By Josh Lipton and Andrew Levine, ONE Commercial Realty Services
Reports of the imminent death of retail in the United States are greatly exaggerated but there is cause for alarm and brick and mortar retail outlets should not expect a respite any time soon.
Online retailing, or what many have come to call the “Amazon Effect,” has been chipping away at traditional retail revenue for years. Anchor tenants that historically drove traffic and, in turn, revenues are now regarded as under-performing behemoths bringing suburban malls to their knees. Industry insiders expect the pace of retail store closures to reach a tipping point in 2017.
In fact, in January 2017, Sears announced it would close 41 stores with its namesake and 109 Kmart stores (a brand it also owns) and this is after shutting 78 stores in 2016 and more than 200 in 2015. In March 2017, the company acknowledged “substantial doubt” about its ability to keep operating as a going concern. Payless Inc., the discount shoe chain, is planning to close 400 to 500 stores as it files for bankruptcy. In 2016, Macy’s announced that it too would close 100 stores in the coming months. The list of other retailers closing or reporting disappointing earnings is long and troubling: JCPenney, HHGregg, Abercrombie & Fitch, The Limited, American Apparel, CVS, Urban Outfitters, Staples, Dick’s and Men’s Warehouse to name a few.
In addition to the massive layoffs resulting from store closures, debt secured by the performance of retail sales is at risk. As shopper volume dwindles in malls outside major urban markets, CEOs struggle to adapt to the new reality while investors are intrigued by the next “big short” opportunity.
The investment advisory group, Alder Hill Management LP, recently issued a report to its investors making the case against commercial mortgage backed securities tied to retail property, saying it expects more defaults to occur in lower-quality malls. Wells Fargo added that “retail is under significant pressure” and companies are “running out of time” to hit their numbers.
With an over-supply of malls, limited foot traffic and a failure of department stores to upgrade the shopping experience for the modern consumer, landlords are struggling to cover their debt service and, in some cases, are simply handing over the keys.
Perhaps America has too many stores (i.e., more than six times the retail sq. ft. per capita than that of Europe or Japan), but the underlying killer of traditional bricks and mortar is unquestionably the “Amazon Effect.” Millennials love to shop online and traditional retail needs to adapt or die. Today, Amazon has a market value in excess of $450 billion, or more than the next eight highest grossing retailers combined and the trend isn’t slowing down.
Amazon founder, Jeff Bezos, claims that “[his competitors’] margin is [Amazon’s] opportunity”—meaning that Amazon can win by selling volume at slightly more than break even and even at a loss in certain categories for years on end.
The metrics support that and, to the intense irritation of physical retailers, Amazon operates at margins ranging between just 1-4 percent. Low margins and the lack of rent in their overall expense structure makes it nearly impossible to effectively compete with Amazon. To exacerbate matters, Speaker of the House Paul Ryan recently introduced a corporate tax overhaul that retailers believe would drastically cut into already thin profit margins. Minimum wage increases in many States are also putting pressure on labor costs.
The message is clear: retailers must adjust and many are trying. Traditional brick and mortar retailers are ramping up their online presence and using data analytics to better understand customers. Retailers providing an experience or service such as nightclubs, bars, restaurants and performance venues are also mostly protected from the onslaught of Internet shopping. Retailers are also downsizing and exiting secondary and tertiary markets and focusing on large concentrated urban areas such as New York City with higher income per capita and strong demographics.
For their part, retail investors/funds are focusing their portfolios on assets located in high density urban markets. Accordingly, retail and retail condo properties south of 96th Street in New York City have fared relatively well amid a general market slowdown.
In Manhattan, cap rates for retail properties increased almost 1% since 2015. Many players in the industry see this as a correction that has been long overdue and remain wary of locations that lack foot traffic and do not expect 2014-15 prices to be achievable anytime soon. Time will tell how prolonged the retail bloodbath will be; but changes are about and retail will never the same again.