A presentation by IREI of their 2008 Plan Sponsor Survey shows that institutional investors are expected to increase their allocations to commercial real estate in 2008, yet the retail property type is increasingly viewed as unattractive. TWR believes that it is unwise for investors to overlook this sector; despite current risks to the economy and the fundamental performance of retail properties, this sector can still play an important role in institutional portfolios.

With the decline of the housing market over the past year, investors have started to worry about similar downturns in the retail sector. The fear is that the assumed source of 2005-2006's surging retail spending is evaporating or even turning negative, and that tenant demand in the sector will falter. This fear is misplaced in a number of ways.

First and foremost is the assumption of the source of the surging retail sales seen in 2005 and 2006. Many analysts simply assumed that growing household wealth in the form of increasing home values was behind the growth in retail sales. If this translation of wealth to consumption were true, the retail sector performance we've seen in recent years would have been much more robust.

In a study presented at TWR's annual Client Conference in 2007, it was shown that from 2000 to 2006, housing values rose from $12 trillion to $20 trillion, with equity rising from $7 trillion to $15 trillion. Consumers increased mortgage debt from $5.0 trillion to $9.3 trillion, though the leverage rate increased only slightly, from 42% to 46%. This leaves $4.3 trillion of wealth to go elsewhere. During the same time frame, personal consumption rose from $7 trillion to $9.2 trillion, an increase very close to the increase in personal disposable income. Just $400 billion or so of the increase in personal consumption is not explained by increasing personal income, and must have come from increased household wealth. This type of ratio, $400 billion of new spending out of $4.3 trillion in increased wealth, is in line with macroeconomic studies of household consumption patterns, with household spending patterns typically changing in response to changes in income, rather than to changes in wealth.
 

Retail Sales: Housing Related vs. Non-Housing-Related 

Source: U.S. Census.

 
Where did most of this extra household wealth go then, if not to sharp increases in consumer spending? In aggregate, the destination of this extra wealth is not entirely measurable, but some of it clearly ended up being reinvested into homes. Some of this reinvestment was in the form of second homes in resort locations, but another major component includes the improvements that many homeowners undertook in recent years. The refurbishment and upgrade of older homes was on such a tear in recent years that it inspired a whole slew of new television shows addressing the phenomenon. As the chart above shows, the fastest growing component in retail sales between 2003 and 2006 was in this housing-related segment of the market.

This boom in home improvement clearly benefited some more than others, with retailers such as The Home Depot happily providing as homeowners sought out and invested in new fixtures such as granite countertops. As home values increased, homeowners were excited about continuing to add to these investments; as values fall, however, such excitement abates. Other retailers such as CVS or Ralph's simply did not tap into the sales related to reinvestment in homes, instead servicing non-housing-related needs.

As the market was in an upswing, the performance of the housing- and non-housing-related retailers varied, and they are likely to vary as the economy slips as well. Given their lower exposure to those retailers that service the home improvement market, TWR expects neighborhood and community centers to better weather any downturn in home reinvestment.

This is not to say the neighborhood and community centers will not face difficulties as the economy slows. As job growth slips and households change their consumption and savings patterns in response to the economic slowdown, neighborhood and community centers will face a slowdown in income growth. TWR is forecasting average annual rent growth of only 2.4% per year over the next five years—just below the average pace of inflation.

This rent growth is better than some are expecting for the sector, as it is feared that falling home values will take the wind out of consumption as a whole. Remember though, that households tend to spend more out of income than out of wealth, and with unemployment rates still at record lows (5% is low) there is still positive pressure on wages in the U.S. economy. So long as the falling construction jobs do not weigh too heavily on the labor markets, ongoing wage growth should keep income up and consumption with it.

Given the leases negotiated at most shopping centers over the last six years, this modest annual 2.4% rent growth will be enough to provide for stable income growth in the sector. Given this stability in income, investments in this neighborhood and community segment of the retail sector can benefit an institutional portfolio. Compared to investments in other commercial property asset types, across markets there is far less uncertainty about future returns.

As shown in the chart below, TWR calculates that the margin of error around future returns is the lowest for the retail sector. We develop these measures of risk for future returns by joining knowledge of a market's current trends in investment returns with some probabilistic outcomes from our market fundamentals forecasts, in a manner similar to a Monte Carlo simulation.

The chart shows that on average, returns for the retail sector over the next five years have a margin of error of ±200 basis points (bps). Each dot on the line represents an individual market and some metropolitan areas are more risky, some with a 600-bps margin of error and others are less risky with a margin of error below 100 bps. By contrast, the average risk or margin of error in the retail sector is smaller than the minimum risk in the Hotel and Office sectors. The total return going forward for the Hotel and Office sectors can be higher than that for retail in many of these markets, but with the stability in the income streams, the risks around these returns are, on average, far lower for the retail sector.
 

Return Risks across Property Types

 
Assumptions that the surge in retail sales seen in 2005-2006 was based solely on rising housing equity are incorrect. Although some of the housing windfall went into retail sales, the allocation was nowhere near 1:1 and not all retail outlets are created equal. While shopping centers with home improvement tenants such as The Home Depot or Lowe's might be adversely affected by the housing decline, the corner grocery store or pharmacy will not be hit as hard.

Given these disparate risks, certain retail subtypes such as neighborhood and community centers can be expected to continue to perform, even as other sub-types aimed at discretionary spending falter. Furthermore, the comparatively stable nature of the income streams from retail investments can provide benefits for the portfolios of institutional investors. Given the slowdown in the economy, adding more retail to a portfolio is certainly not a way to hit for the fences but, with the stable nature of investments in the retail sector, investments in retail at this time can help to build up the yield-driven portion of an institutional portfolio.