While family office investments in retail real estate are facing a number of challenges, opportunities for returns remain.

Squire Patton Boggs, the US-based law firm that works with clients such as family offices, sets out its thoughts here on real estate investment from a family offices perspective. This news service will occasionally publish insights from this firm on matters that affect high net worth clients and the advisors and institutions serving them. (As for what family offices seek from real estate investment, see this recent article here by another authority in the space.) The editors are pleased to share these views and invite readers to respond. Email tom.burroughes@wealthbriefing.com

In search for long-term appreciation and agreeable income streams, family offices have been expanding their portfolio allocations beyond the historical asset classes of bonds and stocks. According to a UBS Global Family Office Report, real estate direct investment was the third largest asset class in the average family office portfolio. Within that allocation, 56.6 per cent of investments were directed towards commercial properties. Investment in retail real estate, in particular, is a long game. Family offices, who do not need asset liquidity to fund daily operations, are well positioned to weather the ebb and flow of the retail real estate industry and become an increasingly important investment player.

While the general feeling seems to be that the retail sector is struggling because storied retail brand names, like K-Mart, JC Penney, Bon-Ton American Apparel and Toys R Us, have been closing stores or shutting down completely, the reality is that these retailers are being replaced by new brands and new retail models. 2017 proved to be a difficult year for the retail sector. There were a reported 662 retail bankruptcies, up by 30 per cent from the previous year. Store closings tripled, with nearly 7,000 locations shutting their doors. High-profile retail bankruptcies, like Toys R Us, Claire’s and Nine West, are causing many real estate investors to scrutinize their investments in the retail sector.

This is only one side of the story. The retail sector is not dying; it is just evolving as it always has over the years. In fact, the National Retail Federation reported that 2017 retail sales were up 3.9% over 2016. With each set of challenges [there] come opportunities for the industry to reinvent itself and remain competitive as retail enters a new era.

Growth markets
As consumers are increasingly looking to stores to offer a full suite of services in addition to the actual product, experiential retail is the next wave. Stores are experimenting with technology and fashion to offer in-store experience specifically tailored to each customer. Vans has opened a 30,000-square-foot “House of Vans” in London that houses a cinema, cafe, live music venue, art gallery and three separate skateboard ramps. Recreational retail experiences, such as yoga, fitness classes, rock climbing and swimming, are popping up, blurring the lines between the traditional retail store and a flexible, social space.

Discount stores and value brands are another growth area. Dollar General’s net sales increased by 6.8 per cent and same-store sales grew by 2.7 per cent last year. It plans to open 900 new stores this year. Aldi has plans to open 150 stores in 2018, and bring their total US store count to 2,500 by the end of 2022. Hobby Lobby has plans to open 60 new stores and hire approximately 2,500 new employees this year.

While most investors will shy away from shopping centers, believing they are on the path toward extinction, a small group of investors see these fledgling spaces as full of potential. The Sterling Organization, a Palm Beach-based private equity firm, has been investing in grocery-anchored shopping centers, street retail, open-air shopping centers and mixed-use properties in major markets, such as San Diego, Los Angeles, Minneapolis, Dallas, Chicago, Miami and Washington DC. The idea is to replace the outdated anchor tenant, who signed cheap, long-term leases decades ago, with trendier retailers who can pay market rent.

This could equal an increase of $2 and upwards to $14 per square foot with the new lease. New owners are experimenting by diversifying their tenants in efforts to win back consumers. In addition to retail, owners are adding medical offices, places of worship, gyms and entertainment venues, such as trampoline parks or indoor skydiving, cafes and call centers, among other “nontraditional” options.

Mixed bag and other changes
There continues to be a cycle of success among clothing brands. H&M is adding 60 new stores in 2018. TJX Companies, the parent company of retailers TJ Maxx, Marshalls and HomeGoods, added more than 250 stores in 2017, and plans to add 240 new stores in 2018.

“Big box” retailers, like Target, Walmart and Costco, are adapting to shifting preferences and opening smaller stores in urban markets with delivery services available, catering to a younger, city-dwelling generation that does not own cars. Most of Target’s 30 planned store openings this year will be the smaller-format stores located in downtown areas or near densely populated college campuses.

Walmart and The Gap, Inc. are two prime examples that highlight other shifts taking place in the commercial real estate space. Walmart has decided to close 63 Sam’s Club locations. However, 12 of them will be converted into e-commerce distribution centers. The shift to industrial real estate warehouses and distribution centers is taking place and will have important consequences for retailers and investors alike. Walmart is adapting to the e-commerce boom, recently acquiring two online-only companies, Jet.com and Bonobos. According to CBRE, the momentum for additional construction of US warehouse space continues to climb higher. Likewise, the data center industry has an increasing need for space, and repurposing retail stores into these alternate uses is only set to rise.

Although The Gap, Inc. is closing a reported 200 Gap and Banana Republic stores, they are set to open 270 Old Navy and Athleta stores over the next three years. With stagnating wages in recent years, discount retailers and “athleisure” wear has benefited from millennial shoppers’ preferences. As retailers continue to refine their inventories and fulfillment models, we are likely to see other retail refocusing of this kind.

Focused on food
Apart from discount and value brands, food retail is booming. Restaurant space continues to do well in urban areas, especially multi-unit food halls and pop-up spaces. There are now 33,000 coffee shops across the country, and that number is expected to increase by 2 per cent this year. Grocery-anchored malls are also remaining steady, even though some grocery stores themselves have become concerned about their footprint. CoStar has found that commercial square footage of retail food space per capita is hitting record highs, with 4.15 square feet of food retail per person. Many grocers have taken note and are increasingly opting for “boutique-style” markets with a smaller footprint and specialty offerings. One cannot help but notice a similarity in strategy to what many big box retailers are pursuing, in opening smaller stores in more densely populated areas.

Walking the walk
Leon Capital Group* (see note below) is a real estate-focused investment company and is an extremely active retail developer. The company has a focus on retail, multifamily, residential development and self-storage properties, and has successfully completed more than 300 investments in these spaces. Jesus Araiza, managing director, retail, Leon Capital Group, commented: “We have deliberately shifted our focus to servicing tenants that enable us to create direct retailer relationships in the single tenant sector. With a specific focus on particular end-users in strategic markets, there is still plenty of room for returns.”

What are the takeaways?
The reality is that the retail sector remains strong, but is evolving in its use of real estate and engagement with customers. Despite calls of a “retail apocalypse,” and the aforementioned bankruptcies, occupancy rates at US malls remain at about 93 per cent. Moody’s has predicted that US retail operating income will increase a full percentage point this year, with sales jumping to 4.5 per cent.

In the era of e-commerce, investors should generally be looking at smaller-format retailers. Many former big-box locations, such as K-Mart, are being subdivided and filled with specialty retailers and more service-oriented offerings, such as gyms, salons, indoor play spaces and health care services. Investors can also look for opportunities in secondary markets. While JLL found that New York remains the retail hub of the country in its recent Destination Retail report, many secondary markets are offering exciting prospects. Texas makes a strong showing in the top 140 retail cities, with Houston, Dallas and Austin all in the top 40. Orlando, Tampa and Washington DC are also in the top 60. Marcus & Millichap’s 2018 Retail Investment Forecast also reported that Dallas/Fort Worth made the largest jump in its National Retail Index this year, followed by Denver and Atlanta.

While investors in retail commercial real estate are facing various risks and challenges, there certainly remains opportunity within the sector for favorable returns. With traditional e-commerce merchants now opening up brick-and-mortar stores and many retail niches doing better than ever, the traditional retail store is certainly not disappearing anytime soon.

Retail is constantly evolving. Today, we have e-commerce, which is replacing some brick-and-mortar stores, shopping malls and big box retailers. Before the suburban malls and large retailers, there were corner drug stores and downtown locally owned stores. Retail real estate investments are by nature built to last. Family offices and advisors should keep this asset class in mind when looking for opportunities to diversify and balance portfolios. It is a resilient industry that will come back on top as it adjusts to society’s styles and demands.

*Leon Capital Group is a client of Squire Patton Boggs.