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Retail Real Estate Investment Banking

Maximizing transaction value through expert advisory.

Our experienced commercial and retail real estate team provides world-class strategic investment banking advisory across the real estate ecosystem. With deep industry knowledge, expertise and execution experience in both the retail and surrounding commercial real estate sectors, our team provides an added layer to our client teams. In every client engagement, we provide partner-level support, shepherding transactions from start to finish.

With access to judgement, borne from transaction experience, we assist our clients in retail, office, industrial, and self-storage real estate M&A transactions.

Our senior bankers have long-standing relationships with some of the most active, key industry executives. With broad transaction experience, we help clients in providing a differentiated go-to-market strategy. Regardless of whether your business requires assistance on a corporate sale, recapitalization, acquisition or capital requisition project, our team has the expertise and tenacity to effectively deliver on our client objectives.

By partnering with some of the most innovative clients in the world, our retail real estate team boasts a high delivery rate of successful outcomes for our clients. Bolstering the standard of care and executing on a long-term strategic vision for your retail or other real estate business is what we are all about. Our team also includes numerous research analysts, covering both public and private buyers and sellers around the globe. We pride ourselves on giving our clients the expertise and focused effort required to navigate difficult transactions. Get in touch with one of our investment bankers today to discuss how we can help with your capital transaction goals.

Retail Real Estate Industry Overview

An executive summary of retail real estate

The retail real estate industry is a category within the commercial real estate sector. While the commercial sector encompasses properties, including buildings and land, that are used to generate profits the retail industry is more specific. Retail real estate consists of establishments that build and develop shopping and entertainment properties. Many people have found themselves in such a property as this category includes shopping malls, clothing shops, florists, and many more. The retail sector provides services that include renting, leasing, managing, buying and selling retail real estate.

While every investor has different needs a few benefits to investing in retail real estate are discussed below.
 
Longer Leases
Investors and property managers who participate in the multifamily industry may find themselves dealing with lease renewals on an annual basis. Retail real estate leases are typically longer at around 5 years.
 
Lower Maintenance
While every property has expenses, the owners of retail space can find themselves in an advantageous position when compared to other property owners. In the retail space the tenant (shop owner) typically will pay for utilities, some maintenance, and other agreed upon expenses.

It is always prudent to weigh the pros with the cons when contemplating an investment. Retail real estate comes with its own unique challenges such as sensitivity to the economic cycle and the difficulty in moving a building should residents start to move away from a specific location.

 

Main Activities

The primary activities of the retail real estate industry include:

 

  • Leasing – A professional leasing agent helps owners and retailers in leasing property. The agent may perform various tasks such as market research, conducting site tours, creating the lease plan, and aid in negotiating the final lease.

 

  • Capital & Investments – This segment focuses on debt and equity in the real estate world. Professionals help clients develop a strategy and help them meet return requirements.

 

  • Appraisal – The appraiser is usually engaged when an objective opinion is needed. They may aid in litigation, financing, or determining a fair value in an M&A transaction.

 

  • Development – Developers manage costs and timelines while overseeing construction and financing functions.

 

  • Property Management – Professionals in this role act as caretakers for the property. This role is responsible for maintenance, collections, repairs and budgeting. This role will work directly with tenants.

 

  • Asset Management – While the property manager oversees the property, the asset manager will manage the acquisition of the asset, the utilization and ultimately the disposition.

 

  • Retailer – The driving force behind the entire industry, retailers own or operate income-producing and consumer facing establishments.

 

Similar Industries

Real Estate Sales & Brokerage in the USA

Operators in this industry primarily act as intermediaries during various real estate transactions including buying, selling and renting real estate. Brokers may specialize and focus on one industry. Each broker is required to complete certification exams and register in the state(s) in which they do business.

 

Office

From single-tenant properties to small office buildings and large downtown skyscrapers this category focuses on the renting, leasing, and buying of property where people work.

 

Industrial

This category could include “big box” properties, warehouses and other very large properties. A key characteristic of this category includes the height of the building. The number and size of docks may also be considered when classifying this type of property.

 

Residential

While not all residential properties may fall directly under the commercial real estate umbrella they are certainly a member of the real estate sector. Apartments and multifamily buildings could be considered commercial, while single family homes would most likely be categorized as residential real estate.

 

Others
Other properties that fall under the commercial real estate umbrella include self-storage property, medical buildings, and leisure facilities such as hotels.

 

REITs

REITs invest in and manage various types of property including offices, apartment buildings, warehouses, retail centers, medical facilities, data centers, cell towers, infrastructure and hotels.

 

Outlook

Retail Real Estate is the second largest by market in the commercial real estate sector with approximately 25.2% market share. The retail deal volume that has occurred throughout 2017 is around $60 billion, which is the third largest behind apartment ($110B) and hotel ($120B).

[1]
[2]

Some industry participants do express concern for the retail industry. The concern was focused on the growing trend of consumers making purchases online from e-commerce platforms such as Amazon. Participants in a survey by National Real Estate Investor (NREI) noted that lenders may be more strict on retail in the future[3]. Participants in the survey also commented that the current structure of leases, particularly long-term leases, posed an issue for the industry.

 

Sources
 
[1]Retrieved from https://www.ibisworld.com/
 
[2]Retrieved from https://www.prnewswire.com/news-releases/commercial-real-estate-deal-volume-edges-down-in-q4-2017-300605191.html
 
[3]Retail Real Estate Trends 2017, Part 1: Retail Sentiment Takes a Turn National Real Estate Investor, http://www.nreionline.com/retail-cre-market-study/retail-real-estate-trends-2017-part-1-retail-sentiment-takes-turn (last visited Apr 4, 2018).

Retail Real Estate Industry Performance and Outlook

Retail Real Estate external drivers, performance, and industry life cycle

The second part of this series will focus on the performance of the retail real estate industry. Key external drivers, current performance and an industry outlook, and an overview of the life cycle will be reviewed.

 

Key External Drivers

 

Demographics
The Millennial generation continues to catch up to the Baby Boomers, with analysts predicting that Millennials will surpass the Boomers by 2019. Many of the decisions that are made regarding real estate and consumer spending are increasingly being made by people under the age of forty. The Millennials also appear to be influencing how Baby Boomers approach retirement and spend their free time. Many Millennials enjoy travel and entertainment and the Baby Boomer generation is adopting this mentality. In certain markets across the US, Boomers are selling their homes and leaving the suburbs in favor of city living. Those involved in the retail real estate industry must be aware of the changing demographics for both generations.
 
Wages and Rising Debt
Recent debates regarding wages for hourly employees and overtime pay will certainly impact the retail industry. How much retailers pay out in wages has a direct impact on their business and profitability. Another driving force that could impact business is the level of debt held by potential shoppers. If we look at the Millennials we see a trend of growing student loan debt. The average debt upon graduation for the Class of 2016 was $37,172[1]. As new graduates enter the workforce and are required to begin repaying debt they will have less income available for discretionary spending.
 
However, all is not doom and gloom in the retail industry. Real disposable personal income per capita in the United States is on a steady rise since a slight drop in the first quarter of 2013.
 
[2]
 
To compete in today’s economic environment retail stores will need to offer a combination of both quality service and a fair price. Low-cost retailers and second-hand stores have been gaining market share because of the rising popularity of budget-conscious consumers. Consumer spending directly influences businesses that rely on consumers for revenues and indirectly affects other businesses in the retail ecosystem. The retail real estate industry benefits from higher consumer spending which raises demand for a variety of businesses that require building space.
 
E-Commerce
E-commerce is having a large impact on brick-and-mortar retail locations. Vacancy rates for regional malls and strip malls increased from 7.9% to 8.1% and 9.9% to 10.0% from Q1 to Q2 2017, respectively[3]. The U.S. has been over-retailed for decades and retailers that have been unable to adopt the new multi-faceted format have been forced to shutter physical stores, such as Macy’s. Other retailers are moving into the virtual space while some are being forced to discontinue operations altogether.
 
Tax Reform
Investors in retail real estate will benefit from the tax reform as investors grow their business while preserving their existing assets. Real estate will be able to take advantage of pass through entities, the 1031 exchanges and capital gains expense deductions. The corporations tax rate will be reduced from a top rate of 35% to 21% and depreciation of non-residential real property, residential real property, and leasehold improvements retain the 39-year, 27.5 year, and 15-year recovery period.
 
Rental Vacancy
The rental vacancy rate measures the degree to which a building space goes unused in the United States. When the rate is high more office space is empty. This indicates an oversupply of building space, a recent decline in the number of businesses, or an overall contraction in the business sector. High rental vacancy rates discourage new building construction while low rates reflect strong demand for construction operators in this industry.
 
Yield on 10-year Treasury Note
The high costs of purchasing property and constructing new buildings forces buyers to purchase on credit and builders to seek financing for new projects. Interest rates, reflected by the yield on the 10-year Treasury note, help determine the cost of borrowing money for these activities. When interest rates are low, financing becomes more affordable; conversely, higher interest rates make debt more expensive. Rates are currently rising and are about 2.83% at the time of writing.
 
Corporate Governance
Retail real estate ventures are generally actively and professionally managed entities. They adhere to the same corporate governance principles that apply to all major public companies. They have a senior management team that is led by a chief executive officer (CEO) who actively manages the overall strategic vision of the enterprise. The board of directors appoints the CEO, which in turn is elected by and accountable to the shareholders of the REIT.
 

Current Performance & Industry Outlook

Retail real estate is an indispensable part of the US economy because it encompasses businesses that build, manage, lease, mortgage, buy and sell properties across the entire retail real estate space.
 
Owners of retail space are diverting from offering the standard products and services to providing experiences. Landlords are looking to shift from the traditional retail space to more entertainment-based venues. Such developments include restaurants, theaters, supermarkets, fitness and recreation centers (including amusement parks, ice rinks, water parks, etc.), office space, hotels, and restaurant/entertainment hybrids such as Dave and Buster’s. These mix-use developments that offer a “live, work, and play” environment are going to continue to be in demand as landlords continue to change their outlook.
 
Due to changes in the industry lease terms are being challenged. Tenants are pushing for a three-year lease as opposed to the more traditional 5 or 10-year lease. Providing a degree of leverage for tenants is the increase of retail space available for lease. Availability rates have been on a steady climb since 2017, rising to 6.6% in Q4 2017[4].
 

 
In 2017, there were just under 9,000 store closures and 36 major retailer bankruptcies, which is just one shy of the 37 that happened in 2009. The projections for 2018 show there is the potential for another 25 to file for bankruptcy and up to 11,000 stores being strategically shuttered.
 
It is expected that the weakest periods for demand should begin in 2018 as closures continue and retailers attempt to revitalize their business. The average asking rent in 2017 rose by 2.9% and it is projects to rise by 2.4% in 2018. Below shows the forecast of Net Absorption, Deliveries, Vacancy Rates, and Asking Rent.
 
[5]
 
The GDP growth for 2018 is projected to be between 2.2% and 2.5%. This should help to support the growth of the retail real estate industry. Supply conditions are also favorable as construction has slowed down slightly in 2017, which has reduced the concerns of an oversupply in new inventory.
 
Some threats that need to be kept in mind are GDP, inflation and interest rates. Although GDP is expected to continue to help the growth of the real estate industry it is important to keep in mind the possibility of overbuilding, overheating, and over-leveraging which could lead to a recession.
 
The inflation rate is currently at 2.4% as of March 2018. It is important that inflation remain in check as a rising rate will reduce consumer’s purchasing power which could impact retailers and those in the retail real estate industry. In the short run retailers may experience an increase in consumer purchases, but over the long run this will erode.
 
Lastly, interest rates have ranged between 2.00% and 2.50% in 2017 and it is expected that interest rates could rise to the 2.50%-3.00% range. An increase in interest rates will have an impact on new construction of retail space and make the cost of borrowing for new businesses more expensive.
 

Industry Life Cycle

The retail real estate industry is usually on cycle with the movements of the economy. Movements in GDP, interest rates, property prices, and inflation all influence the economy and therefore the industry. As mentioned above, the GDP is expected to continue to grow at a slow and steady pace which means that the retail real estate industry should be in a slow growth phase. Over the next 12 months, the probability of an economic downturn has fallen to a low probability of 0-10%.
 
[6]
 
Sources
 
[1]U.S. Student Loan Debt Statistics for 2018, Student Loan Hero, https://studentloanhero.com/student-loan-debt-statistics/ (last visited Apr 12, 2018).
 
[2]Real Disposable Personal Income: Per Capita, FRED (2018), https://fred.stlouisfed.org/series/A229RX0 (last visited Apr 12, 2018).
 
[3]Scott Humphrey, CRE News and Resources Reis: Mall Vacancy Rate increased in Q2 2017, https://www.reis.com/cre-news-and-resources/mall-vacancy-rate-increased-in-q2-2017 (last visited Apr 12, 2018).
 
[4]Esther Fung, Retail Rents Decline in Big U.S. Cities as Landlords Succumb to the Retail Storm The Wall Street Journal (2018), https://www.wsj.com/articles/retail-rents-decline-in-big-u-s-cities-as-landlords-succumb-to-the-retail-storm-1517317200 (last visited Apr 12, 2018).
 
[5]U.S. Macro Forecast – February 2018, Cushman & Wakefield (2018), http://www.cushmanwakefield.com/en/research-and-insight/2018/us-macro-forecast/ (last visited Apr 11, 2018).
 
[6]Ian Formigle, The Four Phases of the Real Estate Cycle CrowdStreet (2017), https://www.crowdstreet.com/education/article/four-phases-real-estate-cycle/ (last visited Apr 11, 2018).

Retail Real Estate Industry Products and Markets

Leading products and services within the industry and demand determinants

The retail real estate industry consists of establishments that build and develop shopping and entertainment properties. This report will focus on the leading products and services within the industry as well as demand determinants and major markets.
 

Products and Services

As is true with many industries, retail real estate has many participants offering a wide range of services that make the industry run. The following graph breaks down the different product and service segments of the industry.
 
[1]

Leasing
Many retail real estate operations use a straight forward business model that involves leasing space to tenants and collecting rent to generate income. The most common lease structures are gross, net, and modified gross[2].
 

  • Gross Lease: All-inclusive rent where the landlord pays a majority, if not all, of the expenses (including insurance, utilities, maintenance) and the tenant pays one lump sum per month.
  •  

  • Net Lease: The tenant pays a base monthly rent and some share of the taxes, insurance and command area maintenance (CAMS) items. Net Lease can be broken down into three sub-categories of Single Net, Double Net, and Triple Net leases. Triple Net is the most popular of the three and is typically more landlord friendly.
  •  

  • Modified Gross: A happy compromise between the Gross and Net models described above. The tenant pays a fixed monthly sum that includes a portion of taxes, insurance, and CAMS.

 
Lease terms tend to vary with retail leases typically ranging from five to ten years. Some tenants are starting to request shorter leases due to the changing retail environment.
 
Leasing makes up a majority of the industry revenue compared to the other services provided by retail real estate.
 
Property Management
Another key service of the industry is property management. Property management companies work on behalf of the property owner and are responsible for managing the life cycle of a property. This includes the maintenance and operation of the building or property. Services can also include collecting rent, accounting, and acquisition and disposition of properties. The property managers are also the intermediary between owners and tenants and can often negotiate leases and maintenance requests.
 
In the United States a property management company is required to be a licensed real estate broker in the states in which they conduct business. They may also be a licensed real estate agent working under a broker. Some states may impose different requirements and restrictions. In addition, requirements are different around the world, so it is necessary to understand the rules and regulations of the country in which you are conducting business.
 
Property managers provide a service and in exchange they expect to be compensated. The below are a few of the most common business models in the industry.

  • Percentage of Rent: The property manager and owner have signed an agreement allowing the manager to lease the property to tenants. The property manager keeps a fixed percentage of the rent, typically 10-15%, and the remainder is allocated to the owner.
  •  

  • Fixed Fee: A straight forward approach where the property manager charges the owner a fixed monthly fee.
  •  

  • Revenue Share: The property manager and owner enter into an agreement allowing the manager to convert a property into a revenue generating business. The manager and owner will then share in the revenues generated by the business. A hybrid structure may exist where the manager is paid a fixed monthly fee and has some share of revenues as well.

 
Retail Property
One of the most important aspects of the industry is the actual property that allows tenants to operate their businesses and generate revenues. Without tenants demanding property for their business, the other products and services would not be in high demand. Retail property is not created equally. Some buildings are of a higher grade and have a higher demand than others. Generally, the properties can be broken down into the following classifications[3].
 

  • Class A: The best of the best. Class A property is generally newer, in an excellent location, and has fewer maintenance issues. These properties typically command the highest rental rates.
  •  

  • Class B: These buildings are older than Class A and might be in a good, but not great, location. Investors who are interested in restoration projects are likely to seek out Class B properties.
  •  

  • Class C: The older properties that are in need of repairs and are not in the best location. Significant costs may be required to update electrical and plumbing systems.

 
Other Activities
Other activities in the industry include land development and acquisitions. Both activities result in the creation or attainment of property suitable for retail activities. Development and acquisitions do require a significant amount of capital as the process of purchasing and building or converting land into usable space is a capital-intensive exercise.
 

Demand Determinants

Demand for retail real estate is generally associated with corporate expansion and a rise in consumer spending. Retail real estate can be influenced by several factors including interest rates, availability of capital, company profitability, current and expected rates of economic growth, expected yield on the investment, tax treatment, vacancy rates of existing building stock, changes in population and changes in demand for retail buildings.
 
Consumer spending directly coincides with the expansion of retail operations. Retailers require space that is highly visible and conveniently located. Retailers that are looking for space in malls generally rely on foot traffic and sales metrics to make leasing decisions. Some different metrics include sales per square foot, conversion rate, sales count, stock turn and profit margin.
 
The sales per square foot shows how efficient a retailer is with the use of sales space and assets (sales/total square feet of store).
 
Foot traffic is the number of people in a retailer’s store over a certain period of time. This helps with anticipating staffing needs and planning marketing, and store layout strategies.
 
The conversion rate is the percentage of customers who bought from a store (number of sales/gross traffic). This can help with various in-store components including customer service and merchandising.
 
Sales count refers to the number of transactions completed in a store. The number of transactions is a fundamental metric that tells an owner how many sales were made in a given period of time.
 
Stock turn is the same as inventory turnover which measures the rate at which stock is sold (Cost of Goods Sold/ Average Inventory). This metric provides the owner with the necessary information to make critical inventory decisions.
 
Net Profit margin is the measure of profitability and can be calculated as (net profit/total revenue) x 100. As a percentage, this shows how much of topline revenue reaches the bottom line.
 
Although retail headlines have announced disruptions within this segment, demand is consistent throughout the U.S. with the overall retail vacancy rate at 6.9% and rents rising about 3% in 2017[4]. As there have been more bankruptcies and store closings, retailers have focused on well-preforming markets while streamlining their brick-and-mortar strategies. While most markets are losing retailers, San Francisco and Miami are seeing vacancy under 4.0 percent because of the high demand for flagship and fleet retailers. Select Tier 2 malls that challenged the retail market in 2015 and 2016 seem to be reinvigorated with redevelopments and re-positioning. Essentially all other retail is seeing some type of retail decline and power center vacancy has dipped due to retailers such as Sports Authority, City Circuit and Staples declaring bankruptcy and closing stores.
 

Major Markets

According to IBISWORLD reports retail real estate market segmentation accounts for about 25% of the industry commercial real estate revenue. Retail focuses on large regional malls, outlet centers, grocery-anchored shopping centers and power centers that feature big box retailers. The retail sector is split into three general classes: Class A, with tenant sales of at least $400.00 per square foot; Class B, with tenant sales of less than $400.00 per square foot; and Class C, with tenant sales of less than $250.00 per square foot. Simon Property Group and General Growth Properties are two of the largest Class A shopping center owners in the U.S.[1]
 

International Trade

The industry consists of real estate and, for our focus, this real estate is located in the United States. In regard to the physical land and buildings, international trade is not relevant. It is worth mentioning that the firms that operate in the industry may have properties both domestically and abroad. A more detailed discussion regarding international trade can be found in our competitive landscape report.
 
Sources
 
[1]Market Research Reports | Procurement Research Reports | IBISWorld US, https://www.ibisworld.com/ (last visited Apr 10, 2018).
 
[2]Mike Cobb, 3 Different Types of Commercial Real Estate Leases 42Floors, https://42floors.com/edu/basics/types-of-commercial-real-estate-leases (last visited Apr 16, 2018).
 
[3]Investopedia Staff, Commercial Real Estate Investopedia (2018), https://www.investopedia.com/terms/c/commercialrealestate.asp (last visited Apr 16, 2018).
 
[4]U.S. Macro Forecast – February 2018, CUSHMAN & WAKEFIELD, http://www.cushmanwakefield.com/en/research-and-insight/2018/us-macro-forecast/ (last visited Apr 10, 2018).

Retail Real Estate Competition

Market share concentration and key success factors in retail real estate

This section will focus on market share concentration and key success factors in the retail real estate industry. We will take a look at cost structure benchmarks, barriers to entry, and globalization within the industry.
 

Market Share Concentration

The retail sector of the commercial real estate industry is the second largest, commanding approximately 25% of the market share and only exceeded by office real estate which holds 30% of the market share.
 

 
[1]
The following table highlights some of the largest retail real estate companies on a market cap basis.
 

Simon Property Group and General Growth Properties are two of the larges Class A shopping center owners in the United States.
 
The 3 largest retail real estate companies on a retail space ownership basis include[2]:
 
1. Simon Property Group: 241 million square feet and 325 properties
2. General Growth Partners: 125 million square feet and 126 properties
3. DDR Corp: 106 million square feet and 319 properties
 

Key Success Factors

Market Environment
The real estate market depends significantly on the overall market environment. This includes factors such as wages, inflation and interest rates, mortgage prices, and market volatility. An important aspect for operators in the retail real estate industry is consumer disposable income. Since retailers rely on consumer spending to maintain their business, a prolonged downturn in which consumers change spending habits or have less income to spend on non-essentials could impact the demand for retail space. A healthy market lends itself to a successful real estate environment.
 
Financial Management
Developing and acquiring real estate takes capital and lots of it. Entities operating in this space will need to ensure they have sound management of their finances. Being able to source competitively priced debt and then service the obligation will be critical. Understanding the opportunities available in the equity market will also be advantageous. As real estate crowdfunding gains in popularity this may be a new avenue to source capital. Properly managing cash flows, reserves, and debt levels can all play a role in helping a company effectively manage a portfolio of retail real estate properties.
 
Create and Maintain Excellent Customer Relationships
Understanding the needs of existing and prospective clients can assist operators in gaining new business and retaining existing clients. This is critical for both property managers and the businesses that occupy the retail space as vendors. Property managers should ensure they are offering competitive pricing and at terms the renter finds acceptable. Part of this requires staying current on changes in the market. For example, typical retail lease terms may be for 5-10 years. However, some tenants have recently started asking for 3-year terms. This would typically not be the standard and is considered a short-term lease. If this should become a growing trend, however, then property managers will need to take note and adopt to the change.
 
Proximity to Key Locations
Tenants are willing to pay a premium for buildings located near business centers, transportation hubs, and entertainment venues. As such, buildings in metropolitan areas usually have higher rental rates and lower vacancies than those in less populated areas. As we have discussed in earlier reports, it is important to consider changes in consumer living and working behavior. Retailers and those that own or manage retail property will need to consider changes in the demographics of a given area as this may influence what items and services will be in demand.
 
Access to a Highly Skilled Workforce
Retail real estate firms that employ highly skilled staff with specialized knowledge can develop a reputation for quality service and increase their bargaining power.
 

Cost Structure Benchmarks

Profits
EBIT (Earnings Before Interest and Taxes) varies for firms in different segments of the real estate industry. Since the subprime crisis, real estate has been recovering in property values and construction projects. Interest expense makes up a large portion of the real estate holdings after EBIT as companies attempt to raise capital for developments and acquisitions.
 
Purchases
The largest of the purchases are associated with contracting and acquiring properties, which can be also financed with debt. Because some form of debt is typically used in the purchase of property, most firms will have fairly high interest expenses. Over time the firms may experience a gradual reduction in liabilities, such as loans, from a company’s balance sheet. Another major purchase incurred is construction materials for development projects. Construction materials will vary depending on commodity prices, as most costs are related to concrete, glass, structural steel, concrete panels, structural timber, metal cladding, aluminum fitting, electrical power, fuels and lubricants.
 
Other Costs
Depreciation and amortization usually accounts for a large portion of the real estate costs. Real estate properties experience annual wear and tear or loss of utility. Due to this reduce utility companies depreciate real estate assets over time to account for this deduction. Selling, general, administration and development also make up a decent amount of expenses incurred throughout the year for firms.
 

Basis of Competition

Competition within the retail segment relies on the ability of firms to acquire and develop properties in the most affluent areas of the U.S. This competition increases as land becomes increasingly scarce in major cities and in areas where the demand is high. As companies within these areas become more established it will be difficult for a new entrant to compete with the major players in the industry. Prices for real estate are always a major factor as companies try to get the best price whether through acquisition or development. Their ability to lower costs and increase revenues is always an ongoing competition between firms.
 
External Competition
External competition has come from the ability to work remotely via video-conferencing, space sharing offices, and e-commerce. Companies have downsized office space which has allowed them to decrease the amount of space necessary for their businesses to operate. E-commerce has also had an impact on the retail space since retailers do not necessarily need to have physical stores to offer their products. Companies can have a few locations or distribution centers throughout the U.S. and still be able to offer their products nationally.
 

Barriers to Entry

Barriers to entry in retail real estate are medium to high because of the capital necessary to acquire, develop and maintain properties. Other areas such as storage rental real estate have a lower barrier to entry because of the smaller amount of capital needed to construct a storage facility. There are many factors that increase the barrier to entry such as lower vacancy rates, new entrants being prohibited from entering a real estate market due to permit requirements, various local, state and federal regulations, and zoning, ordinances, and licensing requirements. Overall, it is difficult to establish a solid foothold in the real estate markets because smaller players will find it difficult to compete due to capital requirements and regulatory hurdles.
 

Industry Globalization

Industry globalization is medium to high because the retail real estate industry is capital intensive and requires knowledge of local markets and trends. Most retail real estate firms that are located in U.S. have a large portion of their real estate investments in the United States, and some may have properties abroad. The industry has large firms that make up a good portion of the retail sector because of the high capital that is required to participate. Retail real estate is expected to remain stable domestically and overseas as it attempts to continue its transitions of traditional retailers to a more event-based experience in an attempt to grow revenue and diversify risk through real estate developments and acquisitions.
 
Sources
 
[1]Retrieved from https://www.ibisworld.com/
 
[2]TOP RETAIL SPACE OWNERS 2017. (n.d.). Retrieved April 26, 2018, from https://www.squarefootprint.com/top-retail-owners

Industry Operating Conditions

Capital intensity, technology used by the industry, and regulation & policy implications

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.
 

Capital Intensity

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

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%[1]. 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[2]. 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[3]. 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.
 

Industry Assistance

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[4]. 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.
 
Sources
 
[1]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
 
[2]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
 
[3]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
 
[4]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

M&A Landscape and Notable Deals

Notable industry transaction and emerging trends

In this series of our report on the retail real estate industry we will examine the M&A landscape, notable deals and identify some evolving trends in the space.
 

M&A Overview

While the words “retail apocalypse” may strike fear into the hearts of retailers, it is music to the ears of strategic real estate buyers. Widespread closures of retail stores in the US has led to lower valuations and increased interest in M&A activity. Real Estate Investment Trusts (REITs) that operate in the retail space have recently been trading at discounts to their net asset value (NAV). These conditions have been enough to entice investors to buy and sell companies that are trading at a discount to NAV.
 
The increased interest in M&A combined with the high levels of available capital have created a prime opportunity for buyers to enter the market. In a peculiar twist, eCommerce businesses have been purchasing brick-and-mortar stores to help overcome the issue of the “last mile”. Amazon’s purchase of the Whole Foods Market chain is evidence that large players traditionally contained online are exploring the potential of physical storefronts.
 
As consumer tastes and buying habits change strategic acquisitions in the retail space will also change. Non-core retail assets are being sold off and some investors are seeking to acquire retailers that focus on electronics, amenities, and other high foot traffic stores. Those firms that own and operate malls are leveraging the power of big data to help make decisions that relate to acquisitions and which retailers they wish to attract to their malls[1].
 
The commercial real estate sector, of which retail real estate belongs, was overall down for 2017. Deal volume for the year was approximately $445.2 billion. Various reasons may account for the decline in deal volume. The change in corporate tax structure that became effective in 2018 may have caused some deal makers to push a close to benefit from the new policy. Many industry participants pay close attention to interest rates. As such, firms may have been closely watching as Jerome Powell assumed the role of Fed Chairman and were waiting to see what actions he may take.
 

Notable Deals

Deals in the retail real estate sector can produce extremely large valuations. It is not simply the physical building that is being acquired, but also the real estate. Below are a few of the more recent and larger deals in the sector.
 
1. CVS Health acquires Aetna ($69 Billion)[2]
In December of 2017 CVS announced that they would be acquiring Aetna, a US health insurer. The consideration in the deal consisted of $145 per share in cash and 0.8378 CVS shares per 1 share of Aetna. The deal is expected to close in the second half of 2018 and produce cost synergies of $750 million.
 
This is one example of an operator of brick-and-mortar locations seeking to provide additional experiences to encourage consumers to visit their stores. Larry Merlo, the CEO of CVS, commented that CVS currently provides a pharmacy, but raised the question of what if consumers could also access a vision audiology center or nutritionist.
 
2. Amazon acquires Whole Foods Market Inc. ($13.7 billion)[3]
The deal, approved in August of 2017, saw Amazon enter the world of physical retail locations. The deal resulted in Amazon acquiring Whole Foods and their more than 400 location throughout the United States. This is clear example of ecommerce businesses expanding into traditional brick-and-mortar stores. In addition to leveraging their technology to improve process, Amazon will also be able to reach more consumers by placing Amazon Lockers in each Whole Foods location.
 
3. Regency Centers Corporation and Equity One, Inc. merge ($4.6 billion)[4]
Equity One merged into Regency in early 2017 according to a merger agreement signed in Q4 2016. Equity One shareholders received 0.45 shares of Regency stock for each share of Equity One. Regency expected to realize cost savings of approximately $27 million by 2018.
 
Regency owns, operates, and develops neighborhood shopping centers with 307 properties in its portfolio as of December 31, 2016. As of the same period, Equity One’s portfolio included 122 retail properties.
 

Trends

Overall, the commercial real estate sector had transaction volume of $117.4 billion in Q4 2017. This represents a decline of about 13.2% YoY.
 

(PRNewsfoto/Ten-X Commercial)

[5]
 
An important measure in the industry is the capitalization or “cap” rate. Cap rates are an important indicator for investors as this helps determine a potential rate of return for a deal. The cap rate is computed as follows:
 
Cap Rate = Net Operating Income / Current Market Value of the Asset
 
Rates are currently holding steady below their 10-year averages. Retail, as well as apartment and office, are currently trending around 60-70 bps below historical averages[4].
 
A rising trend among investors is looking to the secondary and tertiary markets for deals. Deal volume in secondary markets in 2016 saw an increase of approximately 28.6% YoY from 2015. Tier 2 inventory is readily accessible in many lesser known markets. This allows savvy investors the opportunity to discover profits in markets that are untapped or not yet saturated. Prime targets include malls and power centers in sub-markets with strong consumer demographics and little to no retail competition.
 

Transactions

While we highlighted a few notable deals previously in this report, we felt it would be important to provide a deeper insight into other recent transactions. The following is not an exhaustive list but should provide insight into other deals in the retail real estate market.
 
[6]
 
Sources
 
[1]Cohen, J., & Stern, M. (2018, January 16). 2017 Real Estate Symposium Report: The Changing Landscape of Retail. Retrieved May 9, 2018, from https://www8.gsb.columbia.edu/privateequity/newsn/5862/2017-real-estate-symposium-report-the-changing-landscape-of-retail
 
[2]O’Donnell, C., & Humer, C. (2017, December 04). CVS Health to acquire Aetna for $69 billion in year’s largest… Retrieved May 9, 2018, from https://www.reuters.com/article/us-aetna-m-a-cvs-health/cvs-health-to-acquire-aetna-for-69-billion-in-years-largest-acquisition-idUSKBN1DX0NC
 
[3]Turner, N., Wang, S., & Soper, S. (2017, June 16). Amazon to Acquire Whole Foods for $13.7 Billion. Retrieved May 9, 2018, from https://www.bloomberg.com/news/articles/2017-06-16/amazon-to-acquire-whole-foods-in-13-7-billion-bet-on-groceries
 
[4]Regency Centers and Equity One Announce Closing of Merger. (2017, March 01). Retrieved May 9, 2018, from https://www.businesswire.com/news/home/20170301006495/en/Regency-Centers-Equity-Announce-Closing-Merger
 
[5]Commercial, T. (2018, February 27). Commercial Real Estate Deal Volume Edges Down In Q4 2017. Retrieved May 9, 2018, from https://www.prnewswire.com/news-releases/commercial-real-estate-deal-volume-edges-down-in-q4-2017-300605191.html
 
[6]JLL Research. (2018, April 10). U.S. Retail Investment Outlook. Retrieved May 9, 2018, from http://www.us.jll.com/united-states/en-us/research/investor/trends/retail

Retail Real Estate Industry Jargon

Common industry jargon and glossary

As is normal in many lines of business, those operating in the retail real estate industry have a specific set of jargon and terms that are used to define various business functions and industry activities. While not exhaustive, the below glossary will aid a new entrant to the industry in understanding key terms.
 
Barriers To Entry
High barriers to entry mean that new companies struggle to enter an industry, while low barriers mean it is easy for new companies to enter an industry.
 
Building Classifications
Buildings can be classified as either A, B, or C Class. Class A buildings are high-end space that is new and well maintained in prime locations. Class B buildings average with fewer amenities and are typically around four stories. Class C buildings tend to be more than 20 years old and are in need of repairs. Rents are lower due to less desirable locations.
 
Capitalization “Cap” Rate
Annual Net Operating Income / Property or Asking Sales Price
 
This is the unleveraged initial yield on the investment.
 
Common Area Maintenance (CAM)
Additional rent paid by a tenant, in addition to the base rent, to maintain the common areas of the property shared by all tenants. This may include parking lot sweeping services, snow removal, insurance, outdoor lighting and more.
 
Concessions
Granted by a landlord to a tenant during negotiations. This could include, but isn’t limited to, better rental rates, lease buyout options, or moving allowances. Concessions are less common in a hot market.
 
Letter of Intent (LOI)
A written document that indicates a tenant’s commitment to rent a space. The LOI is executed prior to signing the actual lease agreement and typically summarizes the terms of the lease, including concessions. The LOI can be either binding or non-binding.
 
Life Cycle
The periods of recovery, growth, maturity and decline that industries all go through.
 
Mortgage REIT
A mortgage REIT is a company that specializes in underwriting, acquiring and holding debt obligations guaranteed by real estate properties. Mortgage REITs are essentially loan portfolios as opposed to ownership of the asset, as is the case with their equity counterparts.
 
Net Absorption
The net change in occupied space in a given market between the current measurement period and the prior period. This figure can be either positive or negative and must include increases and decreases in inventory levels.
 
Net Operating Income
A calculation used to analyze real estate investments that generate income.
 
Revenue from the property – reasonable operating expenses
 
Revenue can include rent as well as parking and other service fees. Operating expenses include those expenses that are necessary run and maintain the property. This could include insurance, management fees, utilities, property taxes and more.
 
Real Estate Investment Trust (REIT)
A legal entity that uses pooled investor capital to purchase and manage income property or mortgage loans. To qualify as a REIT, the entity must distribute at least 90.0% of taxable income. REITs are a security that can sell like a stock on major exchanges.
 
Tenant Improvements
The customized alterations a building owner makes to rental space as part of a lease agreement in order to configure the space for the needs of the tenant. This may include changes to walls, lighting, floors or ceilings.
 
Usable Square Footage
The actual space that can be occupied in a rental property. This does not include spaces such as lobbies, restrooms, storage rooms or hallways. If a tenant rents an entire floor then restroom and hallway space is included.
 
Vacancy Rate
The amount of real estate space unoccupied as a percentage of total available space.
 
 

Carlos (Charlie) Izaguirre contributed to this report.

Our retail real estate transaction advisory services include

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  • Follow-on Equity Offerings

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