I recently received a request for comment from National Real Estate Investor asking:
“Given recent events, what is the outlook for grocery-anchored retail?”
In my answer to that question I discussed the effects on percentage-rent revenues and the longer-term effects on investment valuations.
In this entry, I’ve opened with some clarifications for readers who aren’t familiar with commercial real estate investment.
Background information for non-retail investors
Grocery anchored retail
Many retail properties have anchor tenants, for regional shopping malls, such as Bayshore, and Rideau Centre, the anchor tenants are Wal-Mart and Nordstroms. In most strip malls, the anchor tenant is typically a large pharmacy (e.g., Shoppers Drug Mart) or a grocery store. Grocery anchored retail is any retail property anchored by a grocery store.
On average, a household buys groceries two to three times per week – regardless of the economic circumstances. This serves to insulate the sales of tenants in grocer-anchored strips during recessions, which reduces vacancies. Consequently, grocer-anchored strips have fared better during recessions. As such, they have been viewed as less volatile investments; accordingly, these strips have commanded higher valuations relative to the income they generate.
Percentage rent, net rent, and operating expenses
Retail rent is often divisible into three components:
- Net rent
- Operating expenses
- Additional rent
Net rent is a pre-defined amount payable to the landlord at regular intervals. Typically expressed in terms of dollars/square foot/year.
Operating expenses are basically all of the non-financing expenses the landlord gets a bill for: Insurance, grounds keeping, property taxes, etc. The landlord passes those on to the tenant and the tenant pays them in addition to the net rent she pays to the landlord.
Additional rent is anything beyond net rent and operating expenses. For example, some tenants are required to contribute to an advertising budget, and the landlord is required to spend that budget on advertising the shopping centre.
A popular type of additional rent is percentage rent.
Percentage rent is a percentage of the tenant’s sales payable to the landlord. Typically, percentage rent is calculated annually. Percentage rent is more common in regional shopping complexes, but some strip mall landlords do charge it to their tenants.
The effect of COVID-19 on retail landlords
Percentage rent shrinkage
Social distancing has dampened retail shopping. However, grocery anchored strip malls are seeing more visitors. The increased traffic seems largely attributable to stockpiling. It seems unlikely that the increased traffic will spill over into surrounding retail. It’s hard to imagine someone popping over to Mattress Mart while stockpiling for the apocalypse.
So, in the immediate term, the anchor will see increased sales from stockpiling, and the other tenants (the line tenants) will see reduced sales from social distancing.
Stockpiling will reduce the need for future grocery purchases. That reduction in demand for staples will likely offset the sales boost attributable to stockpiling. As such, the net effect of stockpiling on the landlord’s percentage rent will be neutral.
Some discretionary purchases that are not made during isolation will be made afterward. For example, a mattress that needs replacing will still need replacing months from now. However, transient desires motivate many discretionary purchases. For many, the opportunity to have, for example, well-manicured nails during the last half of March will be forever lost to social distancing. Likewise, the opportunity to remedy the boredom one experienced during that time will also pass.
In sum: I expect that the sales boost owing to stockpiling will be offset as consumers use their stockpiles. Consumers will postpone some purchases. However, some sales opportunities will be lost. I expect landlords who charge percentage rent will see the effects of those lost sales opportunities on their income statements.
During previous recessions, the grocery anchor has buoyed traffic at line tenants. However, the first months of this recession will be unprecedented: grocery shoppers will avoid visits to line tenants. Moreover, in some cases, those line tenants have been legislated to close; the grocery anchor will not benefit these tenants.
Some temporary net-rent relief will be needed to avoid vacancies. For stronger tenants, postponement of rent should suffice, as these tenants should have the means to repay back-rent when their sales recover.
However, for marginally viable tenants without a strong personal covenant, landlords may need to offer several months of free, not postponed, rent. In those cases, the alternative will often be worse. Not only will the landlord lose several more months of net-rent to vacancy, she will lose the opportunity to bill a tenant for operating expenses during that vacancy. Moreover, weak, or non-existent, personal covenants will limit the landlord’s ability to recover the lost income.
Rational landlords will grant meaningful net-rent relief to their tenants. However, landlords are human, and some humans are stubborn. I expect that many landlords will give too little relief to their tenants. The effect will be additional retail vacancies, which will put downward pressure on net-rents, which, in turn, will put pressure on valuations.
Longer term, social distancing may habituate online shopping for staples, which could permanently erode the traffic of grocery anchored strip. For evidence, consider these examples.
The 1994-95 MLB strike changed the sports viewing habits of North Americans. The League hasn’t recovered its television market share.
The 2014 disruption of the London Underground forced commuters to find new ways to work. Many travel patterns remained changed even after the Underground reopened.
There’s little doubt that, over the next few months, some segment of consumers will buy their staples online for the first time; that purchasing will engender new habits in some them. It seems unlikely that the change will be so substantial that it entirely erodes the advantage of grocery anchored retail. Nevertheless, a detectable, and lasting, effect seems plausible.
If some consumers do begin shopping for staples online, it will dampen the stabilizing effect of the grocery anchor, which will adversely affect the stability of the grocery anchored strip, and thus adversely affect valuations of those strips.
The grocery anchor will not insulate line tenants from the recession. Some of these tenants will need rent relief. Landlords should provide relief to those tenants in order to obviate marketing the space in a less favourable market. Long term forced experimentation may change the staple shopping habits of some consumers, which may adversely affect the value of grocery anchored strips.