Why Real Estate Investors Shouldn't Give Up on Retail

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Real estate investing can offer a hedge against market volatility while enhancing diversification in a portfolio, but some sectors may outperform others. Retail has become a major question mark for investors amid the rising demand for online shopping with buyers turning to their browsers for purchases.

“E-commerce represents a huge secular shift in consumer behavior that has had major implications for the retail market,” says Christopher Muoio, quantitative strategist at Ten-X Commercial. “Online sales now account for nearly 15 percent of total retail sales and as a result, retail space per person has been falling over the past decade.”

Muoio says that’s translated to higher vacancy rates and stagnant rent growth in the retail real estate market. The shifting in fundamentals within the sector have triggered store closings and bankruptcies as retailers struggle to keep pace with companies like Amazon.com (ticker: AMZN).

It might appear that retail is a dead end, but there’s a silver lining, says Jeff Checko, a real estate broker with Ashton Real Estate Group in Nashville, Tennessee. Shoppers still rely on brick-and-mortar locations for making returns, as well as the instant gratification that online stores can’t offer.

Rather than bailing out, Checko says real estate investors are better served by determining where still lie. Investors should examine the following:

— Consider that the strongest companies may rise to the top.

— Know that smaller operations could gain traction.

— Keep in mind retail’s evolution could be a positive.

— Look for more than face value.

[See: How to Invest in Real Estate Without Buying Property.]

Strong Companies Rise to the Top

Sean O’Hara, president of Pacer ETFs in Pennsylvania, says the e-commerce revolution may be viewed positively by the discerning real estate investor.

“It’s creating a large discrepancy between the good operators and the bad operators in the retail space,” O’Hara says. “Only the best, most financially sound and creative operators will be able to navigate their way through the changing landscape.”

Investors who can separate the good from the bad stand to do well, O’Hara says. He points to Simon Property Group ( SPG), the largest retail real estate investment trust in the U.S., as a success story.

“They operate shopping malls and have done a great job of luring high-end retailers to be their anchor tenants, while significantly increasing the buying experience,” O’Hara says.

The REIT has a healthy dividend yield of 4.68 percent, with annualized dividend growth of 9.3 percent over the last three years. Another retail-focused REIT is Realty Income ( O), which invests in free-standing, single-tenant commercial properties and yields 3.9 percent. Through these REITs, investors can capitalize on companies that are holding their own against e-commerce.

The companies that fail to adapt to a changing environment are the ones that may fall behind.

“Retailers must be looking to expand sales in the e-commerce arena, rightsize store footprints, address direct to consumer options and focus on what consumers want most,” says Ben Easterlin, senior vice president of commercial lending at Angel Oak Companies. “The deepest impacts are being felt amongst the stale, old brands who make no attempt to increase their internet presence while continuing to push for long-term leases on stores that don’t fit consumer needs and taking on debt to pursue this business plan.”

[Read What Higher Interest Rates Mean for REITs.]

Smaller Operations May Gain Traction

While big-box stores have undoubtedly suffered in the wake of e-commerce’s rising popularity, that potentially presents an opening for smaller retail stores to thrive.

“Large pieces of real estate that house major department stores aren’t getting the traffic they need to survive,” Checko says. “The ensuing closures create large, empty storefronts that cost some investors heavily.”

The upside is that those negative effects may not trickle down as much to the local business level.

“While the growing dominance of e-commerce is hurting national chains, it’s not having the same effect for small businesses,” Checko says. “Investors may want to look at those retail spaces more closely.”

That includes dry cleaners, nail salons and other service-focused businesses that meet the needs of a local customer base. Easterlin says it’s the nonanchored mom and pop shops that may prove most successful.

Muoio says o pportunity zones, designated economically distressed areas, may also spur retail investment in smaller metro areas, thanks to tax incentives that make assets in those zones more attractive. Investors may be able to defer or reduce capital gains tax on qualified opportunity fund investments.

Retail’s Evolution Could Be a Positive

Retail locations and warehouse spaces for shipping are two distinct entities within real estate, but the line between them may soon blur, says Zach Aarons, co-founder and partner at venture capital fund Metaprop.

Aarons says malls often have dead space as stores close, but at the same time, “retailers in malls want to ship stuff directly from their stores, but they don’t have logistics centers nearby.”

The solution? Converting stores into miniature logistics centers. The flip side of that is introducing retail functions at logistics centers. Doing so “would reduce processing and delivery time, as well as costs and carbon emissions,” Aarons says.

He says this type of repurposing is already happening in other real estate areas, such as turning unused hotel space into short-term rentals. “With technology, you can better match the supply side with the demand side and create an opportunity for the real estate owner to make money off different elements of the supply chain,” Aarons says.

[See: 9 Must-Have REITs for Sustainable Investing.]

New investing opportunities may also present themselves as brick-and-mortar retailers incorporate e-commerce into their sales strategies.

“As e-commerce becomes a larger part of the overall retail sales environment, a major build out in the infrastructure that supports e-commerce is necessary,” O’Hara says. “Cell tower companies, data center operators and industrial distribution centers should all thrive as a result.”

He says the Pacer Benchmark Data & Infrastructure Real Estate SCTR ETF ( SRVR) and the Pacer Benchmark Industrial Real Estate SCTR ETF ( INDS) offer that type of exposure for investors seeking an alternative to retail. SRVR invests in industrial REITs and data centers, while INDS is focused on industrial real estate holdings.

Look for More Than Face Value

Making assumptions about where the retail market is headed could cause your portfolio to miss out on the upside.

“The yields are still good and better than most other asset classes, due to the continued ‘e-pocalypse’ concerns that are driven by the media,” Easterlin says. “We still feel there are a lot of good opportunities and the market shouldn’t be painted with a broad brush.”

When there’s risk, there’s return, he says and “while retail will continue to face headwinds due to e-commerce growth, well-positioned retail will always be successful and needed.”

Taking an analytical approach matters for choosing the right real estate investment.

“What’s important is relying on the data: traffic, income and wealth concentration,” Checko says. “Follow the formula and if the numbers are right: Go for it.”

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