How has the Midwest retail market weathered the pandemic?
Really well, overall. While pandemic-related closures still caused difficulty for tenants, Midwestern retailers fared much better than their coastal counterparts who experienced lengthier lockdowns and tighter restrictions. Another possible benefit to tenants in the central part of the country is a lower expense load – in the form of lower property taxes and rental rates – which might have offered these businesses a small counterbalance against revenue losses. In 2021 and beyond, I expect we’ll see retailers in the region return to a growth mindset. We are currently working on a number of net lease projects in the Midwest – national retailers in the home improvement sector and QSR space are committing to new store openings, and we’re working on grocery stores undergoing significant lease extensions and remodels of existing stores.
Which retail sectors are in the highest demand from investors?
The effects of the pandemic exacerbated an existing trend in the net lease space toward “essential” retail investments, pushing certain segments to record levels of demand. This included retail superstores, grocery stores, drug stores, QSRs, dollar stores and convenience stores. Retail/medical cross-over assets such as dialysis have also remained incredibly liquid. As deal making activity ramped up in Q3’20 following an uncertain Q2, cap rates for these product types began to compress. We have seen first-hand swings of more than 100 basis points on some investment-grade credit deals since Q2’20. Investor sentiment towards other retail classifications, including casual dining, gyms and some childcare assets suffered though. Fortunately for those segments, demand is now normalizing. We recently closed on one single-tenant childcare asset and have a second location headed to contract, suggesting growing confidence in this segment again. While the long-term demand characteristics for these deals are very good, the market softened a little bit on these assets through the winter.
What challenges are buyers and sellers facing right now?
Buyers are most immediately challenged by limited inventory. Extremely low interest rates have proven a “double-edged sword” for buyers. While the opportunity to lock in cheap debt still exists for the time-being, buyers must compete against their peers in a market where cap rates have moved downward with loan constants. I don’t expect the pace of net new construction deliveries in the Midwest to off-set this supply-demand imbalance. Rather, it will likely be a combination of market factors that will cycle the dynamic in the other direction.
Seller challenges are somewhat more variable and are often deal-specific. In addition to some non-essential retail classifications falling temporarily out of favor, we are seeing buyers – and also lenders – underwrite such deals to a new, tighter standard. For instance, above-market rent, or liberal force majeure lease language, could impact a deal to a degree not seen prior to the pandemic. Even sellers transacting A+ assets are subject to some difficulty. A frothy market brings emotional and sometimes unpredictable buyers to the fray – in any market, performance is paramount.
What are your predictions for the next 18 months?
I believe many Midwestern markets will experience a boost in growth as our economy continues to recover from the pandemic. Whereas pre-pandemic, primary cities and their urban cores were the focus of the boom, I think you will see secondary cities share in the momentum going forward. These secondary markets have so much to offer in terms of amenities and quality of life. Smaller communities will be differentiated by their ability to either attract new industries, or by recreational attributes that appeal to remote employees. The “reshuffling” of the past year has been a benefit to many Midwestern locales and more real estate opportunity will follow.
Despite the tightness in the market, there is real opportunity for real estate investors. Identifying those market segments that were slower to recover from the effects of the pandemic is a real buying opportunity, especially in combination with current interest rates. Evaluating existing holdings for rapid appreciation may be a smart exit opportunity in a favorable tax climate. All signals suggest that interest rates will begin to rise in the next 18 months, which in turn will impact cap rates. It is a very good time to pay attention to lease economics and how yours are structured to perform in an inflationary environment.