Of the four major real estate asset classes, retail had the poorest performance headed into 2020. The COVID-19 pandemic has exacerbated this, converting late adopters into reliable e-commerce users and shaking consumer confidence in densely populated experiential ventures.
According to Sean Sharko, senior vice president, investments with the Sharko | Weisenbeck Team of Marcus & Millichap, every transaction has to be reevaluated on its own merits. He has seen plenty of deals, either in escrow or that were about to enter escrow leading up to COVID-19, fall apart.
He pointed to one in particular that had an LA Fitness as the central tenant. Pre-COVID, both sides would have come together easily. But as gyms shut down during the stay-at-home lockdown—and LA Fitness had a rent abatement built into their lease, unrelated to the pandemic—the transaction never culminated.
“Our buyer just wasn’t comfortable because nobody knows how long this is going to take or when these tenants would reopen,” Sharko said. “There is a fear factor, an unknown as to how long COVID-19 could really impact our lives that is just so hard to quantify and predict.”
All is not lost, however. The Sharko|Weisenbeck Team saw their deal velocity slow to between 60 and 65 percent since the beginning of March, compared to this time last year. All things considered, they judge themselves fortunate to have closed that amount of retail transactions.
More than half of these involved single-tenant properties where the tenant did not cease operations during the pandemic. However, they were able to close on some shopping centers, which required some ingenuity. As these all required financing, a lender was part of the discussions along with the buyer and seller. Only by carefully contracting any rent deferrals, payback periods or other factors could all sides be fully comfortable going forward with a transaction during these uncertain times.
“We’ve gotten creative in a lot of cases, but that’s what it takes right now—a little creativity and a lot of willingness from all sides,” said Austin Weisenbeck, senior vice president, investments.
While there are instances of buyers with fresh capital wanting to buy a piece of real estate, most of the deals that have gone ahead in the past two months involved 1031 exchanges and/or net-leased tenants. Due to COVID-19, the IRS recently extended the identification and exchange deadlines for those engaged in a 1031 exchange, but these deals—along with net-lease assets—are generally more stable than other retail properties.
“Everything today is about predictability of income stream,” Weisenbeck said. “You really have to have a corporate guarantee from an investment-grade tenant where you can easily quantify the risk of that tenant.”
Multi-tenant shopping centers are a harder sell at the moment, as each individual tenant introduces varying levels of risk and different vectors for possible future lost rental income. Some large-format tenants, such as grocery stores or national pharmacy brands, can stabilize that risk to a degree, but the extent to which they can shelter smaller tenants within the shopping center is limited.
Experiential retail had been the one shining hope before the pandemic—and the sector’s largest liability since. It’s little surprise, then, that investor interest has cooled off for properties that have a large proportion of these types of tenants.
“I personally don’t think you’re going to see a whole lot of buyer interest for some time until they open up a little bit more,” Sharko said. “Until there’s a general assurance about patronizing a large restaurant or being in a bowling alley or a gym with dozens of other people, those are going to be challenging types of assets to sell. It’s going to take some time until confidence is restored in those types of businesses, and then therefore those types of assets.”
The main component driving consumer confidence in experiential retail is time. Until new cases start to dwindle, and a vaccine has become available, a large segment of the population simply won’t feel safe returning to these properties.
There is another factor that gives more control to the tenants and landlords, however. Many sit-down restaurants, for example, have allocated funds for outdoor seating to accommodate patrons in a safer environment. This capital outlay is relevant to vacant retail space as well; despite the uncertainty in the market, tenant improvement allowances are on the rise.
“I had a conversation with a pretty large landlord the other day who said that there are still tenants out there looking for space,” Weisenbeck said. “They are fielding interest from tenants who think that things are going to come back and feel in a power position and that they can lock up a good deal. He said that the TI that landlords are being asked of is the highest he’s seen his entire career.”
The situation will only get worse before it gets better. New data from Coresight Research forecasts between 20,000 and 25,000 retail closures in the U.S. this year—more than doubling the record number of closures last year. With this in mind, investors will carefully scrutinize retail deals more than ever before—or simply stay out of the sector altogether, until the pandemic crisis subsides.