Necessity Retail: The Battle Tested Retail Niche
By Jim Dillavou, Principal, Paragon Commercial Group
In 2017, I argued to a room full of hedge fund investors that the so-called “Retail Apocalypse” narrative was patently false when applied to a specific niche within retail: necessity retail. Investors were failing to distinguish between bad retail (that should fail) and good retail (that remained solid). Instead, they were electing to throw the proverbial baby out with the bathwater.
Since that time, necessity retail was further stressed by mandatory government shutdowns during the pandemic, e-commerce pressures, and now by the largest capital market adjustment since the GFC. And, yet, notwithstanding these headwinds, this battle-tested asset class continues to outperform. As the tide goes out and it becomes increasing clear who has been swimming naked, necessity retail is finally being recognized for its enduring characteristics: high barriers to entry coupled with steady, durable, and consistent returns.
Let’s pause for a quick refresher on two basic – and often forgotten or ignored – tenets of real estate investing. First, never confuse trading (short-term) with investing (long-term); and second, return on investment should always be measured against the risk assumed to generate that return.
Never Confuse Trading (short-term) With Investing (long-term)
Real estate is for investors, not traders. However, the vast majority of real estate investment theses are based around short-term external factors over which we have no control such as interest rates, inflation, supply chain and geopolitical concerns. This thinking suggests that real estate investors are attempting to make money by “timing the market,” notwithstanding the decades of data suggesting this strategy is a fool’s game.
Perhaps the desire to time the market is a result of private equity fund life pressures or perhaps more cynically it is the bonus driven incentive structure of most investment professionals. Regardless, it will always be a mismatch to overlay a short-term capital structure on long-term real estate assets, which are inevitably subject to unpredictable mark-to-market fluctuations.
Return on Investment Should Always Be Measured Against the Risk Assumed to Generate the Return
Volumes upon volumes have been written on the topic of measuring risk vs. return, and yet our industry repeatedly fails to digest this fact (or perhaps intentionally ignores it). Instead, real estate investors commonly chase yield without the offsetting concern for risk. This behavioral error is positively reinforced by lengthy investment cycles (such as the most recent one), which reward risky behavior by masking poor fundamental underwriting. Low risk and consistent return (the hallmark of real estate investing) is shunned as perceived risk is reduced to zero and only high returns are lauded.
Applicability to Necessity Retail
Necessity retail has re-emerged as a favored asset class because real estate investment fundamentals matter once again. Current yield matters. Contractual growth matters. Operational expertise matters. Cash flow matters. The once mundane is again en vogue. Taking risk and chasing yield has been replaced with solid, bottom-up underwriting. Necessity retail – with its perpetually high barriers to entry – continues to stubbornly produce consistent investment returns.
Warren Buffet often prophesizes that the most important thing in evaluating business is figuring out how big the moat is around the business. That is, how easy or difficult is it for others to replicate the business. “No formula in finance tells you that the moat is 28 feet wide and 16 feet deep. That’s what drives the academics crazy. They can compute standard deviations and betas, but they can’t understand moats,” Buffet said.
There are three main moats creating high barriers to entry into necessity retail: the operational moat, the capital moat, and the narrative moat.
The operational moat is comprised of deep tenant relationships, highly localized market knowledge, design and placemaking, rigorous asset management, knowledge of ever-evolving consumer sentiment and habits, and a thorough understanding of retailer prototypes, business plans, balance sheets and operational expertise.
The capital moat around necessity retail requires both flexible capital and comparatively small equity checks, the combination of which makes it extremely difficult to scale and therefore inefficient from an institutional capital deployment standpoint.
Lastly, the narrative moat refers to the “retail apocalypse” storyline that permeated retail for nearly a decade. This fear-inducing phraseology instilled a belief that e-commerce was swallowing all forms of physical retail, which would no longer be necessary and, therefore, all physical retail was dead. Non-necessity retail was certainly adversely impacted by the growth of e-commerce, however, the narrative was largely inapplicable to physical daily-needs anchored centers.
While digital channels, last-mile distribution and direct-to-consumer innovated the retail ecosystem, they have not replaced the efficiency, customer engagement, and brand loyalty that occurs in necessity-based retail stores. In fact, the term “omnichannel” was born to describe the multiple consumer touchpoints outside of the physical location, but which required the physical store to remain at the center of the retailer’s operational network. This was precisely the opposite of the death of the physical store: this was the recognition that the physical store was the intersection of the omnichannel ecosystem of the future.
Capital market fluctuation, overly simplistic narratives, and emotion are hallmarks of any investment landscape: and necessity retail is no exception. Like many before it, the trajectory of this past real estate investment cycle encouraged risk-on underwriting in pursuit of outsized returns as real estate competed for capital against other growth industries.
However, the market and the mentality have now changed. Risk is once-again weighed against reward and fundamental underwriting is the new normal as investors are searching for sustainable and dependable yield. Necessity retail has been battle tested and the results speak for themselves. With its moats intact and fundamentals strong, necessity retail has once again become a darling of the real estate investment community and is well-positioned for the foreseeable future.