First National Realty Partners is a private equity commercial real estate investment firm that specializes in the purchase and management of grocery store anchored retail shopping centers. Given the seismic shifts in retail shopping behavior over the past decade – driven by the rise of e-commerce – we are occasionally asked “is owning a shopping center profitable?”
The short answer is…it definitely can be. But, it takes a tremendous amount of effort, a rigorous property selection process, and proactive property management. In this article, we will provide some insights into our investment process and the characteristics that we look for to maximize the chances of a profitable shopping center investment.
How Do Shopping Centers Make Money?
Like any commercial property, shopping centers make money from two sources, lease income and sales proceeds.
In a typical configuration, a shopping center is filled with retail tenants, each of whom are contractually bound by a lease agreement to pay a certain amount of rent each month. Depending on the specifics of the lease, the tenant may also be required to pay a certain portion of the shopping center’s operating expenses. These sources, combined with ancillary fees produce a property’s Gross Income. The difference between Gross Income and operating expenses is known as Net Operating Income and this is the first measure of a retail property’s profitability.
While rent payments can produce a steady stream of income, the largest portion of the investment return tends to come from the profit when the property is sold. The sales price of a retail space is a function of the tenants in the center (particularly the anchor tenant), the length of time left on their leases, the demographics of the market in which it is located, and the characteristics of the property itself like the size of the parking lot and the amount of foot traffic that it receives. If the property is managed well and the market is strong, profits can be significant and deliver a strong return to investors.
So, the combination of regular lease income and profits upon sale is how a shopping center makes money. How much is another question entirely.
How Much Money Does a Shopping Center Make?
The answer to this question is that it… depends. The amount of money a shopping center can make is highly dependent upon several factors. They include:
- Class: Commercial property classes are graded from A – D. Class A properties are the newest and the best. Class D properties are the oldest and in need of the most work. B and C are in between. It may be counterintuitive, but Class A properties tend to be the least profitable because they are the least risky. Class C and D properties have the potential to be the most profitable, but they also have the most risk and the most variability in potential returns.
- Location: A property with a good location can be more profitable than one with a bad location. This is because the increased car and pedestrian traffic count attracts higher quality tenants, which means the property owner can demand higher rent. For example, a property in New York is likely to sell for a higher price than a similar property in Nebraska, in part due to the better location.
- Tenants: A property with high quality tenants – meaning there is little doubt about their ability to pay rent – commands a higher sale price than one with lower quality tenants. Tenant quality is particularly important for the anchor stores that occupy a high percentage of the space in the property. In addition, a property with high levels of tenant occupancy will command a higher price than one with low levels of occupancy.
- Lease Terms: Properties with tenants who have long terms left on their leases will sell for a higher price than one with tenants that have little time left on their leases. This is because longer lease terms means steady cash flow (less risk) over longer periods of time.
- Lease Rates & Expenses: Fundamentally, a retail center is similar to a small business. Lease income is like sales and operating expenses for things HVAC repairs, taxes, insurance, and landscaping are like the cost of goods sold. Higher lease rates and lower operating expenses equals more net operating income, which is key to a highly profitable investment.
With these factors in mind, the annual return on a shopping center investment typically ranges from 5% to 20%+. At the lower end of the spectrum are the highest quality properties for which there is little credit risk and a high degree of confidence that the rent will be paid each month. At the higher end of the spectrum are value-add properties with some risk and a somewhat higher level of potential income variability. Real estate investors should take note of these attributes and only invest in properties that match their level of risk tolerance.
Given the risk/return profile, the next most logical question for a potential investor to ask is, “are shopping centers a good investment?”
Are Shopping Centers a Good Investment?
Rather than focus on whether or not shopping centers are an objectively good investment, it is better to reframe this question around whether a shopping center investment is a good fit for a given individual’s personal strategy. To do this, it is helpful to point out the pros and cons of a retail shopping center investment.
There are a number of benefits to investing in a retail shopping center. They include:
- Income: As long as the property produces more income than expenses (including debt service), any money left over is distributed to investors on a regular basis. These distributions can produce a steady stream of income for investors.
- Depreciation & Favorable Tax Treatment: A property’s operating expenses are written off against its income, which reduces overall tax liability. In addition, capital gains taxes can be deferred using a type of real estate transaction known as a 1031 Exchange.
- Reduced Risk: Even in an environment with falling retail sales, there are plenty of ways to invest in a shopping center with a low level of risk. The most common way to do this is to ensure that the shopping center is filled with tenants who sell essential goods, like grocery stores, and experiences like a high end movie theater or hair salon. These types of retailers tend to be more resilient during economic downturns and more resistant to e commerce driven change.
- Simplicity: From a management standpoint, shopping centers tend to have a bit more simplicity given their relatively low number of tenants. For example, even a large shopping center may have just 20 or 30 tenants. An institutional multifamily property could have 300+ tenants, which adds a layer of complexity to property management.
But, like anything, there are also potential downsides to consider.
The potential downsides to a retail shopping center investment include:
- Maintenance: Institutional grade retail shopping centers are large buildings with many mechanical systems that need to be maintained. This is particularly true of older properties where some of these systems may require major upgrades. These types of upgrades can be very expensive and can impact returns if not planned for.
- Market Risk: Rental rates and sales prices are constantly changing. An economic downturn can cause them to decline, which can have a negative impact on property returns.
- Credit Risk: When leasing a retail storefront to a potential tenant, the primary concern is their ability to pay the rent. If they can’t or won’t, the property’s income and returns could suffer. This risk underscores the need to perform a significant amount of due diligence on each tenant and their retail business prior to making an investment.
Potential risks must be measured against the benefits to ensure the risk profile of the investment is a good fit for the investor’s strategy.
Retail Trends in 2021 and Beyond
Shopping center investments are made for the long term. As such, it is necessary for investors to spend a significant amount of time thinking about the trends shaping the future of retail stores and how they may impact investment strategies. Here are 5 trends we are watching:
- Omnichannel Sales: Successful retailers can no longer sell through a physical storefront alone. They need to sell through all channels available to them including the physical storefront, their own website, through third parties, and even through social media applications.
- Omnichannel Delivery: The COVID 19 pandemic required many retailers to rethink the entire shopping experience. For the sake of convenience and safety, they now need to deliver their products through multiple channels as well. This includes options like in person pickup, curbside pickup, and home delivery. For many retailers this may mean taking some square feet away from the sales floor and converting it into distribution space.
- Social Commerce: Social commerce is the act of selling products through social media channels. With many of the applications, the shopping experience is integrated and seamless.
- More Augmented Reality: Retailers are increasingly using augmented reality tools to improve the shopping experience. For example, home improvement stores can use them to allow a customer to visualize paint colors on the wall or clothiers could use them to allow customers to virtually try on their clothes.
- Focus on Safety: One of the major changes that is expected to linger after the pandemic is over is an increased focus on safety and cleanliness. These protocols include things like hand sanitizing stations, one way aisles, partitions for cashiers, and buy online, pickup in store options.
Retailers who embrace these trends will build continued customer loyalty and stronger brands, both of which bode well for a shopping center’s investment performance.
Summary & Conclusions
Yes. Owning a shopping center can be profitable. However the amount of profitability is highly dependent upon the price paid for the property, the efficiency of management, and the characteristics of the center itself. If all goes according to plan, shopping center investors can expect an annual return in the range of 5% – 20%, based on the factors described above.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate (CRE) investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
IF you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.