Opportunities in an Evolving Retail Sector

An evolving retail sector is providing opportunities for investors and giving underwriters more confidence in retail’s long-term outlook, said Marcus & Millichap, Calabasas, Calif.

“Retail has witnessed dramatic change over the past several years, but the transition is still ongoing,” the Marcus & Millichap Retail Outlook said. “Companies are finding ways to mesh brick-and-mortar locations with strengthening online capabilities to produce seamless omni-channel experiences for consumers.”

The report noted brick-and-mortar stores, including Walmart and Target, are embracing digital and logistical systems to better compete with Internet retailers while digital-native companies such as Bonobos and Warby Parker are opening physical stores to increase brand awareness and customer engagement. “The confluence of these factors is reinventing retail, helping companies realize the importance of a combined physical and online presence,” it said.

Several retail categories have a positive outlook as the retail sector transforms, the report noted. “Bars and restaurants will remain highly sought after tenants as consumers continue to increase spending at these establishments…Gyms are also expanding quickly, particularly as an increasing number of big-box vacancies can accommodate these types of businesses,” it said. Entertainment retailers, such as e-sports venues and dine-in movie theaters are also moving into vacant big-box store locations. “As some retail concepts falter in the face of sector transformation, many owners are surveying options to fill empty space, giving other retailers opportunities to expand their footprint.”

In addition, Millennials are changing the retail sector as they mature. “Suburban real estate may be biggest winner of evolving Millennial lifestyles,” Marcus & Millichap said. “The Millennial cohort will have a transformative impact on real estate markets as this generation approaches a new life stage.” Many Millennials are moving into their late 20s and 30s and forming families. “Corporations are taking note of this, setting up campuses in suburban employment hubs, bringing jobs to the growing talent pools,” the report said. “This is bringing more retail space to the suburbs as retailers seek to get their products closer to growing consumer bases. New retail developments are molded around sustainable tenant blends as these emerging trade areas are composed of many modern consumers who favor omni-channel retail platforms.”

Despite the evolution, the report said lenders remain relatively conservative regarding lending on retail assets. “However, a wide range of financing is available for strong proposals,” the report said. “Underwriters are beginning to focus more on tenant mixes, heavily emphasizing the inclusion of tenants with sustainable business models before they sponsor a deal.”

The sector’s most active lenders include small and large banks as well as insurance companies, “with a primary lender focus on net-leased assets and premier mixed-use structures being highly desirable,” Marcus & Millichap said. “Meanwhile, outlying malls and non-credit tenants will undergo much more scrutiny.”

Current loan-to-value ratios generally remain in the 60 to 70 percent range and typical debt service coverage ratios are above 1.3 depending on borrower, asset and location factors. “Mezzanine and bridge loan structures have been more frequently used in this environment, with owners undertaking capital improvements at higher leverage ratios on the short-term debt before seeking long-term financing options once their operations have been proved,” the report said.