Finding Stable Real Estate Investments In An Unstable Economy
The combination of pre-pandemic trends, the coronavirus-triggered recession, and government-imposed economic shutdowns resulted in more than three dozen major retailers in Chapter 11 in 2020, and weakened or jeopardized many more.
At the same time, certain retailers actually thrived during the pandemic and the resulting economic turmoil as they focused on essential goods and services. Necessity-based, net-leased retail properties such as pharmacies, grocery stores, discounters and healthcare providers have been the most resilient real estate asset class over the past year. This trend occurred not only during the pandemic, but also in the face of other crises and economic downturns such as the Great Recession of 2008-2010.
Retail properties with long-term net leases backed by financially strong companies doing critical business offer unique benefits that can result in a more stable investment experience, even in the midst of economic downturns and recessions. The key to taking advantage of this particular type of real estate investment is understanding the various factors that can lead to pandemic and recession resilience and making sure those factors are present in the real estate investments you are purchasing.
The Principles of Pandemic Resilient Real Estate
An investment in rented retail property is largely based on a tenant’s financial strength and their ability to profitably deliver goods and services to meet consumer demand. It is therefore important to ensure that your tenant has strong financials and business activities so that they can meet their leasing obligations in the face of economic crises and recessions. Likewise, it is imperative that your tenant’s business meet the ongoing needs of consumers regardless of economic circumstances.
Traditionally, this type of property is known as on-demand retail because it often involves the provision of goods and services that people rely on throughout all parts of the market cycle. More recently, as a result of the COVID-19 crisis, this type of property has come to be known as essential real estate, based on the government’s designation of businesses that were allowed to stay open while all other parts of the economy were forcibly closing.
In contrast to a normal recession, the difference between discretionary retail (“want to have”) and essential retail (“must have”) has been intensified by the pandemic. According to CBRE’s third quarter 2020 US retail figures, retail stores with discretionary experience such as full-service restaurants, fitness centers, and movie theaters have been hard hit by the pandemic, while retailers such as grocery stores, pharmacies, and fast vendors have had a need for restaurants with take-out options , has done very well.
These differences in performance were due not only to the fear and uncertainty of the pandemic, but also to the fact that so many other businesses were forcibly shut down by government mandates. In the second half of 2020, retailers who were allowed to stay open saw a significant increase in demand for their goods and services. According to a brand intimacy study by marketing agency MBLM, consumers have increased their spending on personal care products, liquor, and home repairs.
Targeting major retailers is one of the key ingredients in securing a stable income from your real estate investments that can be both pandemic and recession resistant.
Corporate-backed leases to investment grade companies
When renting a property to a national retailer, it is important to make sure that the rental payments made to you are supported by companies. This means that they are guaranteed by the national company and not a franchise or location specific company. This ensures that you get your rental payments regardless of the performance of a particular location through the business and financial strength of the entire national company.
In addition to having the right company-supported lease structure, the financial strength of the tenant guaranteeing your lease must be able to weather economic crises. A key indicator of a tenant’s financial strength is their corporate creditworthiness. Company ratings issued by third-party agencies such as Standard & Poor’s or Moody’s assess the default risk for corporate bonds. Over a 10-year period, companies with investment grade ratings from S&P or Moody’s were 10 to 11 times less likely to default than companies with non-investment grade or speculative / junk ratings.
By targeting leases backed by investment grade companies that are also considered essential, you can get the best of both worlds – a tenant who is financially strong now and more likely to stay strong in the future remains a result of the provision of needs-based or essential goods and services.
But what about the rise of online trading? Does the “Amazon Effect” mean the death of the retail trade? According to the US Census Bureau, the percentage of retail sales from e-commerce followed a steady trend line. In the first quarter of 2018, 9.6% of retail sales were from online purchases. Retail sales had increased to 11.8% in the first quarter of 2020 due to e-commerce and rose to 16.1% of total retail sales in the second quarter of 2020 due to shelter-in-place orders imposed by the pandemic and the government.
It is clear that online trading will stay here and is likely to continue to grow. Even in the first wave of COVID-19, when lockdowns were toughest across the country, roughly 84% of retail sales were in brick and mortar stores. Even when the government ordered entire retail sectors to be closed, an overwhelming majority of retail sales in the United States were indoors, not websites.
In addition, it should be noted that the grocery, pharmacy and discount retailers also saw record growth over the same period, showing that online retail growth is primarily at the expense of discretionary rather than on-demand retail. When it comes to groceries, medicines, discount goods, agriculture, home improvement, and healthcare, people prefer and are often critically dependent on instant access and personalized service. Online retail cannot replace that. However, for discretionary items such as clothing, electronics or entertainment where personal experience is not that important, online retail can be expected to continue to gain market share.
The focus on business-supported, needs-based retail stores that are rented to major investment-grade tenants provides better protection against the threat of e-commerce in addition to resilience to crises and recessions.
Location, location, location
Ultimately, the three most important factors of real estate remain location, location, location. In addition to all of the other factors mentioned in relation to tenant strength, it is crucial to focus on properties with strong local demographics, high population, high traffic, low crime, etc. Strong locations offer a much greater likelihood that the tenant will succeed in that location and attempt to renew their lease later. And even if a tenant does not renew their lease, a strong location offers much better potential to find a suitable replacement tenant to rent out your property.
While discretionary retail will continue to struggle in the face of e-commerce, crises, and recessions, on-demand retail investments remain and have consistently been the most recession-resistant real estate asset class you could choose. By combining all of the factors of on-demand goods and services, key lines of business, national company-backed lease guarantees, investment-grade credit, and solid locations, you can generate stable revenues that are more likely to withstand future crises and economic downturns.
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