Retail’s COVID-19 Recalibration
By Justin Krieger, Principal at Pinnacle Real Estate Advisors
Investors have been worried about the demise of retail real estate for decades, and Amazon’s influence (among other factors) is something that most have been pricing in for years. A global pandemic, however, is not something most accounted for and is adding fuel to fire burning down retail. While there is hope that a COVID-19 vaccine will be available within the next year, the psychological scars affecting retail tenants and customers will likely last much longer and change the way we do business for a long time (and maybe forever). Therefore, retail investors and tenants will need to recalibrate the way they perceive risk in doing deals.
When evaluating a retail property, most investors consider the tenant’s rent to sales ratio (if it is available). It is in the best interests of the landlord and tenant to have a rent to sales ratio that allows the tenant to be profitable and continue to pay rent for the long-term. If the occupancy of the space is reduced, a tenant will serve fewer customers, resulting in lower sales and a reduced ability to pay rent. A pre-pandemic lease is unlikely to have any mechanism to recalibrate the rate, and a tenant may be stuck with it for years. Since many retail tenants survive on thin margins and have little savings, a bad month could spell disaster. Landlords should proactively evaluate how their tenants are doing to determine whether to make deals with them. If a tenant is struggling but could survive at a lower rate, then renegotiating the lease could make sense for both parties because an occupied space at a reduced rent is better than a vacant one (especially today).
When considering a purchase, investors now more than ever need to be very diligent about evaluating a tenant’s long-term viability and the ability to replace the rent. It is difficult to say where things could end up because this is such a black swan event, but it is likely that retail cap rates will increase as investors perceive substantially more risk than they did three months ago. Furthermore, it’s likely that a division will appear between tenants better-suited to a pandemic (e.g. fast food restaurants with drive-thrus) and those that are not (e.g. large, sit-down restaurants).
As Americans who were reluctant to shop online become addicted to its convenience, retail tenants must learn to balance attracting customers to their stores against following constantly changing health and safety protocols. That is a very difficult challenge, and retail tenants will likely be hesitant to move forward on deals as they realize the costs in opening a brick and mortar retail business may be high and the profits may be low. It is very possible that we will reflect upon this period of time and realize that we had way too much retail space.
It is likely that the retail market will be somewhat frozen for a period of time until investors and tenants feel like they are on solid ground to make decisions. Investors who recently took out high LTV loans may be the first ones to be forced to sell as their margin for error and ability to carry a property without receiving rent could be zero. Colorado, however, may be more stable than most other states because our positive migration trend could continue as Americans flee coastal markets (e.g. New York and California) and move here. Either way, 2020 will be an unforgettable year that most would like to forget.