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Surveying the Retail Landscape
Could retail real estate have emerged from the pandemic as a preferred asset class?
Retail continues to evolve as consumer preferences shift, new retailers emerge, and old retailers either change with the times or go out of business. The pace of change and the threat of widespread disruption accelerated with the advent of online shopping and gave rise to predictions about the imminent “death of retail.” Current reports are more likely to tout retail’s comeback. However, well-located, functional retail that meets current tenants’ needs has been enduring for years.
Survival of the Fittest
The retail evolution (or revolution) has hit certain types of retail properties harder than others, but none more so than the classic American regional mall. The popularity of e-commerce greatly influenced this shift, but changing consumer preferences also played a role, with shoppers increasingly favoring open-air shopping centers that offered parking close to the store of their choice. There are about 1,150 malls in the United States currently, but projections show this number could be reduced to 150 by 2032. As GlobeSt.com reported, more than 130 million square feet of retail space has been demolished in the last five years alone, and according to CoStar, retail space per capita in the 45 largest markets dropped to a multidecade low of 54.3 square feet in September 2023.
COVID-19 dealt a significant blow to many retail store concepts, but most of the chains that shuttered during this period were most likely doomed to fail within the next five years, with the pandemic merely accelerating their eventual demise. According to McKinsey, the 25 top-performing retail companies (excluding Amazon) increased their market cap by 38% on average between the start of the pandemic and April 2021, significantly outpacing the rest of the industry, which grew by only 10%. The data indicates that retailers that adapted their strategies to changing consumer preferences saw substantial financial growth compared with those that did not.
Challenges and Opportunities
The surprising strength of retailers as they adjusted their operating strategies and successfully navigated through the uncertainty of the pandemic buoyed retail’s reputation among real estate professionals. E-commerce sales accelerated during the quarantine period, but over time, consumers came to realize the constraints of overnight delivery and expressed an increasing desire to leave the house and socialize. Private capital seemed to sense these shifts and went into the market during 2022 and 2023, doubling its share of the investment market in retail assets. At the same time, retail net absorption increased sharply in 2024, with the average time to secure tenants once shopping center space became available dropping to 8.5 months, the fastest pace in more than two decades, according to CoStar. New construction builds are at a record low, and construction and financing costs have kept new projects on hold, allowing existing landlords to hold firm on rents during lease negotiations.
There has also been a dearth of capital available for retail investment of all types. Retail development in the U.S. went from 217 million square feet in 2008 to a projected 17 million in 2024. However, retail has generally weathered the increase in interest rates better than other asset classes and kept owners’ equity intact since cap rates were typically higher for multitenant retail centers than was the case with offices in central business districts, multifamily properties and industrial properties. Retail, for the first time in many years, stands relatively unscathed and looks like a preferred asset class, leading new entrants into the world of retail ownership.
At the same time, development costs continue to inflate, making ground-up construction difficult. Construction costs were projected to increase by 2% to 6% for materials and 3% to 5% for labor in 2024, primarily due to ongoing labor shortages and rising interest rates, according to JLL. This has led to opportunities to buy existing properties and reposition the assets to better meet the needs of today’s consumers and retailers. However, this requires finding well-located centers, understanding their local demographics and delivering a product that will attract the right retailers to excite shoppers.
Notable Retail Leasing Trends
The key to many successful retail centers is experiential retail, which enhances the shopping experience with stores offering unique, immersive experiences that can’t be delivered online. Most of Capstone Advisors’ tenant growth is concentrated in food and beverage, wellness, and health and beauty. Colliers reported that in 2023, 53.8 million square feet of retail space was absorbed, with the majority being leased by sectors such as food and beverage, health and wellness, and experiential retail.
Capstone Advisors’ portfolio is seeing an increase in small-scale restaurants, especially those with counter service. Large-format sit-down restaurants are extremely difficult to operate profitably, especially in high-cost labor markets. Restaurant operators have needed to aggressively optimize their cost structures to survive in a competitive market, especially during the last few years of high inflation.
Small-format gyms are also extremely popular and continue to be niche-focused. This is an extremely competitive space with concepts that rise and fall in popularity quickly, so landlords need to consider their tenant improvement costs.
Southern California, where Capstone Advisors is based, is seeing real growth in wellness-related tenants, such as infrared saunas, cold plunges and breathwork classes — concepts that didn’t exist a few years ago. Landlords must navigate a fine line between looking to deliver unique concepts to their centers and balancing the risk that such concepts will be here today and gone tomorrow.
The number of health-related tenants coming to retail centers has increased notably. It is much more common now for urgent care offices and satellite offices of medical centers to be located in neighborhood retail centers. In addition, the growth of medical spas and dental spas in higher-income demographic areas is significant, especially with the new generation of weight loss drugs that nurse practitioners and physician assistants can prescribe. According to Colliers, over 15% of all new retail leases in major metropolitan areas in 2023 were signed by wellness-related businesses, including medical and dental spas. The overall square footage dedicated to health and wellness tenants in retail centers grew by 12% in 2023, a clear indicator of the sector’s expansion.
Another notable growth area is the migration of formerly digital-only retailers to a hybrid model that includes brick-and-mortar retail. These retailers have found that customer acquisition and retention costs are improved when having both online and physical stores. A JLL report indicated that in 2023, 38% of the top 100 e-commerce brands had opened physical stores as a growth strategy. This figure is expected to rise to 50% by 2025. Successful retailers have learned to blend their online and physical stores. In the process, they discovered that their physical stores not only picked up sizeable sales but also boosted the amount of online shopping in the immediate area.
As retail continues to evolve, investors who adapt their strategies based on the market and long-term trends, understand the demographics of the areas in which they operate, and see the value in having both a digital and physical storefront are the most likely to see success. While retail real estate may have emerged from the pandemic as a preferred asset class, investors should remain strategic and nimble to adapt to an unpredictable future and be willing to explore new opportunities and diversify their tenant portfolios.
Alex Zikakis is president of Capstone Advisors.
Retail at a Glance
Unless otherwise indicated, all information courtesy of The Shopping Center Opportunity: 2024 Retail Investing Outlook, a white paper released by MCB Real Estate in October. |
