In this section we will review the industry operating conditions. Factors such as capital intensity, technology and systems used by the industry, and regulation & policy will be reviewed.
The retail real estate industry is characterized by a medium to heavy capital intensity. Companies in this industry must maintain the real estate properties that they own. This requires large capital spending. For companies that are engaged in acquisitions this will add to the capital requirements. Over the next few years acquisitions should continue as the retail industry expands in different ways.
Companies that operate in capital intense industries typically have higher levels of depreciation and fixed assets on the balance sheet. Due to the amount of capital required to operate in the industry many firms have high leverage ratios when compared to other industries. This isn’t necessarily bad since the debt may be backed by assets such as equipment, land, or a building. Due to the higher levels of depreciation, which is a non-cash expense, many analysts will use EBITDA as opposed to net income when calculating performance ratios. The use of EBITDA helps to offset the impact of a large depreciation expense.
Technology & Systems
The retail real estate industry is facing many of the same challenges that other industries are facing. New technology, shifting customer demographics, and better and faster data access are all transforming how the industry operates. Some of the main areas in retail real estate that have been impacted by changes in technology are operational performance, customer incentives and experiences, and funding sources. One company in particular, Amazon, has had a major effect on the industry and is changing the retail real estate landscape. Amazon’s ability to provide consumers with almost any good they can imagine and with free shipping is changing how and where people make their purchases. Certain retailers are going to have to evolve and provide more niche and personalized products and experiences to attract consumers. However, Amazon is not going to destroy retail real estate. Those who follow the industry will remember that Amazon purchased Whole Foods in 2017 in a $13.7 billion deal that included the chain’s 440 U.S. stores. Rather than operating solely online, Amazon is seeking to leverage its technology with the brick-and-mortar grocery store chain. Looking to the future, it is possible that technology companies and those that have operated purely online will seek to integrate their technology with physical stores. Increasing efficiencies and reducing the problem of the “last mile” are both areas where technology may improve processes and customer experiences.
Enhancements in how companies access capital will also play a role in the industry. In recent years companies have been developing a plethora of solutions that involve big data, artificial intelligence (AI), and process improvement and automation software. As these companies raise capital to help build and improve upon their ideas, participants in the retail real estate industry stand to benefit. New solutions could help automate tasks traditionally done by one, or several, people. Big data solutions that help retailers and property managers analyze large sets of data will result in new insights that can help determine which properties would be best in a given location.
The increased availability of capital has implications beyond third party solutions for the industry. It can improve how firms raise money to buy and construct property. Crowdfunding platforms, such as RealtyMogul and RealtyShares, allow investors to invest capital for either debt or equity stakes in real estate deals. As we discussed in a prior article real estate crowdfunding continues to be the poster child for equity crowdfunding.
While technology presents many opportunities, it is also necessary to evaluate the downside. From an operations perspective, real estate transactions and property management services are heavily dependent upon information systems and technology. Implementing and maintaining systems are a critical part of a successful operation. System downtime, security vulnerabilities, and cyber threats, such as phishing scams, ransomware attacks, distributed denial of service (DDoS) and permanent denial of service (PDoS), all present challenges for those in the industry.
Revenue volatility in the industry can be seen through the lens of either retailers or firms that own and manage the real estate. Factors such as the unemployment rate, consumer disposable income, and tourism may all play an important role. The most recent data shows that the U.S. has an unemployment rate of only 3.9%. Rates this low have not been seen since the year 2000.
While a reduction in the unemployment rate usually triggers an increase in the average wage rate, this has not been the case in recent months. Wages barely outstripped the rate of inflation and rose only 2.6%. With a lower unemployment rate more individuals have entered the workforce, yet wages are not rising as quickly as they should. This may impact business that are hiring employees, but who are not seeing the increased spending that would be typically associated with more employed individuals.
Interest rates are also a critical factor in the industry. As was mentioned previously, those operating in this area require capital to build and maintain properties and to conduct acquisitions. Interest rates directly impact the cost of debt that a borrower will pay. As of this writing the rate on a 10-year Treasury is 2.9%. With the Fed wanting to control any potential inflation a modest increase in rates may be likely.
Real GDP increased 2.3% in the first quarter of 2018. The continued moderate expansion in macroeconomic growth should support the continued moderate expansion in demand for retail properties. Property prices have risen 52% over the past five years and are 23% above the peak reached prior to the financial crisis. Prices have slowed over the last 12 months, which has alleviated some of the concerns about the possibility of overheating.
Regulation & Policy
Retail real estate is required to adhere to various building and safety codes during construction, before the property can be operated, and once the property is in use. Regulations relate to handicap accessibility, fire codes, zoning restrictions, and general construction standards. Construction firms must adhere to environmental standards such as minimums for the amount of waste material recycled on the building site. In addition, various laws and regulations impose liability on real property owners or operators for the cost of investigating, cleaning up and removing property contamination caused by hazardous or toxic substances. A strong example of this type of regulation relates to the use and cleanup of asbestos, particularly within older buildings.
In addition to building regulations, the industry is directly impacted by lending regulations. One such example involves the appraisal of property before a bank can lend against the property. Recently regulators increased the threshold from $250,000 to $500,000. This means that before a bank can lend against real estate worth more than $500,000 an independent third-party must evaluate the value of the land. While this threshold increase may benefit some businesses seeking a loan, increases in underwriting standards and higher compliance costs for banks may have a negative effect.
Real estate companies and developers can elect to be taxed as a real estate investment trust (REIT) under Section 856 through 860 of the Internal Revenue Code. As a REIT, these organizations must distribute, at minimum, an amount equal to 90% of taxable income to investors every year to avoid paying corporate federal income taxes. REITs are subject to several organizational and operational requirements to retain their status. They must be structured as a corporation, business trust or similar association and be managed by a board of directors or trustees. They must derive at least 75% of their gross income from investments in real estate or mortgage on real property. Additionally, at least 75% of their total investment assets must be in real estate. If an organization fails to qualify as a REIT in any taxable year, the organization will be subject to federal income tax on taxable income at regular corporate tax rates. Even if the organization qualifies for taxation as a REIT, it may be subject to state and local income taxes and to federal income tax and excise tax on its undistributed income.
While the cost of doing business in the retail real estate industry can be high, certain incentives can be very beneficial. Below we look at a few of the incentives available in the industry. These incentives are available in most states, though the exact benefit may vary from state to state.
1. Job Credits – If a project will produce a specified number of jobs incentives may be available. While the number of jobs is important, the type of job is also considered. Some states are providing increased incentives for projects that produce higher paying and higher skilled jobs.
2. Sales Tax Revenue Sharing – Government agencies share a portion of future sales tax revenue that is generated by the retail sales of high volume retailers. This incentives certain retailers to locate a store front in a specific area.
3. Fee Waiver and Rent Abatements – These incentives reduce the occupancy costs for businesses.
It is important for any business that operates in the retail real estate industry to do proper research before selecting a state or a site where they wish to operate. Contacting a regional economic development authority may provide a firm with a better understanding of the incentives offered in a given area.
Kitroeff, N. (2018, May 04). Unemployment Rate Hits 3.9%, a Rare Low, as Job Market Becomes More Competitive. Retrieved May 4, 2018, from https://www.nytimes.com/2018/05/04/business/economy/jobs-report.html
More U.S. real estate deals can go ahead without appraisal: Regulators. (2018, April 02). Retrieved from https://www.reuters.com/article/us-usa-fed-real-estate/more-u-s-real-estate-deals-can-go-ahead-without-appraisal-regulators-idUSKCN1H91MZ
26 U.S. Code § 856 – Definition of real estate investment trust. (n.d.). Retrieved May 3, 2018, from https://www.law.cornell.edu/uscode/text/26/856
Cromwell, D. B. (n.d.). Economic Development Incentives. Retrieved May 3, 2018, from https://www.ccim.com/cire-magazine/articles/323985/2015/09/economic-development-incentives/?gmSsoPc=1