Strip Center REITs: Bang For Your Buck

REIT Rankings: Strip Centers

This is an abridged version of the full report and rankings published on Hoya Capital Income Builder Marketplace on January 12th.

Flying under the radar amid recession concerns and the looming shadow cast by their persistently-troubled mall REIT peers, the outlook for strip center REIT has improved considerably over the past year as supply/demand fundamentals in the grocery-anchored and power-center formats are now quite a bit stronger than before the pandemic. While the enclosed regional mall format faces a choppy road to recovery, the versatility and larger footprint of the strip center format has been a winning formula as retailers have increasingly utilized their brick-and-mortar properties as hybrid “distribution centers” in last-mile delivery networks. In the Hoya Capital Strip Center REIT Index, we track the 17 strip center REITs which account for roughly $60 billion in market value.

The combination of near-zero new development and positive net absorption since early 2021 has driven occupancy rates to record-highs and allowed Strip Center REITs to enjoy some long-awaited pricing power. Earnings results across the strip center REIT sector have been as impressive as any property sector with a full recovery in both FFO and NOI now complete. As discussed in our REIT Earnings Recap, strip center REITs delivered the best “beat rate” of any property sector in the third quarter – and occupancy rate trends and leasing spreads have been especially encouraging. Results in the third quarter pushed the average occupancy rate to the highest level on record at 94.7% while rental rate spreads have exhibited a notable acceleration since bottoming early last year with double-digit average increases in 2022.

Critically, after a surge in store closings during the pandemic, retailers have been in ‘growth mode’ over the past 24 months, fueled in part by the stimulus-driven boom in retail spending and by increased levels of investment in brick-and-mortar channels relative to the late 2010s. Coresight Research reported that the number of store openings has outpaced closings by nearly 2x since early 2021 with particular strength in larger-format ‘big box’ and grocery-anchored strip centers. After surging to around 10,000 in both 2019 and 2020, just 5,000 retail stores shut down in 2021 while only 2,600 closed in 2022 – the lowest level of store closings on record. The evidence suggests that this slowed pace of store closings – particularly in the strip center format – goes beyond the near-term COVID-related trends and is indicative of a sustained retailer focus on highly efficient and well-located large-format space which can serve as hybrid showroom/distribution centers.

After outpacing the REIT sector last year, Strip Center REITs have lagged in early 2023 following the warning from Bed Bath & Beyond (BBBY) that its facing potential bankruptcy which renewed concerns that the tighter monetary environment may push other troubled retailers over the edge or at least into cost-cutting mode – a list of retailers that includes many of the “usual suspects” including Party City (PRTY), GameStop (GME), and a handful of mall-based retailers. While an uptick in store closings and resumption of retail bankruptcies is expected following the record-low closure-rate in 2022, but the majority of big box retailers and grocery brands remain in “growth mode” and are reportedly already eyeing potential vacated BBBY locations. Coresight has tracked 522 planned closures and 1,846 planned openings for 2023 with off-price and discount retailers leading the way for store openings including Dollar General (DG), Five Below (FIVE), and Family Dollar.

Importantly, after a development boom during the 1990s and early 2000s, a limited amount of new retail space has been created since the Financial Crisis and the retail development pipeline remains almost non-existent, declining another 12.1% in 2021 to its lowest level in nearly 20 years and remaining near record-lows again in 2022. Despite that, the US still has more retail square footage per capita than any other country in the world, but the gap between total spending and square footage has narrowed rather significantly over the past half-decade. The majority of new retail development by strip center REITs has been through redevelopment or modest expansions of existing properties with only a handful of complete ground-up construction.

Meanwhile, the growing usage of alternative (and higher-margin) “delivery” options including in-store pickup, “curbside” pickup, and delivery-from-store have been a tailwind for well-located strip center REITs. Shopping centers have increasingly become hybrid distribution centers in a decentralized third-party delivery network powering “same-hour” delivery to challenge Amazon’s (AMZN) dominance in ultra-fast delivery. The pandemic significantly accelerated retailers’ investment in their in-store order fulfillment platforms which have evolved from a pure “click and collect” model into a multi-channel “last-mile” delivery network supplemented by delivery platforms like Uber (UBER), Postmates (POSTM), and DoorDash (DASH) as the food delivery model is becoming more ubiquitous across all retail categories.

Not all strip centers are equally well-suited for this evolution, however, and many retail locations lack the logistical infrastructure – location, parking, ease of pickup – to serve as hybrid fulfillment hubs. We believe that the longer-term outlook for most open-air strip centers remains far more promising than their regional mall REIT peers due precisely to their physical layout and strategic importance in the retail fulfillment network. From a portfolio strategy perspective, Strip Center REITs are considered an “all weather” property sector that isn’t particularly exposed to any single macroeconomic risk factor – unlike net lease REITs which tend to be highly interest-rate-sensitive, or mall REITs which tend to be more economically sensitive.

Strip Center REIT Fundamentals

Over the past six REIT earnings seasons beginning with Q2 2021, Strip Center REITs have delivered the highest total quantity of full-year guidance increases and the positive trend continued in Q3 with twelve of thirteen REITs that provide guidance raising their full-year FFO outlook. Upside standouts included Kite Realty (KRG), which raised its full-year FFO growth outlook to 25.3% – up 330 basis points from last quarter – and is now on-pace to deliver total FFO growth of over 13% above the pre-pandemic 2019 baseline – the best in the Strip Center REIT sector. Kimco Realty (KIM) was also an upside standout, boosting its full-year FFO growth target to 14.5% – up 220 basis points from last quarter – driven by an acceleration in leasing spreads – and now sees its full-year FFO to be nearly 10% above the pre-pandemic baseline.

Strong leasing activity has been the positive highlight of the past several quarters and unlike their mall REIT peers, leasing volumes and rental rates have picked up considerably since early 2021. Encouragingly, leasing spreads stayed positive throughout the pandemic and meaningfully accelerated since mid-2021 with blended leasing spreads rising by over 8% for the fifth-straight quarter in Q3, indicating clear signs of pricing power for the first time since the mid-2010s. Notably upside standouts in Q3 on the leasing front once again included Kite Realty and Brixmor (BRX) – each delivering a fifth-straight quarter of double-digit leasing spreads – along with several small caps including Saul Centers (BFS), Acadia Realty (AKR), and Whitestone (WSR). Notably, recent pre-earnings updates show that the momentum continued into the fourth quarter. Urban Edge (UE) provided preliminary fourth-quarter metrics this week noting that it achieved rent spreads of 31% in the fourth quarter across 53 new leases and renewals totaling 788,000 SF.

Unlike malls, the majority of strip center tenants – particularly grocery stores and “big box” retailers – remained operational as “essential businesses” even during the peak of the lockdowns. While mall REITs finally reported complete “normalization” in rent collection by early 2022, strip center rent collection rates fully normalized in the first half of 2021, up from an average of around 75% during the worst of the shutdowns in mid-2020. We noted early in the pandemic that, in exchange for rent deferrals, strip center REITs were able to negotiate non-monetary concessions including waiving co-tenancy clauses, lifting use restrictions, and extending lease terms and we believe that some of these modifications are beginning to bear fruit and – combined with the double-digit leasing spreads this year – provide a strong growth runway for mid-to-high single-digit average FFO growth in 2023.

Total leased occupancy rates improved 130 basis points from the prior year and 40 basis points sequentially in Q3 with notable improvement in the quarter from Site Centers (SITC) and InvenTrust (IVT). Small-shop occupancy improvement has been a key contributor to the earnings beats in recent quarters – a trend that continued in Q3 with a 270 basis point average rise in small-shop leased occupancy – climbing to the highest levels since 2017. Kite Realty noted in its prior earnings call that its “still seeing a healthy appetite” for small shops despite the macro headwinds and noted that its occupancy is still over 300 basis points below the high-level mark prior to the pandemic “which shows a lot of growth yet to come.”

Strip Center REIT Stock Performance

Strip Center REITs were the third-best-performing property sector in 2022 behind Casino and Net Lease REITs, but likely earned more recognition than they received as valuations still remain very attractive across much of the sector. A common theme across the strip center sector over the past several years, new reasons for caution always seem to emerge just as investors were starting to feel confident in the outlook. Strip Center REITs declined 13% on a total return basis in 2022 – outpacing the 25% decline from the Vanguard Real Estate ETF (VNQ) and 18% decline from the S&P 500 (SPY).

Notably, Strip Center REITs delivered a second-straight year of outperformance following a dismal stretch of five-straight years of lagging the broad-based REIT Index. Diving deeper into the company-level performance, Kite Realty was the lone Strip Center REIT to deliver positive total returns in 2022, but a handful of names were close behind including Philips Edison (PECO), Whitestone (WSR), and Federal Realty (FRT). Laggards in 2023 included Acadia Realty (AKR) – which has a large urban street-level retail portfolio – and Urban Edge (UE) – which has a large coastal presence. Through the first two weeks of 2023, however, Strip Center REITs are among the laggards in the REIT sector amid the aforementioned concern over renewed retail distress.

Performance trends since the start of the pandemic closely mirrored balance sheet quality more than any other factor as the eight REITs with investment-grade S&P credit ratings have delivered double-digit outperformance relative to their non-investment-grade peers over this time. Balance sheet metrics – particularly the critical Debt/EV Ratio metric – have improved considerably as share prices have rebounded and all but one REIT – WSR – is now trading with Debt Ratios below 50% – down from 15 at the end of 2020.

Strip Center M&A and External Growth

Before the surge in interest rates over the past nine months, the “animal spirits” had come alive across the strip center REIT sector with several mergers, two new listings, and the highest level of acquisitions since the mid-2010s. Kimco Realty (KIM) and Weingarten Realty closed on their merger in late 2021 while Kite Realty closed on its acquisition of Retail Properties of America in late 2021 as well. Last March, Cedar Realty was acquired by small-cap diversified REIT Wheeler Real Estate (WHLR). Two sizable new public REITs have emerged as well, graduating from the “non-traded” REIT ranks: InvenTrust Properties (IVT) went public through a “Dutch Auction” in late 2021 while Phillips Edison went public through an IPO in 2021 as well.

A sharp disconnect had persisted between private market valuations of retail real estate assets and the REIT-implied valuation, forcing retail REITs to be net sellers of assets for nearly a half-decade. The tide a bit during the pandemic, however, as strip center REITs became net buyers for the first time since 2016, acquiring $6.6B in assets over the past year while selling $3.97B for a net positive total of $2.62B. Nevertheless, a pair of small-cap REITs that traded at persistent Net Asset Value discounts headed for the exits – recognizing significant shareholder value in the process: Retail Value (RVI) sold the majority of its portfolio in two separate transactions while Cedar Realty (CDR) sold the majority of its portfolio before being acquired by Wheeler.

Strip Center REIT Dividend Yields

Powered by a wave of sixteen dividend increases this past year – a “perfect” slate of increases across the entirety of the sector – strip center REITs currently pay an average dividend yield of 4.3%, which is well above the market-cap-weighted REIT sector average of 3.7%. Shopping center REITs pay out only about half of their FFO, leaving significant embedded upside potential for dividend growth – and a solid cushion for dividend protection if economic conditions take a turn for the worse. While strip center REITs have produced below-average dividend growth over the past half-decade, we believe that the headwinds of the “retail apocalypse” are beginning to shift favorably into moderate tailwinds for the strip center REIT sector.

Diving deeper into the sector, we note that dividend yields range from a sector-high of 8.12% from CTO Realty (CTO) to a sector-low of 3.33% from InvenTrust (IVT). Small-cap REITs generally offer dividend yields in the space including Saul Centers (BFS) and Urstadt Biddle (UBA) with yields of over 5.5%. Notably, three REITs in the sector have recorded positive dividend growth over each of the one, three, and five-year time horizons – Regency Centers (REG), Federal Realty (FRT), and Saul Centers. Also of note, Federal Realty’s (FRT) dividend hike this past year marked the 55th consecutive year that FRT has raised its dividend – the longest record of consecutive annual dividend increases in the REIT sector.

Takeaways: Solid Bang For Your Buck

For strip center REITs, the versatility and larger footprint of the strip center format have been a winning formula as retailers have increasingly utilized their brick-and-mortar properties as hybrid “distribution centers” in last-mile delivery networks. After a surge in store closings during the pandemic, the number of store openings has outpaced closings by nearly 2x since early 2021 with particular strength in larger-format strip centers. Favorable supply/demand fundamentals have translated into impressive double-digit rent growth spreads throughout 2022 and the best earnings “beat rate” of any property sector during the year. We’re buyers on this recent pull-back and currently see strip center REITs as some of our favorite names in the “sweet spot” of value and growth with 4-6% dividend yields – while also being fundamentally well-positioned for a variety of potential economic scenarios.

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Editor’s Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.