Finding Stable Real Estate Investments In An Unstable Economy

The combination of pre-pandemic trends, the coronavirus-driven recession, and the government-imposed shutdowns of the economy drove more than three dozen major retailers into Chapter 11 in 2020, and weakened or imperiled many more. 

At the same time, certain retailers actually thrived during the pandemic and resulting economic turmoil due to their focus on essential goods and services. Necessity-based, net-leased retail real estate, such as pharmacies, grocery stores, discount retailers, and healthcare providers, have been the most resilient real estate asset class over the last year. This trend occurred not only during the pandemic, but also in the face of other crises and economic downturns like the Great Recession of 2008-2010.

Retail properties that feature long-term net leases that are backed by financially strong companies that operate essential businesses provide unique advantages that can result in a more stable investment experience, even in the midst of economic crises and recessions. The keys to benefitting from this particular type of real estate investment are to understand the different factors that can lead to pandemic-resilience and recession-resilience and to ensure that those factors are present in the real estate investments you acquire.

The Principles of Pandemic-Resilient Real Estate

An investment in net-leased retail real estate bases most of its return expectation on the financial strength of a tenant and its ability to profitably deliver goods and services to satisfy consumer demand. Therefore, it is imperative to ensure that your tenant has strong financials and operations so it can continue to meet lease obligations even in the face of economic crises and recessions. It is likewise imperative that your tenant’s business caters to the ongoing needs of consumers regardless of economic circumstances.

Traditionally this type of real estate has been known as necessity-based retail, since it often features the provision of goods and services that people depend on throughout all parts of the market cycle. Most recently, as a result of the COVID-19 crisis, this type of real estate has come to be known as essential real estate, based on the government’s designation of businesses that were allowed to remain open while all other parts of the economy were forcibly shut down.

Essential Retailers

Unlike an ordinary recession, the difference between discretionary retail (“want to have”) and necessity retail (“need to have”) was heightened by the pandemic. According to CBRE’s Q3 2020 U.S. retail figures, discretionary experience retail, such as full-service restaurants, fitness centers, and movie theaters, were hard-hit by the pandemic, whereas necessity retailers, such as grocery stores, pharmacies, and quick-service restaurants with take-out options, did very well.

This disparity in performance was not only due to the fear and uncertainty of the pandemic, but was also coupled with the fact that so many other businesses were forcibly closed by government mandate. During the second half of 2020, the retailers that were allowed to remain open actually saw a significant increase in demand for their goods and services. Consumers increased spending for personal care products, spirits, and home repair, according to a brand-intimacy study by marketing agency MBLM.

Targeting essential retailers is one of the key ingredients to securing stable income from your real estate investments that can be both pandemic-resilient and recession-resilient.

Corporate-Backed Leases to Investment-Grade Companies

When you lease a property to a national retailer, it is important to ensure that the rent payments being made to you are corporate-backed, meaning that they are guaranteed by the national company and not by a franchise or location-specific entity. This ensures that you are getting your rent payments backed by the operations and financial strength of the entire national company regardless of the performance of any particular location.

In addition to getting the right corporate-backed lease structure, the financial strength of the tenant that is guaranteeing your lease must be able to weather economic crises. A key indicator of a tenant’s financial strength is their corporate credit rating. Corporate credit ratings, issued by third party agencies such as Standard & Poor’s or Moody’s, evaluate the risk of default for corporate bonds. Over a 10-year horizon, companies with investment-grade ratings from S&P or Moody’s have been 10 to 11 times less likely to default than companies with non-investment-grade or speculative/junk credit ratings.

Targeting leases that are backed by investment-grade-rated companies that are also deemed essential allows you to get the best of both worlds—a tenant that is financially strong right now and that has a higher likelihood of continuing to be strong in the future as a result of providing necessity-based or essential goods and services.

E-Commerce Activity

But what about the rise of online retail? Does the “Amazon effect” mean the death of retail? According to the U.S. Census Bureau, the percentage of retail sales from e-commerce followed a steady trend line. In Q1 2018, 9.6% of retail sales were a result of online purchases. In Q1 2020, the number of retail sales due to ecommerce had risen to 11.8% and then jumped to 16.1% of all retail sales in Q2 of 2020 as a result of the pandemic and government-imposed shelter-in-place orders.

Clearly, online retail is here to stay and will likely continue to grow. However, even in the first COVID-19 wave, when lockdowns were at their most stringent across the country, approximately 84% of retail sales still took place in brick-and-mortar stores. Even as the government ordered whole sectors of retail businesses to close, an overwhelming majority of retail sales in the U.S. took place in buildings, not on websites.

Additionally, it should be noted that grocery, pharmacy, and discount retail also saw record-breaking growth during this same period, showing that the growth of online retail is primarily at the expense of discretionary rather than necessity-based retail. When it comes to groceries, medicine, discount goods, agriculture, home improvement, and healthcare, people strongly prefer, and often critically depend on, immediate access and in-person service. That is something online retail cannot replace. However, for discretionary items like clothing, electronics, or entertainment, where in-person experience is not as crucial, online retail can be expected to continue to grow in market share.

Targeting corporate-backed, necessity-based retail leased to investment-grade, essential tenants provides greater protection against the threat of e-commerce, in addition to resilience in the face of crises and recessions.

Location, Location, Location

At the end of the day, the three most important factors of real estate remain location, location, location. On top of all of the other factors mentioned regarding the strength of the tenant, it is of critical importance to focus on properties with strong local demographics, high populations, high traffic counts, low crime rates, etc. Strong locations provide a much greater likelihood that the tenant will be successful in that location and seek to renew their lease down the road. And even if a tenant does not renew their lease, a strong location provides a much better potential for finding a suitable replacement tenant to lease your property. 

Conclusion

While discretionary retail will continue to struggle in the face of e-commerce, crises, and recessions, necessity-based retail investments are here to stay and have consistently been the most recession-resilient real estate asset class you could select. By combining all of the factors of necessity-based goods and services, essential businesses, national corporate-backed lease guarantees, investment-grade credit, and solid locations, you can achieve stable income that is more likely to weather future crises and economic downturns.

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