The Arizona commercial real estate market has fared relatively well during the COVID-19 pandemic. Multifamily and industrial growth has continued in Arizona as the country struggles to emerge from the pandemic-caused economic slowdown. One market sector that was hit hardest by the pandemic shutdown was the retail sector. While Arizona hasn’t had it as bad as other markets across the country, retail property owners and users are definitely feeling the squeeze on their bottom line.
AZRE Magazine reached out to Phil Voorhees, vice chairman of the CBRE National Retail Group, to get his overview of the retail market as we hit the final quarter of 2020 and how long it might take for the retail market to recover.
AZRE: How has the pandemic affected the kinds of deals and the number of deals that you have worked on?
Voorhees: Since the onset of the COVID-19 pandemic in early March, our team’s deal volume remains on pace with previous years, but we’ve seen a decrease in transaction size and a shift to more simple properties. Year to date, we have closed 36 deals, averaging one deal a week, with three closing this week. Credit tenant, single tenant net-lease (STNL) investments on longer leases, and conventional pad retail or strip retail assets with three to seven “essential” tenants are favored by investors; properties that are easy to understand and transparent. Traditional, anchored shopping center inventory has been historically low since the start of the pandemic, likely because some centers still have tenant collection/rent abatement/rent deferral situations in play. Consequently, pegging NOI and determining value is challenging. The impact of stimulus—undoubtedly necessary— and uncertainty regarding COVID-19 and the forthcoming U.S. presidential election all make it hard for properties and investors to find firm footing in 2020. Going forward, grocery (necessity) anchored shopping centers – always the institutional favorite – should enjoy even stronger demand and likely cap rate compression with the U.S. 10-year treasury rate about 125 bps lower now than pre-COVID-19. The best STNL and pad retail assets could see cap rate compression as well.
AZRE: What are you seeing in the market about the percentage of tenants keeping up on rents, and are there certain submarkets of the Valley that are performing better in that regard?
Voorhees: As you would expect, enclosed malls, lifestyle centers and properties anchored by gyms and theaters are challenged. Many of these tenants were closed by the government or defacto due to concerns about the spread of COVID-19. Unfortunately, uncertainty around these retail formats and tenant types will continue so long as COVID-19 is at large and may continue post-pandemic. Real estate business intelligence system Datex Property Solutions, owned by Mark Sigal and Sandy Sigal of Newmark Merrill Companies, provides the proxy for rent collections during COVID-19 by rolling up financial reporting from centers using Datex. Datex reported total rent collections of 57 percent in May, 68 percent in June, and 77 percent in July. While this trend is positive, a center with a 60 percent loan-to-value (LTV) loan and collections of 70 percent is effectively 100 percent leveraged, a daunting situation for properties with near-term loan maturities. Curiously, at the start of COVID-19, local and regional tenants performed better than national tenants in terms of collections, though, as time wears on, national tenants are outperforming locals, likely because local tenant cash reserves/balance sheets are weaker. Regarding geography, I cannot point to specific data, though anecdotally, centers in lower-income demographics seem to have strong collections than higher end properties where customer spending is more discretionary than necessity.
AZRE: What are the biggest long-term concerns for retail property owners as the state tries to emerge out of the pandemic?
Voorhees: The willingness of the government to effectively turn off the income spigot for tenants (and consequently landlords) overnight is a major challenge, one not encountered in modern times. In this respect, retail in Arizona should outperform retail in California. When the pandemic hit, landlords quickly provided relief to tenants, and for the most part, lenders provided relief to borrowers. The longer the pandemic continues, the more pressure will build for landlords to adjust rents commensurate with reduced tenant income potential (balancing occupancy costs/health ratios). Similarly, pressure will build for lenders to default borrowers not keeping loans current. As aforementioned, the government stimulus/financial support essentially “kicks the can” down the road, delaying an inevitable financial reckoning for tenants, landlords and lenders. Most retail properties have debt financing in place, and landlords will increasingly find themselves between a rock and a hard place with rent collections reduced and loan maturities impending.
AZRE: Are there any retail sectors that are seeing surprising growth, even during the pandemic? If so, what factors helped those sectors thrive in such difficult times?
Voorhees: Since March, online retail sales and buy online, pickup in store (BOPIS) accelerated tremendously, with Amazon and Instacart leading the charge per the headlines. Though, it’s widely acknowledged that delivering groceries to customers is not a profitable business due to high delivery costs and low grocery margins. The omnichannel BOPIS approach of ordering online and picking up at the physical store location seems viable, sustainable and perfect for the current environment. Many retailers, including Target, Walmart, Kroger and others, now have convenient parking locations designated for BOPIS execution. In fact, we’ve seen restaurants of nearly every format doing the same. Drive-thru and quick-casual restaurants adapted quickly to provide efficient, cost-effective, low-contact delivery systems. Correspondingly, STNL investments, many of these quick-service restaurants, posted the highest collections since the onset of COVID-19. Tenants like Dutch Bros Coffee with dual drive-throughs and walk-up windows are ideal for the low-contact, COVID-19 environment.
AZRE: From your point of view, what is the Valley’s outlook for the remainder of 2020 and how do you think the market will look a year from now?
Voorhees: In uncertain times, investors typically adopt a “wait and see” strategy either by choice or necessity. As aforementioned, rent rolls at traditional, multi-tenant shopping centers will not likely stabilize in 2020, perhaps not even during the first half of 2021, depending on COVID-19. This uncertainty creates underwriting challenges for owners and investors and also for lenders. Presently, except for just a handful of life insurance companies and banks, few players are in the market to lend on retail. Active lenders generally constrain LTV to sub-55 percent without an interest-only period – 25 and 30 year amortizations are the norm – and often with six to twelve months of principal and interest reserves except in cases where the grocery/credit anchor tenant cover the debt service in a 1.2 or better ratio; few properties are in this situation. Until the debt market for retail returns, most investors will tread water on transacting, focusing instead on stabilizing existing projects and making arrangements with existing lenders.
The financial crisis induced by the COVID-19 pandemic is unprecedented, but this too shall pass. Real estate has always been a cyclical business, and we just completed the longest period of U.S. expansion, besting the 120 months of growth from March of 1991 to March of 2001. Though, even if we had a vaccine today, it’s likely that all commercial real estate sectors, not just retail, will continue to feel the disruption through at least the first half of 2021, if not for the full year. There will be a trough, potentially lasting for a few years, and there will be another expansion. It’s been said that since the Great Recession—and more so since the so-called retail apocalypse in 2017–that retail is binary: Great properties that work and investors covet and challenged properties on which cap rates expanded widely (think “less-than-A” malls where cap rates are in the high teens if not 20 percent). This “As and Fs” view of retail could be exacerbated as institutional capital flows out of “less-than-A” properties and pricing adjusts, particularly on larger properties greater than $35 million or $40 million in value. Disruption creates opportunity. One of my favorite lyrics is from a band called Purple Mountains: “A setback can be a setup for a comeback if you don’t let up.” To succeed in retail, this is a healthy mindset for the next year or two; or three!