2020 was a roller coaster for large parts of the country’s economy, particularly for retailers and retail real estate. When the global pandemic spread to Canada early in the year and it became obvious that large parts of the economy would close or be put on hold, it was immediately clear to me that retail REITs in particular could be in deep trouble.
The Globe & Mail’s recent article on retail REITs, which I mentioned in a recent post (dated December 8, 2020), explained that investors big and small seemed to be treating all REITs the same, keeping valuations low across the board, even though the impact of the pandemic has not been the same across the industry—some REITs such as office and retail have been hit hard, while others such as residential REITs have experienced relatively minor impacts. The thing is, retail REITs were in trouble well before the pandemic—just slower moving, longer term trouble.
What am I talking about here?
A decline in bricks-and-mortar retail has been anticipated for years, as online shopping expands and big online retailers keep growing and growing. Retail landlords, in particular the REITs, have known for years that they had to start shifting away from retail and diversify their properties with other land uses, such as multi-unit residential. Some REITs did start a shift to residential but to only a small degree, while others were still exploring their options when the pandemic came and made that shift a much higher priority. (Obviously retail landlords have more immediate things to worry about at the moment, like survival, but the pandemic won’t last forever and the long-term challenges facing bricks-and-mortar retail will still be here after the pandemic is brought under control.)
What would I do if I was running a retail REIT? Because it has not been possible for retail landlords to completely change their business focus during the pandemic, I’m going to fire up my time machine and jump back a couple of years to before the pandemic and explain what I would have done if I was them, back then.
Here we go…
One large retail REIT which did start building multi-unit residential buildings before the pandemic focused on urban sites, presumably because they saw the high rents which urban projects achieve, and probably because they wanted big, prominent projects to prove to investors they were serious about diversifying.
In my opinion, instead of building upmarket condo and rental towers on marquee sites in downtown Toronto, this REIT should have used B-class rental buildings to intensify some of their suburban, low-density retail sites. These mid-priced buildings could have been developed faster, would have leased faster, would have had lower turnover (and therefore lower vacancies and lower turnover and leasing costs), and, ultimately, would have generated much more reliable revenue flows.
How does this work? Both urban and suburban sites benefit from high demand among households for new, good quality, purpose-built rental housing. Urban sites require high density since land values are high and that means they require high-rise towers. High-rises are expensive to build, so high rents are required. Suburban sites, by contrast, don’t always require high-density, so projects can be low-rise and mid-rise. These are less expensive to develop, so rents can be lower and more affordable to a wider range of prospective renters. Since most REITs have both urban sites and suburban sites, developing B-class buildings on suburban sites is the quickest way to diversify, intensify, and obtain reliable revenue flows.
B-class buildings in low-density sites might not be as impressive in the annual report, but would have been better for the bottom line and would have demonstrated to investors the sort of conservative steadiness REITs are supposed to be focusing on.
Of course, it’s easy for me to say these things since I’m not running a REIT, and I don’t own any shares of any REIT (anymore) so I can’t claim to be a concerned shareholder or investor. But I think it’s good advice for REITs for the reasons I’ve described. And I think it’s good advice for non-REIT developers too.