This piece was first published on the business blog for Johns Hopkins University, "Carey The Torch." You may view it here.
Since their inception in 1960, real estate investment trusts (REITs) have become a tool for increasing accessibility to stock and mutual fund investors. By law, they’re required to pay out at least 90% of their taxable income in dividends to shareholders. Hence, they are an ideal investment for those who desire cash flow benefits of real estate investing without inconveniences such as negligent tenants or maintenance hardships. REITs have diversified into many different commercial property types such as office, industrial, and retail, and the REIT investing strategy has been replicated in many developed and developing nations. However, the rise of the e-commerce industry presents challenges which have brought profound and permanent changes to both the retail and industrial REIT industry. Such challenges also apply to an emerging REIT sector centered around data centers.
The most seismic real estate-related change spurred by online retailing is a sustained drop in demand for traditional retail real estate. Retail real estate boomed in the latter half of the 20th century with indoor shopping malls becoming a retail and social mecca in virtually every urban and suburban community in the U.S. At their peak in the late 1980s, malls accounted for more than 50% of all retail sales. The emergence of big box retailers such as Walmart and Home Depot further fueled the demand for retail space.
However, the 1990s saw the advent of Amazon as well as thousands of much smaller internet retailers. As of the first quarter of 2017, online retail is estimated to account for 8.5% of all retail activity, up from 3.6% in 2008. This increase is causing visible effects in the retail landscape. Retail construction peaked at 175 million square feet in 2007. The financial crisis impacted the industry as new construction fell to about 35 million square feet by 2011, and by 2016 construction only rose to 52 million square feet. While construction is expected to rise to above 80 million square feet in 2017, that’s still less than half the levels seen in 2007. Retail closings have also risen. In 2016 alone, 14 major retailers announced plans to close 100 stores or more.
Retail REIT investments have not been immune to these effects, particularly the regional mall and shopping center REITs. For 2016, the retail REIT sector overall had a 0.95% return from investors. The only sub-sector negative return came from regional mall REITs at -5.42%. REITs focused on free standings stores had a 17% return. So far in 2017, the trend away from retail real estate investing has appeared to accelerate. In the first five months of the year, all retail REIT sectors have had negative returns, with the overall return falling nearly 15%. The shopping center sub-sector has been hurt the worst, falling 20%.
Other than a few notable exceptions, the transition to online retailing has shifted, rather than eliminated the retail industry’s demand for real estate. Since most retail products are still physical products, retail real estate’s loss has been industrial real estate’s gain. The demand for warehouse space has greatly increased. Warehouse construction increased from just under 11 million square feet in 2010 to approximately 76 million by 2014, a number that remained steady in 2016.
One company that has increased its acquisition of warehouses is Amazon. To increase its ability to offer same-day shipping, Amazon moved aggressively to acquire warehouses beginning in 2010, and today has over 70 fulfillment centers across the country. An additional benefit Amazon and other online retailers enjoy is the ability to utilize lower-cost real estate. The average retail space rented for $16.97 sf/year according to CBRE, with the lifestyle/mall retail segment averaging $23.76 sf/year. This compares to an average of $6.71 sf/year for industrial space. Even with rents rising and low vacancies for warehouse space, this represents a substantial savings for retailers.
The benefits are not limited to warehouse properties alone. Another less-noticed but important REIT and real estate-related beneficiary has been a relatively new and emerging class of REITs called data center REITs. Data center REITs are equity REITs that invest in properties designed specifically for the safe storage of digital data. These properties are unique in that they must offer services such as an uninterrupted power supply, air-cooled chillers, and physical security. While online retailers are only one of many types of clients these data centers serve, data centers are an indispensable part of e-commerce, both for data storage and insuring safe financial transactions. With a 16% growth rate in 2016 and projected growth rates of 8-12% in future years, online retailing is an important component of data center growth.
REITs for both industrial and data centers have yielded large returns. For 2016, the return on all industrial properties was 30.72%, greatly exceeding NAREIT’s 8.62% average return for all equity REITs. The first five months of 2017 showed continued growth with the year to date return standing at 7.75%, compared to all equity REIT average of 2.63%. Data center REIT returns have also exceeded the average return on REITs. The data center REIT rate of return was 26.41% in 2016. The strong growth trend has continued in 2017, with a return of 23.55% for the first five months of the year.
The advent of online retailing is shifting the focus of retail real estate from traditional brick and mortar stores to other types of real estate. Instead of viewing products inside a physical store, customers can now see the product online. This removes the need for customer-friendly spaces and physical displays, allowing retailers to store products in lower-cost warehouse assets. This shift has been devastating to retail REITs who explicitly specialize in properties such as regional malls or shopping centers. Conversely, it has been a boon to REITs involved with building and purchasing warehouse spaces, as well as REITs who specialize in data centers. While a need still exists for traditional retail real estate space, warehouse and data center space are becoming a major component of retail real estate.
Rather than viewed as in a decline, perhaps the retail REIT industry should change the definition of retail property to include warehouses and (if known to be retail-specific) data centers. In all, this market space provides a unique investment and trading class for individual investors or private equity interested in cash flow without the managerial hardships associated with property oversight.