Navigating the Retail REIT space Identifying the winners
Retail REITs (Real Estate Investment Trust) face secular headwinds from rising share of ecommerce in retail. Since the beginning of the year, MSCI US retail REITs Index lost 11.4% vs. 2.1% gain for the US REIT Index. The same applies in Europe with the Stoxx Europe Total Market retail REIT Index underperforming the Stoxx Europe 600 REIT Index (-7.2% vs. -3.3%). While the increasing adoption of online sales has hit both US and European retail REITs, different factors explain their underperformance in the US and continental Europe.
In the US, declining same store sales at major department stores on the back of a tough retail environment (oversupply, rising ecommerce sales) have weighed on retailers’ profit margins and their ability to stay afloat. As a result, 2017 has witnessed the highest number of retailers filing for bankruptcy since the global financial crisis. This has resulted in a fall in occupancy rates and reduced pricing power for retail REITs, leading to a decline in same store net operating income (NOI) growth. Five of the nine major mall REITs have reduced their same store NOI guidance for FY17.
On the other hand the underperformance of European retail REITs has been mainly driven by the concern that the rise of online sales will eventually impact the European retailers and retail REITs in a similar way as in the US. However, we believe several factors may temper such scenario 1) Europe does not face an oversupply problem (mall density in the US is 5.5x that of continental Europe); 2) European malls on average are less exposed to department stores (most impacted by online sales). They include more “Food and Beverage” offerings (favourably geared towards internet) and “Leisure & Entertainment” facilities (internet resistant). They also have a stronger focus on active tenant rotation; and 3) European malls’ Average Quality is higher (Malls rated A- and above are 56% in Europe vs. 36% in the US as per Green Street data). In our view, the trend of stores rightsizing by retailers is likely to continue in Europe. We expect REITs with dominant and higher quality malls to be key beneficiaries of this trend given retailers tendency to consolidate at higher quality centres.
Overall we believe that the future of the retail space will be divided between winners and losers. On this basis we would adopt a cautious and selective approach to the sector. We have a regional preference for Europe over the US. We find in the former a better supply demand situation as well as a more attractive tenant mix on average. European retailers also have stronger financial health and better growth prospects. Further, we favour companies with strong management, healthy balance sheet, strong track record of active tenant rotation and a diversified geographical presence. Our selection focuses on REITs with higher quality and large scale malls that focus on improving the quality of their existing portfolio (through regular upgrades and extensions). In our view, Unibail Rodamco and Klepierre are best positioned to benefit from the current transformation in the retail space and should sustain healthy growth in earnings and cash flows.
Data & recommendations as of 20 November, 2017 close
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