“Given these occupancy challenges, investors are interested in redeveloping malls into other uses, such as medical offices or multifamily communities.”

The slowdown of the commercial real estate market has affected all asset classes, but the retail sector — which faced its own difficulties prior to the period of rising interest rates and return-to-work challenges — is somewhat less impacted. Unlike industrial and multifamily properties, retail did not see significant pricing increases over the past few years. Capital market struggles and capitalization rate increases are being felt across all property types, but the recent changes in retail property values are not as dramatic when compared to other sectors.

Value by subsector

Across the country, there are varying levels of interest in retail properties based on size, quality and tenancy. Single-tenant net-lease properties with long remaining lease terms continue to be the most sought-after assets.

This property type typically attracts a large pool of potential buyers, which drives pricing upward. Net-lease properties with strong credit tenants and remaining lease terms of 10 years or more are seen by many investors as being similar to a corporate bond. The shorter the lease term or the higher the risk associated with rent payments (tenant credit), the less interest the property will gather in the marketplace, pushing pricing downward.

Overall, the second most-desirable retail property type is the grocery-anchored community shopping center. Many institutional investors view grocery-anchored centers as a stable investment opportunity. Typically, grocers have performed well over the years and have been relatively “internet-proof.” Many tenants in grocery-anchored centers strategically lease these spaces due to the increased customer traffic that a grocery store will drive to a center. While grocery-anchored centers are judged as a positive, the specific grocer in place affects this desirability. Many investors still view Whole Foods and some large, national grocers as value-add opportunities, while local grocers and other national chains are not viewed as strong in-place tenants.

Power centers and lifestyle centers can be attractive to investors at higher capitalization rates. These are large outdoor shopping complexes. Power centers typically have three or more big-box stores, while lifestyle centers house upscale shopping, restaurant and fitness options in promenade-style spaces. The main driver of value for a power center is the tenant mix. If there is a good blend of national and local tenants with internet-proof offerings, the center will likely command decent investor interest. Many of these properties have a large entertainment focus (movie theaters, experiential offerings or restaurants) that can create a more attractive tenant mix. The most significant concern for these centers is the occupancy cost that a tenant can bear during their lease term.

As real estate operating costs (e.g., insurance and taxes) continue to rise, tenants are hyperfocused on industry-average occupancy costs, local occupancy cost ratios and brand occupancy cost ratios. If occupancy costs at one location are considerably higher than average, many tenants will look for cost-effective alternatives in the market. As tenants continue to focus on operational expenses, landlords must offer upper-level amenities and incentives to retain existing tenants and attract new ones.

Mortgage environment

Toward the lower end of the range in value for retail properties are smaller neighborhood centers with local tenants, as well as Class C and lower regional malls. Many of these centers have seen continuous declines in occupancy rates and tenant quality, which can result in questions of highest and best use for the center, as well as its long-term viability.

Overall, debt remains available for retail properties, but commercial mortgage lenders are taking a harder look at asset quality, tenant quality and cash-flow stability before financing a transaction. Lenders are still willing to finance upper-tier retail assets and single-tenant net-lease properties with relatively long remaining lease terms.

These types of properties are viewed as strong investments and are less risky than many other retail assets. While lenders are willing to place debt on these assets, property owners are dealing with lower loan-to-value (LTV) ratios compared to prior years. On top of the LTV constraints, the debt-service-coverage ratio may also impede the lending decision, as many borrowers are experiencing lower levels of cash flow than in previous years.

For less desirable assets, traditional financing remains difficult. Lenders are often concerned with the best uses of these properties and their future viability. Owners of these assets may seek alternative financing from private lenders, hard money lenders or mezzanine lenders. The short-term funding offered by a nontraditional lender allows the property to be repositioned or stabilized so that traditional long-term financing can eventually be secured.

Occupancy challenges

As a result of market disruption caused by e-commerce, malls continue to struggle. With brick-and-mortar retail sales permanently impacted by online competition, retailers must reduce expenses to keep physical stores open.

Since they’re among the most expensive retail environments for tenants, malls must reduce rents to remain competitive. Consumer sales are not likely to increase dramatically, so rents must trend down. This leaves mall owners to choose between lower occupancy and more income, or higher occupancy and less income as compared to prior years.

Given these occupancy challenges, investors are interested in redeveloping malls into other uses, such as medical offices or multifamily communities. Municipalities are beginning to work with developers to help loosen the restrictive covenants that have historically hindered redevelopment efforts, resulting in success for some properties. But adaptive reuse can be more costly than ground-up construction, particularly in the case of a retail-to-multifamily conversion.

Vacancy issues, of course, are not limited to malls. With the closure of businesses like Bed Bath and Beyond, vacancies plague owners of big-box retail centers everywhere. Gyms and other types of tenants have absorbed some of these vacancies, and in some markets, landlords have attracted community colleges or churches to replace the former anchor tenants. Where demographics support them, experiential tenants such as golf simulators may lease large spaces — a boon for landlords since these ventures not only solve the vacancy problem but attract valuable foot traffic to other parts of the center.

If they’re unable to attract a replacement tenant, many landlords will have to redevelop these big-box spaces and create smaller spaces. Multiple small spaces will bring in higher rents than one large space, but converting a big-box space into in-line suites requires significant capital investment.

Informed decisions

To undertake any of these options, retail property owners must determine whether a project offers sufficient return on capital. To inform their decision, they may request a market study, performed by a valuation consultant with retail expertise and knowledge of the local market.

A market study can inform income projections for the proposed use by providing an analysis of supply and demand within the local market. Owners may also engage with a qualified engineering consultant to perform a feasibility study. This includes information about the site and its infrastructure, potential improvements, a conceptual layout, permitting requirements and costs, and an estimate of construction costs.

If owners can overcome the obstacles to redevelopment, the overall inventory of retail square footage will decrease to a volume that might be more appropriate for today’s retail industry, where online sales compete with traditional stores. Less inventory will allow for better absorption of space, providing a potential upside for the retail sector in the long term. ●

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Commercial mortgage lenders, brokers and investors will need to closely follow these issues. Evolving attitudes toward increased sustainability and better building practices for new and existing retail properties may affect how these assets are valued in the future.

A shifting focus among lenders and investors is apparent by the expansion of the environmental, social and governance (ESG) criteria being used to help identify socially positive commercial real estate investments. Although it is generally undefined and lacks set standards, ESG is an increasingly popular framework being used to assess how commercial real estate assets stack up when examined from broad environmental, social and governmental standpoints.

Helping to support this new valuation method is news from the United Nations’ 2020 Global Status Report for Buildings and Construction, which stated that the operation of existing buildings and the construction of new buildings accounted for 38% of carbon emissions worldwide. As such, investors are accelerating the reallocation of capital toward green investments. Research by PwC indicates that 77% of institutional investors plan to stop purchasing non-ESG properties by 2022.

According to JLL research, many global corporations and ambitious governments aim to achieve the goal of reaching net-zero greenhouse gas emissions by 2030. Net zero refers to the balance between the amount of greenhouse gases produced and the amount removed (or offset in some way) from the atmosphere. As for the commercial real estate sector, the vision is for all buildings — both new and existing — to be net zero by 2050.

Retail’s role

The growing awareness and importance of ESG among industry stakeholders means that all assets, no matter their location or type, will be impacted by long-term sustainability challenges. Retail is one of the real estate sectors facing the greatest challenges on carbon emissions. It also affords some of the greatest opportunities.

An important part of supporting value in any retail strategy is to ensure that brick-and-mortar assets have a positive social impact for stakeholders and the environment. The big challenge facing retail owners, however, is how to implement net-zero programs while remaining profitable. Shopping centers, for one, will find it extremely difficult to achieve the necessary carbon reductions and reach the goal of net-zero emissions, even with investments in state-of-the-art retrofitting.

But even with worries about building emissions, retail stores may have an environmental edge in some ways over their e-commerce rivals. Retail typically involves a physical product trading hands, leading to emissions throughout the product’s lifecycle — including manufacturing, transportation, distribution and disposal.

For building occupants focused on achieving ESG goals, reducing their carbon footprint through improvements in supply chain management and logistics is more efficient than focusing on the brick-and-mortar space. This is because the supply chain is one of the main environmental impacts of their business.

For instance, the amount of fuel used to deliver packages to individual homes is considerably more than the fuel used by consumers who drive to a retail store to buy the same item. The fuel usage by consumers is minimized, in part, because they often purchase multiple items in a single trip.

Eco-friendly obstacles

Another problem for e-commerce in its bid to be more eco-friendly is the issue of item returns. CNBC reported that between 15% and 40% of all items bought online end up being returned, increasing the carbon footprint of the delivery and pickup processes. By contrast, a physical store has lower amounts of returns and waste, with only 5% to 10% of in-store purchases being returned, according to the same report.

On top of that, many of these returned goods end up being thrown away. Logistics firm Optoro found that 5.8 billion pounds of returned items and excess inventory end up in landfills each year. While more research is necessary, an argument can be made that retail centers may provide a more energy-efficient way to sell consumer goods.

There are other additional benefits of reviewing supply chain management and logistics, including a look at bulk transport. Retail stores encourage a more efficient way for transporting products, as opposed to home delivery. Operators of outlet and discount stores find that physical retail spaces are still a highly efficient channel. From a social perspective, retail outlets also strengthen community ties.

Market opportunities

Commercial mortgage lenders should realize that as retailers continue to move away from owning real estate and are instead leasing their properties, partnerships with landlords to create the most energy-efficient stores will be a must. The property owners who do not make this a key focus for their upcoming capital investments will start to see a decline in their tenant base and, therefore, in the value of their portfolio.

Placing environmental and climate concerns at the forefront of investment decisions can save money for a company. As the minimum requirements for sustainability increase and stakeholders set ambitious, time-sensitive targets to reach net-zero and carbon-neutral operations, retail properties will need to incorporate sustainability in ways that are both revolutionary and impactful in order to remain an investable asset class.

ESG criteria can be incorporated into a retail space through its infrastructure and operations, although determining how to implement these changes can be financially challenging. Retailers and landlords will need to look for buildings that offer green certifications — such as the Leadership in Energy and Environmental Design program — which will allow them to reduce environmental impacts in brick-and-mortar retail locations.

To meet these demands, owners are increasingly incorporating eco-friendly steps such as “green leases,” which require tenants to share energy-use data and to commit to recycling materials, thus giving the landlord greater control in reducing carbon emissions. Many owners are installing electric vehicle charging stations, which not only attract shoppers who own electric vehicles but also signal a strong commitment to sustainability and the environment while reducing overall carbon emissions.

By investing in sustainability, landlords can reduce operational and tenant costs while creating a healthier environment. They can identify environmental improvements and savings to ensure their property is being used as efficiently as possible. This can include installing solar panels, collecting rainwater for use in toilets or to water indoor plants, expanding access to natural light and improving a building’s ventilation, among other things.

Property owners also can empower consumers to choose low-impact transportation options. In return, they will be able to communicate these efforts and raise awareness about the improved carbon footprint of their building.

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Choosing to make eco-friendly upgrades to buildings can help owners and investors attract environmentally conscious clientele and become better candidates for commercial mortgages. To make these strides, there will be large capital costs that can impact the bottom line. There will be short-term pain as these improvements may not immediately add to the asset’s value, but the changes will result in long-term gains by providing protection from asset-value erosion and obsolescence.

The growing awareness and importance of ESG with stakeholders means that all commercial real estate assets, including retail, will be impacted by long-term sustainability challenges. The ability of owners to meet these challenges will influence asset valuation and will be key investment metrics as the retail sector moves toward a net-zero environment. ●

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