The Resilient Pillar of Commercial Real Estate

Only a few years ago, the news suggested that the grocery sector would be swallowed up by e-commerce, but that hasn’t happened yet. In fact, brick-and-mortar grocery stores are doing better than ever, thanks to the pandemic. And, despite today’s challenging market for deals and financing, grocery-anchored shopping centers have found their place with investors. The industry is bullish on grocery-anchored centers and views them as a buffer from economic headwinds due to the necessity of goods they provide – food. This has translated to frequent, consistent visits, higher foot traffic, and immunity from disruptors and market headwinds.

The Rise of Grocery-Anchored Retail

Sentiment on shopping centers has flipped over the last few years. In the early days of the pandemic, grocery-anchored retail was dismissed because of the assumption that e-commerce would vastly expand and reduce the need for the mass amount of square footage a grocery store requires. However, consumer preferences and shopping habits, plus the additional challenges of running a profitable delivery service, have solidified the strategy of investing in grocery-anchored retail as a specific asset class. Grocery is a high-volume, low-margin business which has historically been less prone to the disruption of e-commerce.

Where Do Grocery Pickup and Delivery Stand?

Major grocery stores have shifted focus towards strengthening and broadening their in-house grocery pickup and delivery operations, diminishing their dependence on marketplace firms and e-commerce service providers. The reason for this shift lies in realizing that efficiently and cost-effectively delivering groceries is challenging. The significant transportation expenses make it exceedingly tough for delivery companies to generate profits, and consumers are generally averse to paying substantial delivery fees.

While establishing and expanding their proprietary online platforms, major grocery chains also reduced their reliance on marketplace companies and e-commerce providers like Instacart, DoorDash, and Uber Eats.

Increased Foot Traffic

Grocery-anchored centers have joined the darling asset classes of industrial and multifamily as a favored place to plant capital. Investors are targeting these properties as traffic to grocery stores has increased and shoppers walk through the door’s week-after-week. For example, some of Westwood’s largest centers have clocked six million visits a year. New investments in grab-and-go food options have generated more traffic and returning shoppers.

Another current market challenge revolves around uncertainty regarding the return to traditional office work. The work-from-home trend that persisted after the pandemic led to an increase in mid-day and mid-week grocery store visits by remote workers between meetings. These additional visits resulted in higher purchases, boosting the operations performance of grocers and nearby daily needs retailers. Interestingly, the return of some workers to offices has not significantly deterred foot traffic at grocery stores, especially in suburban areas. These predominantly suburban sites are poised to increase in value as suburbs regain popularity and growth in the Sunbelt region continues.

Grocery-anchored retail centers have some of the highest occupancy levels and generate consistent foot traffic. As such, retailers’ demand for space in grocery-anchored centers continues to expand.

Current Pricing

There has been a significant shift from high-end shopping centers to something much more pedestrian, such as neighborhood centers, due to the experience and convenience provided. Many grocery-anchored neighborhood centers are still aggressively priced. Going-in cap rates have moved upward to an average of 6.5% with sub B quality sites at or above a 7.05% cap rate. In addition to risk-adjusted returns, the market is focused on basis, and believing in value creation. Some larger centers are still priced high and have a better going-in yield. Demand for grocery-anchored assets under $50M is still high and aggressive with all cash-buyers.

Shopping centers with prominent brands such as Whole Foods, Sprouts, and Erewhon tend to boost property value. However, there’s value expanding for various discount and regional chains as anchor tenants. Examples of these chains include ALDI, H-E-B, and Publix. In the Midwest region, shopping centers anchored by these tenants demonstrate the most robust returns, typically trading at an average of 80 bps wider.

Owners and buyers of less desirable sites can upgrade facilities relatively cheaply. A few million dollars spent on landscaping, façade improvements, and carving out space in the parking lot for pickup online orders can bring aging centers up to par.

In-Line Tenants

Recent changes in the tenants that occupy the smaller retail spaces adjacent to the grocery anchor indicate increased profit opportunities for property owners. Businesses like dry cleaners, impacted by the rise in remote work and decreased formal attire, are making way for tenants with a stronger emphasis on health and fitness. This includes establishments like yoga studios, bicycle shops, health stores, nail salons, and hair salons. Further, changes in dining and fast-casual establishments attract more foot traffic and boost overall consumer spending.

Fundamentals like linear feet and neighboring freeway visibility/accessibility are becoming as important as healthy rental rates.

Navigating Market Headwinds

Like other segments in commercial real estate, transactions have been influenced by the current state of the economy and ongoing financial and banking challenges. Private capital has played a more significant role as financing has become harder to secure. Still, very few grocery-anchored centers have been developed over the past decade, creating high demand in expanding markets across the Sunbelt region. This scarcity makes them a sought-after opportunity for real estate investors, as new supply is limited, and investors prefer higher capitalization rates over borrowing costs.

Unlike the GFC, there is a healthy amount of demand from high profile shopping center investors. Higher interest rates will continue to influence the going-in cap rate, but fundamentals remain attractive to investors. As always, well positioned and fundamentally sound centers will continue to attract investor interest.

Conclusion

While the economy isn’t in its prime, opportunities are still available for investors today. Grocery stores have proven to be relatively resilient to both interest rates and inflation and are high contenders for investors looking to expand portfolios.