Physical Retail's Long Shadow

November 28, 2016

 

An article I posted on my LinkedIn timeline from National Mortgage News entitled "Macy's Store Closings to Hit $3.64B of CMBS” (commercial mortgage backed securities) garnered more clicks than usual. As someone who lives in a part of the country where shopping malls make up a large part of the property tax base, this issue was of particular interest, but the wider implications for the country as a whole should bear some scrutiny. This could be big. And highly problematical.

 

In an August 16 report from Moody's Analytics titled "Brick-and-Mortar Retail Faces Distressing Credit Picture," it was noted that “despite the broad advance in US consumer spending, traditional retailers are struggling to lift sales. The online sales spike is relentless.” Online sales racked up a $16.5 billion increase year-over-year in the 2nd quarter, while general merchandise store sales decreased by $1.6 billion over the same period. The trend shown in this chart says it all:

 

 

Not only that, the online retailers are enjoying fatter margins. If a shopping mall loses an anchor like Sears or JC Penney, it doesn't necessarily spell automatic default of the mortgage credit that backs the property, although that has happened. What we'll probably see is an ongoing deterioration of credit quality over time. The struggles of many smaller retailers also present a challenge to keeping these properties leased up: Sports Authority, Delia's, Radio Shack, Abercrombie & Fitch, Pacific Sun, Wet Seal, Aeropostale, Quiksilver, American Apparel, Cache, to name a few, have either shut down, shuttered units, reorganized, or are seeking lifelines. But the mall operators are taking note, and they're playing defense. One local mall is adding high end luxury brands to it's stable of tenants. Simple reasoning here: you won't find Prada or La Perla on Amazon. Some mall operators already pay Apple for the privilege of siting a store in their mall, since their mere presence generates foot traffic. But not every community has the consumer base to support the "carriage trade," and once again, just as we saw with the housing bubble, it's going to be the secondary and tertiary markets, without the population density, or the diverse economic base, that will get slammed the hardest from any fallout in the need or demand for physical retail. This is the last thing in the world these economically stressed communities needed. 

 

An analysis by CoStar Group revealed failing malls shared the following traits: 

 

1. They were all located in areas with lower than average household income for the market; 


2. They all saw sales cannibalized by larger super regional malls or large community centers within a five-mile radius; 


3. Their anchor stores lost their drawing power as a proliferation of trendy niche retailers increasingly fragmented the market, drawing shoppers away from the big retailers who cast wider nets, and; 


4. The weaker malls lacked capital for repositioning and re-tenanting to remain vibrant.

CoStar also noted: "The average income among households near malls favored by investors was twice that of those near the specially serviced (i.e., defaulted) malls. The median housing value was almost three times as high. The projected population growth through 2021 was twice as high. And importantly, the number of people living below the poverty level was four times higher near the specially serviced malls vs. the favored malls.

“Those who think that department store and apparel closures are the problem and not a symptom are simply putting the cart before the horse,” said Garrick Brown, vice president, retail research of the Americas at Cushman & Wakefield."

In other words, this is more economic detritus caused by the geographic concentration of wealth, job migration to larger cities, and the widening gulf in earnings power and real estate values we're seeing between large urban centers and more rural communities. That could get ugly. 

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One thing that HAS surprised me is what the internet did to apparel. Anyone could reason that digital downloads would hurt physical bookstores and shut music stores. You could rationalize that commodity consumer items like flat screen TVs and electronics would be likely candidates to hurt physical retailers. But I always thought the need to try on a garment for size, look and feel would shield apparel retailers. Clothing purchase is a highly personal decision which would seem to defy, at least to some degree, online penetration. I was dead wrong. If sales remain on course, Amazon will be America's biggest apparel retailer by 2017.   

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One of the odd things about the commentators who are noting this change in our shopping habits is an obligatory mention of the American retail space footprint. We are supposedly "ripe for consolidation" since we have four times the square feet of retail space per capita compared to say, Europe. That may be surprising to some, but it's actually been that way for decades, so the retail consolidation we're seeing now was being foretold well before online shopping became common. Even as the retail footprint shrinks, I don't think we'll get to parity with any other developed nation any time soon, and observers have been calling our country "overmalled" since the 1970s. Ironically, at long last, they finally have a reason to. 

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In any case, the economic angle is something to be watched. Aside from the risk in securitized commercial mortgages, and what this means for commercial real estate lending, a lot of communities rely a great deal on the property and sales taxes generated from these sprawling, land gobbling properties. Re-purposing malls is developing into a public policy specialty, with new ideas for conversion to affordable housing, offices and medical centers being floated. And if these marginal communities don't want to see even more of their tax base erode, they had better have a "Plan B." 

 

As the winnowing away of these properties accelerates, there will be winners and losers along the way, and a lot of struggles to stay relevant and keep customers coming. The process will take some time: for example, at its height, Blockbuster Video once ran a remarkable 6500 stores world wide. As online adoption of content delivery broadened, a long, drawn out, and painful process of a shrinking retail base dragged on.

Look for a similar process to happen in this space in the years to come. 

 

 

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Donald R. Davret, Investment Advisor Representative

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