E-Commerce Isn't the End for Retail REITs
Here's why mall and shopping center REITs should still expect solid growth.
Traditional brick-and-mortar retail has come under pressure from the rapid growth of e-commerce as consumers shift an increasing amount of their buying online. The U.S. Census Bureau reports that e-commerce has grown at double-digit year-over-year rates for nearly every quarter since it began tracking digital sales in 1999. Focusing on the categories of retail sales that people generally buy online, e-commerce’s share is over 20%. However, the growth rate for e-commerce sales has followed a smooth, declining curve over time. Extending this curve out produces another five years of double-digit sales, but eventually the growth of e-commerce will converge with the growth of brick-and-mortar retail. Even though e-commerce’s market share will continue to climb, we believe that brick-and-mortar retail’s portion will remain large enough to sustain positive sales growth over time, as it has the previous nine years.
However, we also believe that there is a significant bifurcation between high-quality and low-quality retail locations. Retailers want to place their stores in the best locations, even in a retail environment when retailers are closing stores. Many formerly online-only e-tailers are opening stores in the highest-quality locations. Meanwhile, struggling retail locations will face store closures, and increased vacancies will lead to lower sales for remaining tenants. While we expect store closures to dominate headlines, we think that the top retail locations should be mostly spared from the brick-and-mortar attrition. The retail real estate investment trusts that we cover have all built portfolios with high-quality retail assets that should produce continued solid growth. The Class A properties owned by these REITs should see higher foot traffic and sales growth and be less affected by store closures than lower-quality retail.
We find a strong correlation between nominal GDP and retail sales and use that as our basis for predicting future sales growth. Approximately 74% of total retail sales growth can be explained by nominal GDP growth. However, there are several categories of retail sales that are not relevant to malls or shopping centers. Excluding these categories, approximately 80% of relevant retail sales growth can be explained by nominal GDP growth. Therefore, a forward estimate of nominal GDP growth should provide a solid foundation for a retail sales growth estimate. While e-commerce is generally reported to be just over 10% of total retail sales, that includes several large retail categories that either can’t be sold online (gasoline) or are a tiny fraction of e-commerce sales and are not relevant to malls or shopping centers (building materials). Restricting our definition of retail sales increases e-commerce’s share to over 20%. The higher relevant market share implies that continued e-commerce growth will steal more brick-and-mortar sales than the smaller number implied but also that e-commerce growth is likely to slow sooner than many might expect as it is closer to a saturation point across relevant retail categories.
Despite double-digit growth for the next several years, e-commerce will decline enough over time to allow brick-and-mortar retail to continue to produce positive sales growth. The spread of e-commerce sales growth over retail sales growth has been following a declining curve since 2003. Extending out this curve provides an estimate of e-commerce sales growth. While we expect e-commerce to post double-digit growth through 2024, eventually the spread between e-commerce and total retail sales will approach zero. Given a prediction for total retail sales growth and the rate of decline for e-commerce sales, we predict that brick-and-mortar retail sales will continue to grow around 1% per year over the next decade. When we analyze historical sales growth, the highest-quality retail locations consistently produced higher sales growth than lower-quality retail locations. This is particularly true in malls, which we attribute to the network effect and efficient scale moat sources found in the Class A mall owners we cover. We believe that network effect and efficient scale moat sources will continue to benefit Class A malls, leading them to outperform the brick-and-mortar average. Meanwhile, store closures will mainly affect lower-quality properties, leading them to underperform the average and potentially close altogether.
Shopping center REITs are exposed to several categories of retail that are naturally resistant to disruption from e-commerce. Many types of tenants more typically found in shopping centers (compared with malls) provide a product or service that is difficult for e-commerce to penetrate. Restaurants provide a product and service that requires brick-and-mortar stores to prepare. Even if delivery apps are increasing in popularity, the food order must still be prepared for delivery from a physical store. Similarly, grocery stores are insulated from e-commerce as they are already a distribution point for online grocery orders. Additionally, shoppers tend to prefer to shop for groceries in person, and grocery stores are motivated to push shoppers to the store to save on shipping costs. Shipping costs are prohibitive for low-price items sold at dollar stores and off-price retail, which gives the brick-and-mortar retailer a price advantage. Finally, service-oriented retailers like gyms and salons provide a product that is impossible to replicate online. Over the past economic cycle, these tenant types have shown a combination of higher sales growth and/or more consistent sales growth than traditional brick-and-mortar retail sales, a trend that we believe will persist. Therefore, these tenants provide shopping center REITs a source of rent that is relatively higher and more stable than traditional brick-and-mortar tenants.
Among the retail REITs, our best idea is Macerich (MAC), a Class A mall REIT currently trading at a substantial discount to our fair value estimate. We believe that it benefits from a narrow economic moat derived from the network effect and efficient scale found in its portfolio of high-quality malls. The company has traded off due to the large number of store closures announced in 2019 (we think the number of retailers opening stores supports Macerich’s high occupancy levels), the increasing potential that a recession could affect fundamentals (we think the impact of a recession would be limited), and fears that the company might need to cut its dividend to fund renovations (we think the company can safely issue debt to cover all short-term financial obligations). Additionally, we believe the company could benefit from renovating old Sears boxes into more-productive spaces that pay higher rent, and that it is successfully attracting new tenants to its Class A portfolio.
Kevin Brown does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.