Retail REITs – Improving Fundamentals Support Stable Credit Outlook for Sector
- Dec 04, 2013
Real estate fundamentals for retail properties continued to improve this year, with occupancy, leasing spreads and renewals all rising, which bodes well for the credit ratings of retail REITs.
We do not expect to make material changes to our ratings or outlooks for the investment-grade retail REITs over the next year. The outlook is stable for 15 of the 18 retail REITs we rate and positive for two; the rating on one is on review with direction uncertain because of an impending merger.
Moody’s retail group’s outlook for U.S. retail corporate ratings is stable. Industry-wide operating income will grow at a moderate pace of 3.5 percent to 4.5% over the coming 12 to 18 months, although earnings are likely to be stronger, growing 4.5 percent to 5.5 percent, as sales stabilize at J.C. Penney and Sears and strengthen at others, such as Home Depot, Costco and Target.
Consumers continue to face mixed economic signals, however, despite signs of improvement, job creation remains slow, while wage growth is weak, making it difficult to predict which catalysts will drive consumer spending higher. Still, over the past two holiday seasons, Americans have largely ignored negative headlines about fiscal policy and have gone ahead with gift shopping, and we believe they will do the same this year. We expect fourth-quarter sales to grow 4.5 percent to 5.5 percent, compared with 4.2 percent in the fourth quarter of 2012, which compares favorably with ICSC’s forecast of a 3.4 percent increase for 2013 holiday sales.
Consumers will continue to focus on value. Performance among retailers has diverged significantly. Retailers operating at both ends of the value spectrum – luxury merchants on the one side, and home improvement, auto and parts retailers, discounters and dollar stores on the other side – are outperforming segments such as department stores, office supply and convenience stores.
Retail REITs’ properties tend to be above average quality. Many have long-term leases with solid occupancy, which supports relatively stable cash flows. “B” and “C” properties in secondary and tertiary locations with weaker tenants continue to perform worse than their “A” counterparts. National retailers, however, are showing more interest in leasing “B” space; at the same time, private investors have low-cost debt capital available to purchase these noncore properties.
Re-leasing spreads have widened this year, and dominant landlords have regained pricing power. Some small businesses are still feeling pressure, which adversely affects inline store leasing and the ability to increase rents. However, there are fewer mom-and-pop lessees and more national tenants are moving into shopping centers, changing the complexion of these centers. One positive for leasing is that fresh retail concepts continue to spur new store openings, as national retailers exploit the opportunity to open attractive stores in quality locations that failed retailers had previously occupied. The dearth of new retail development has allowed landlords to lease vacant space and regain pricing power. In addition, to remain viable, malls are reinventing themselves by renting to a more diversified group providing services that are not available on the Internet – not just restaurants, but also hair salons, crafts, gyms and medical offices.
 See Growth will Accelerate in 2014, but Mixed Economic Signals Will Restrain Momentum, Moody’s Investors Service, 29 October 2013.
Development is still restrained, consisting mostly of redevelopment except for the outlet sub-sector, which has become a successful distribution channel for retailers in the U.S., Canada and overseas. Simon opened its first outlet center in Toronto as part of its Calloway REIT JV; the Tanger/RioCan REIT is also constructing a number of centers in Canada.
Retail e-commerce sales constituted 5.9 percent of total retail sales during the third quarter of 2013, up from 3.6 percent in the second quarter, while total retail sales increased 1.3 percent. Third quarter 2013 e-commerce increased 17.5 percent from third quarter 2012, while total retail sales increased 4.7 percent. The prevailing notion among retailers is that bricks-and-mortar space and e-commerce are both fundamental elements of a successful omni-channel retail strategy, which is prompting some to downsize their store sizes, but maintain some store presence.
Some overseas investment has taken place, such as Simon’s investment in MacArthur Glen, its 2012 investment in Klépierre and its continued expansion of Asian outlet centers, as well as DDR’s in Brazil. However, Kimco is selling its South American interests to concentrate on its U.S. and Canadian portfolios. (The vast majority of the retail REITs’ portfolios are in the U.S.)
Most of the retail REITs are managing their balance sheets conservatively. The retail REITs we rate have maintained stable leverage metrics as a result of robust equity issuance, cost containment and astute balance sheet management. For the rated retail REITs, average secured debt/gross assets (20.1 percent for the third quarter of 2013) has declined and fixed charge coverage has increased (2.8x for 3Q13) the past three years on improved earnings and declining interest expense. Overall debt/EBITDA (7.1x at 3Q13) has increased slightly due to unsecured note issuance and the entry of new rated issuers such as CBL & Associates and American Realty Capital Properties, as the following exhibit shows.
 U.S. Department of Commerce, U.S. Census Bureau, Quarterly Retail E-Commerce Sales, 3rd Qtr 2013, 22 November 2013.