REIT Column: What’s in Store for Retail in 2016?

By Merrie Frankel, Vice President & Senior Credit Officer, Moody’s Investors Service

Continued improvement in real estate fundamentals for retail properties—with occupancy rates, leasing spreads and renewal rates all rising—bodes well for the credit quality of the retail REITs Moody’s rates. Since real estate fundamentals are improving, we don’t expect to make material changes to our ratings or outlooks for most investment-grade retail REITs in 2016. Our outlooks are stable for 21 of the 22 retail REITs we rate and negative for one.

The retail sector will grow modestly in 2016. Moody’s has a positive outlook for the U.S. retail industry, with the expectation that the industry’s operating income will grow between 5 percent and 6 percent in 2015 and again in 2016. Continued strong performance among key companies in the home improvement, auto parts, supermarket, specialty, off-price retailers and department-store sectors in particular will drive growth into next year. Despite a still-cautious consumer, especially those in the lower-income demographic, many companies are benefiting from better operating efficiencies, improving U.S. GDP, higher consumer confidence and lower unemployment.

Landlords retain pricing power, bolstering rents. Re-leasing spreads continue to widen, partly because limited new development is bolstering landlords’ pricing power. Some small businesses are still feeling pressure, which adversely affects in-line store leasing and landlords’ ability to increase rents. However, more national tenants are moving into shopping centers, changing the complexion of these centers: Fewer individual mom-and-pop lessees remain, and many are becoming franchisees. Fresh retail concepts continue to spur new store openings. In order to increase traffic, malls and shopping centers are renting to a more diversified group of both domestic and international retailers, providing non-retail services that are unavailable on the Internet, such as restaurants, hair salons, craft stores, gyms and medical offices.

Development has increased in all sub-sectors (mall, shopping center, outlet), although mostly in the outlet sector, which has become a successful distribution channel for retailers in the U.S., in Canada and overseas. Redevelopment is making older malls and shopping centers more modern, service oriented and Internet friendly, as well as enlarging their footprint.

Bankruptcies among retailers such as A&P, American Apparel, Body Central, Cache’, RadioShack and Wet Seal—which have been on landlords’ watch lists for years—reduced occupancy for some retail REITs, yet they are still maintaining occupancies in the 90 percent range. Landlords view these bankruptcies as an opportunity to remerchandise their centers with better-quality retailers at higher rents.

E-commerce is growing, but brick-and-mortar is still king. Retailers are accessing multiple avenues to reach consumers by integrating stores and the Internet: the omni-channel experience. Although e-commerce sales increased by 15.1 percent in third-quarter 2015 over third-quarter 2014, compared with a 1.6 percent increase for total retail sales, the vast majority of retail sales (92.6 percent, or $1.2 trillion in third-quarter 2015) still take place in brick-and-mortar establishments. E-commerce sales made up a fairly small 7.4 percent of total sales in third-quarter 2015, but are driving significant change and remain a fast-growing segment of the industry, according to the U.S. Census Bureau’s third-quarter 2015 report. The fact that online retailers such as Warby Parker and Microsoft are leasing physical space signifies the value of bricks enhancing sales.

Retail REITs remain conservative. Most of the retail REITs are managing their balance sheets conservatively. The prevailing theme among retail REITs is simplicity: They are undertaking fewer joint ventures and maximizing property income and values through redevelopment, culling portfolios and taking advantage of the capital markets to finance upcoming maturities or acquisitions. The retail REITs we rate have maintained stable leverage metrics as a result of robust equity and unsecured debt issuance, cost containment and astute balance sheet management—fixed charge coverage has increased, while leverage has stabilized and secured debt hasdeclined (see chart above).