PECO - Strip Center REITs: Retail Apocalypse Is Over

2023-06-22 09:00:00 ET

Summary

• Strip Center REIT fundamentals have improved materially over the past year and continue to be underappreciated in the market as a decade-long “retail apocalypse” narrative has been tough to shake.
• The combination of near-zero new development and positive net store openings since 2021 has driven occupancy rates to record-highs and allowed Strip Center REITs to enjoy some long-awaited pricing power.
• These favorable property-level supply/demand fundamentals have translated into impressive double-digit rent growth spreads since mid-2022 and the best earnings “beat rate” of any property sector during that time.
• Despite several high-profile retail bankruptcies - including Bed Bath & Beyond and Party City - store openings have continued to outpace store closings by 50% so far in 2023, led by demand for space in large-format open-air strip centers.
• A "higher for longer" monetary environment may be ideal for well-capitalized Strip Center REITs with the balance sheet firepower to accretively consolidate as debt-dependent private owners seek an exit. Strip Center REITs remain some of our favorite names in the "sweet spot" of yield and dividend growth.

REIT Rankings: Strip Centers

This is an abridged version of the full report and rankings published on Hoya Capital Income Builder Marketplace on June 20th.

Strip Center REIT fundamentals have improved materially over the past year and continue to be underappreciated in the market as a decade-long “retail apocalypse” narrative has been tough to shake. The combination of near-zero new development and positive net store openings since 2021 has driven occupancy rates to record-highs and allowed Strip Center REITs to enjoy some long-awaited pricing power. While the enclosed regional mall format faces a choppy road to recovery, the versatility and larger footprint of the strip center format has been a winning formula as retailers have increasingly utilized their brick-and-mortar properties as hybrid "distribution centers" in last-mile delivery networks. In the Hoya Capital Strip Center REIT Index , we track the 17 strip center REITs which account for $60 billion in market value.

The combination of near-zero new development and positive net absorption since early 2021 has driven occupancy rates to record-highs and allowed Strip Center REITs to enjoy some long-awaited pricing power. Earnings results across the strip center REIT sector have been as impressive as any property sector since mid-2022, with a full recovery in both FFO and NOI now complete. As discussed in our REIT Earnings Recap , strip center REITs delivered the highest number of upward FFO revisions (7) of any REIT property sector in the first quarter - and occupancy rate trends and leasing spreads have been especially encouraging. Results in the first quarter pushed the average occupancy rate to the highest level on record at 95.2%, while rental rate spreads have exhibited a notable acceleration since bottoming early last year, averaging more than 10% for the past four quarters.

Critically, after a surge in store closings during the pandemic, retailers have been in 'growth mode' over the past 24 months, fueled in part by the stimulus-driven boom in retail spending and by increased levels of investment in brick and mortar channels relative to the late 2010s. Coresight Research reported that the number of store openings has outpaced closings by nearly 2x since early 2021 with particular strength in larger-format 'big box' and grocery-anchored strip centers. After surging to around 10,000 in both 2019 and 2020, just 5,000 retail stores shut down in 2021 while only 2,600 closed in 2022 - the lowest level of store closings on record. The evidence suggests that this slowed pace of store closings goes beyond the near-term COVID-related trends and is indicative of a sustained retailer focus on highly efficient and well-located large-format space which can serve as hybrid showroom/distribution centers.

After outpacing the REIT sector last year, Strip Center REITs have lagged in early 2023 due, in part, to the high-profile bankruptcies of Bed Bath & Beyond and Party City , which has fueled concern that the tighter monetary environment may push other troubled retailers over the edge or at least into cost-cutting mode. We've also seen several retail consolidations in the past several months that will lead to store closures, including Tempur Sealy's ( TPX ) planned merger with Mattress Firm . While an uptick in store closings and resumption of retail bankruptcies is expected following the record-low closure-rate in 2022, the majority of big box retailers and grocery brands remain in “growth mode” and have already scooped up many of the vacated BBBY locations, per recent REIT reports. Coresight has tracked 2,600 planned closures and 4,000 planned openings for 2023 with off-price and discount retailers leading the way for store openings including Dollar General ( DG ), Five Below ( FIVE ), and Family Dollar .

Importantly, after a development boom during the 1990s and early 2000s, a limited amount of new retail space has been created since the Financial Crisis and the retail development pipeline remains almost non-existent, declining another 12.1% in 2022 to its lowest level in nearly 20 years and remaining near record-lows in 2023. Despite that, the US still has more retail square footage per capita than any other country in the world, but the gap between total spending and square footage has narrowed rather significantly over the past half-decade. The majority of new retail development by strip center REITs has been through redevelopment or modest expansions of existing properties with only a handful of complete ground-up construction.

Meanwhile, the growing usage of alternative (and higher-margin) "delivery" options including in-store pickup, "curbside" pickup, and delivery-from-store have been a tailwind for well-located strip center REITs. Shopping centers have increasingly become hybrid distribution centers in a decentralized third-party delivery network powering "same-hour" delivery to challenge Amazon's ( AMZN ) dominance in ultra-fast delivery. The pandemic significantly accelerated retailers' investment in their in-store order fulfillment platforms which have evolved from a pure "click and collect" model into a multi-channel "last-mile" delivery network supplemented by delivery platforms like Uber ( UBER ), Postmates ( POSTM ), and DoorDash ( DASH ) as the food delivery model is becoming more ubiquitous across all retail categories.

Not all strip centers are equally well-suited for this evolution, however, and many retail locations lack the logistical infrastructure - location, parking, ease of pickup - to serve as hybrid fulfillment hubs. We believe that the longer-term outlook for most open-air strip centers remains far more promising than their regional mall REIT peers due precisely to their physical layout and strategic importance in the retail fulfillment network. Further, we believe that the "higher for longer" monetary environment may be ideal for well-capitalized Strip Center REITs with the balance sheet firepower to accretively consolidate as debt-dependent private owners seek an exit.

Strip Center REIT Fundamentals

Over the past seven REIT earnings seasons beginning with Q2 2021, Strip Center REITs have delivered the highest total quantity of full-year guidance increases and the positive trend continued in Q1 with seven of thirteen REITs that provide guidance raising their full-year FFO outlook. Kite Realty ( KRG ) was the upside standout this earnings season, raising both its full-year FFO and NOI growth outlook. Leasing activity was impressive, with cash leasing spreads of 38.0% on 17 new leases, and 10.0% on 77 renewals for a 13.0% blended increase. Brixmor ( BRX ) reported similarly strong "beat and raise" results, with rent spreads accelerating to 19.2% - its strongest in a half-decade. Regency Centers ( REG ) and Kimco ( KIM ) also raised their full-year FFO outlooks.

Strong leasing activity has been the positive highlight of the past several quarters and unlike their mall REIT peers, leasing volumes and rental rates have picked up considerably since early 2021. Encouragingly, leasing spreads stayed positive throughout the pandemic and meaningfully accelerated since mid-2021 with blended leasing spreads rising by over 7% for the seventh-straight quarter in Q1, indicating clear signs of pricing power for the first time since the mid-2010s. Notable upside standouts in Q1 on the leasing front once again included Kite Realty and Brixmor ( BRX ) - each delivering a seventh-straight quarter of double-digit leasing spreads - along with several small caps Whitestone ( WSR ) and Acadia Realty ( AKR ) - while recent REITweek updates show that the leasing momentum continued into the second quarter.

Unlike malls, the majority of strip center tenants - particularly grocery stores and "big box" retailers - remained operational as "essential businesses" even during the peak of the lockdowns. While mall REITs finally reported complete "normalization" in rent collection by early 2022, strip center rent collection rates fully normalized in the first half of 2021, up from an average of around 75% during the worst of the shutdowns in mid-2020. We noted early in the pandemic that, in exchange for rent deferrals, strip center REITs were able to negotiate non-monetary concessions including waiving co-tenancy clauses, lifting use restrictions, and extending lease terms and we believe that some of these modifications are beginning to bear fruit and - combined with the double-digit leasing spreads this year - provide a strong growth runway for mid-to-high single-digit average FFO growth in 2023.

Strip Center REIT Stock Performance

Strip Center REITs were the third-best-performing property sector in 2022 behind Casino and Net Lease REITs, but likely earned more recognition than they received as valuations still remain very attractive across much of the sector, particularly given their modest underperformance thus far in 2023. A common theme across the strip center sector over the past several years, new reasons for caution always seem to emerge just as investors were starting to feel confident in the outlook, but investors have been compensated for their patience with these REITs' hearty 4-6% dividend yields. Strip Center REITs are lower by 3% thus far in 2023 - slightly lagging the 0.7% advance from the Vanguard Real Estate ETF ( VNQ ).

Notably, Strip Center REITs delivered a second-straight year of outperformance in 2022, which followed a dismal stretch of five-straight years of lagging the broad-based REIT Index. Diving deeper into the company-level performance, Kite Realty was the lone Strip Center REIT to deliver positive total returns in 2022, but a handful of names were close behind, including Phillips Edison ( PECO ), Whitestone ( WSR ), and Federal Realty ( FRT ). The top-performer this year has been Urstadt Biddle Properties ( UBP ) on the heels of its acquisition by Regency Centers announced last month, which we'll discuss in more detail below. Retail Opportunity ( ROIC ) has lagged this year after reporting somewhat disappointing first-quarter results as its high level of variable rate debt exposure is expected to drag on FFO this year.

On that note, performance trends since the start of the pandemic closely mirrored balance sheet quality more than any other factor as the eight REITs with investment-grade S&P credit ratings have delivered double-digit outperformance relative to their non-investment-grade peers over this time. Balance sheet metrics - particularly the critical Debt/EV Ratio metric - have improved considerably as share prices have rebounded and all but two REITs - WSR and UE - is now trading with Debt Ratios below 50% - down from 15 at the end of 2020. REITs with relatively high levels of variable rate debt exposure include the aforementioned Retail Opportunity , Acadia Realty , and Whitestone REIT .

Strip Center M&A and External Growth

We may be seeing some revival of these animal spirits following a period of historically low levels of transaction activity, as last month Regency Centers - the second largest strip center REIT - announced a $1.4B all-stock deal to acquire Urstadt Biddle Properties at $20.40/share, a roughly 33% premium to UBP's prior closing price. Urstadt Biddle is a small-cap grocery-focused REIT that owns 77 retail properties concentrated around suburban New York City - of which roughly 85% are grocery-anchored - with the highest average base rent among the pure-play strip center REITs. The combined company - which will have a pro forma equity market capitalization of roughly $11 billion and a total enterprise value of $16 billion - will be comprised of 481 total properties encompassing 56 million square feet of gross leasable area. The transaction is expected to close late by Q4. Regency expects the deal to be immediately accretive to Operating Earnings.

Before the surge in interest rates over the past twelve months, the "animal spirits" had come alive across the strip center REIT sector with several mergers, two new listings, and the highest level of acquisitions since the mid-2010s. Kimco Realty ( KIM ) and Weingarten Realty closed on their merger in late 2021 while Kite Realty closed on its acquisition of Retail Properties of America in late 2021 as well. Last March, Cedar Realty was acquired by small-cap diversified REIT Wheeler Real Estate ( WHLR ). Two sizable new public REITs have emerged as well, graduating from the "non-traded" REIT ranks: InvenTrust Properties ( IVT ) went public through a "Dutch Auction" in late 2021 while Phillips Edison went public through an IPO in 2021 as well. Meanwhile, a pair of small-cap REITs that traded at persistent Net Asset Value discounts headed for the exits - recognizing significant shareholder value in the process: Retail Value ( RVI ) sold the majority of its portfolio in two separate transactions while Cedar Realty ( CDR ) sold the majority of its portfolio before being acquired by Wheeler.

Strip Center REIT Dividend Yields

Powered by a wave of sixteen dividend increases last year - a "perfect" slate of increases across the entirety of the sector - along with another four dividend hikes so far this year, strip center REITs now pay an average dividend yield of 4.5%, which is above the market-cap-weighted REIT sector average of 3.9%. Strip Center REITs pay out only about half of their FFO, leaving significant embedded upside potential for dividend growth - and a solid cushion for dividend protection if economic conditions take a turn for the worse. While strip center REITs have produced below-average dividend growth over the past half-decade, we believe that the headwinds of the "retail apocalypse" are beginning to shift favorably into moderate tailwinds for the strip center REIT sector.

Diving deeper into the sector, we note that dividend yields range from a sector-high of 6.34% from Saul Centers ( BFS ) to a sector-low of 3.31% from Phillips Edison . Notably, three REITs in the sector have recorded positive dividend growth over each of the one, three, and five-year time horizons - Regency Centers , Federal Realty ( FRT ), and Saul Centers. Also of note, Federal Realty's dividend hike this past year marked the 56 ^th consecutive year that FRT has raised its dividend - the longest record of consecutive annual dividend increases in the REIT sector.

Takeaways: Retail Apocalypse Is Over

Strip Center REITs fundamentals have improved materially over the past year and continue to be underappreciated in the market as a decade-long “retail apocalypse” narrative has been tough to shake. The combination of near-zero new development and positive net store openings since 2021 has driven occupancy rates to record-highs and allowed Strip Center REITs to enjoy some long-awaited pricing power. Despite several high-profile retail bankruptcies - including Bed Bath & Beyond and Party City - store openings have continued to outpace store closings by 50% so far in 2023, led by demand for space in large-format open-air strip centers. A "higher for longer" monetary environment may be ideal for well-capitalized Strip Center REITs with the balance sheet firepower to accretively consolidate as debt-dependent private owners seek an exit. We’re buyers on this recent underperformance and currently see strip center REITs as some of our favorite names in the "sweet spot" of value and growth with 4-6% dividend yields - while also being fundamentally well-positioned for a variety of potential economic scenarios.

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