net absorption. Demand has now outpaced new construction for 16 straight quarters since mid-2012. During the 2004-2007 period, developers delivered 30 million square feet a year — in the big-box power center category alone.
In the other major trend defining the late stages of the recovery, retailers are finally beginning to ring up higher sales after a downward slide in sales per square foot since 2000.
Over last two years however, with little new development to dilute sales, per-square-foot real buying power – defined by CoStar as the median household income multiplied by the number of households near the retail location – has increased by about 12%.
“We’re just getting back to the lower range of what would be considered normal. Tenants can only pay landlords a certain percentage of their sales, and until full productivity recovers, we won’t see a full recovery in rents,” Mulvee said. “Given the manageable supply pipeline we forecast over the next two years, there’s no reason to believe productivity will not keep rising, and rent growth along with it.”
Shopping Center Developers More Selective
“Low levels of construction have really been the key to this real estate cycle. Construction is below historical levels in virtually every market today, setting the stage for strong occupancy recovery and the increase in retailer productivity,” McCullough said. “It’s happening everywhere, even in less supply constrained markets.”
The amount of space under construction as a percentage of inventory in Atlanta, for example, is less than one-third of its 2004-07 average. Dallas has only about one-quarter of the prior average under construction. In Phoenix, a recovering housing bust market, construction levels are only 1/9th of the mid-2000s average.
With so little new retail building underway having just recovered to late-2008 levels, developers are being highly selective, favoring dense, urban core locations. Six of the 15 malls under construction nationwide are located in urban core districts. Eager to attract retailers willing to pay a premium to reach the surging number of downtown renters and other consumers, developers have resurrected a modified version of the urban mall concept, with a mixed-use open-air format replacing the dark downtown fortress malls of previous eras.
Many of these new urban mall developers are focused on the luxury end of the market, boasting tenants such as Neiman Marcus at The Shops at Hudson Yards in New York City and Saks Fifth Avenue in Miami’s Brickell City Center.
Moreover, developers are being more selective about their sites. In an analysis of retail construction since 2002, CoStar Portfolio Strategy found that since 2010, developers have delivered a lower proportion of projects in the weakest trade areas, which CoStar defines as inventory within the lowest one-third of locations for adjusted buying power, a CoStar metric based on aggregate consumer buying power within a three-mile radius. The strongest locations are defined as being within the top one-third for adjusted buying power.
From 2005 to 2007 when power center construction was peaking, the ratio of weak locations to strong locations was about 2 to 1 as many developers believed that demographics and housing growth would eventually create sufficient demand to sustain even the new centers in weaker trade areas, McCullough said.
“Some locations did succeed, but the rapid growth diluted the performance across the entire footprint of some retailers,” he said. “Since 2010, deliveries have scaled back dramatically and the ratio is much higher and healthier for stronger locations, helping minimize the risk for oversupply.”
Developers are targeting high-density areas with solid retail productivity for new community and neighborhood centers, as well as luxury retail. In Orange County, CA’s Tustin, Regency Centers will break ground later this month on The Village at Tustin Legacy, a $40 million, 112,000-square-foot center anchored by a Stater Bros. grocery. The project is located in the 1,600-acre Tustin Legacy master planned development, with more than 6,800 residences and 1.9 million square feet of office space.