Outlook positive for commercial real estate M&A despite retail woes

Shopping malls' successful repurposing into co-working spaces suggests the “death of the mall” may be overhyped.

Only two years ago, real estate M&A surged, with 453 deals globally delivering US$215 billion in 2017. In 2018, value and volume took a dip, falling to 431 deals worth US$173 billion—the 5% drop in volume and 20% drop in value year on year was an unsurprising pullback following a record-making year.

The first quarter of 2019 saw yet another dip. With US$23.2 billion invested across 58 deals, Q1 2019 was the lowest quarterly period for value and volume since Q1 2013 and Q2 2012 respectively. The softening came amid a significant stock market rout, a flattening yield curve and concerns that the US Federal Reserve was weighing an interest rate hike.

But since that slow start to 2019, the outlook has turned upward. In March, the Federal Open Market Committee, the Fed's policymaking arm, took a more conservative stance, deciding to hold the rate and indicating that there would be no more increases in 2019.

This was good news for real estate investors and will likely lift their returns forecasting, suggesting that the soft Q1 may only be a blip ahead of a strong 2019 for real estate M&A.

Malls repositioning

The rationale for continued investment is strong, although not always predicated on historical growth trends.

Major retailers including Gap, Express and Victoria’s Secret owner L Brands are expected to close stores in 2019, while the future of Sears is hanging in the balance after it fell into bankruptcy. Coinciding with this are falling occupancy rates. According to research firm Reis, 91% of space in US regional and super regional malls was occupied in Q4 2018, down from 91.7% for the same period a year prior.

As retailers pare back their physical store portfolios to focus on their online offerings, co-working companies are exploiting this retreat by moving in to take the place of retailers.

WeWork, which was valued at US$47 billion when it last raised funds privately, is a case in point. The co-working company has a partnership with Unibail-Rodamco-Westfield, Europe’s largest commercial real estate firm, providing office space in Manhattan’s Fulton Center. This emerging trend looks set to continue.

Property company Jones Lang LaSalle forecasts that co-working space in retail will grow at an annual rate of 25% through 2023, and estimates that the highest concentration of co-working spaces in US retail is in malls.

This ongoing shift works to the benefit of mall owners and their investors. Office tenants are attractive because, unlike retail occupants, their commercial viability is not dependent on footfall or long-term consumer trends. This makes them a more reliable source of income than retail and restaurant occupants. Having permanent, or semi-permanent, tenants also makes malls more attractive to retailers as office workers shop and eat in the mall during their downtime, meaning both retail and co-working can successfully co-exist and improve occupancy rates.

Asian e-commerce spells opportunity

Other real estate trends linked to the changing nature of retail are also prompting M&A activity. The largest deal in the sector so far in 2019, Singapore-based CapitaLand’s planned US$8 billion acquisition of domestic peer Ascendas, demonstrated how some real estate groups are attempting to diversify away from direct retail exposure. The motivation for the deal is Asia-Pacific’s under-consolidated and fast-growing logistics segment, which is benefitting from the rise of e-commerce, just as brick and mortar retail is in retreat.

The rising tide of e-commerce and its impact on M&A can be seen in other logistics sectors. For instance, Alibaba, Asia-Pacific’s largest online retailer, in March announced plans to acquire a 14.7% stake in STO Express in an effort to further strengthen its control over China's courier service sector.

The same drivers behind the Alibaba-STO Express deal also apply to warehousing. As consumers turn to the internet and retail real estate increasingly repositions itself as office space, so too are greater volumes of online purchases creating demand for logistics property to accommodate the flow of goods. The race is now on to build regional market leaders to support the e-commerce sector's expansion by delivering last-mile warehousing.

All the REIT moves

A further reason to expect sustained deal activity in 2019 is the trend towards REIT (real estate investment trust) mergers. Rather than selecting individual stocks in the sector, financial investors typically opt to put their money into REITs for diversified exposure. While the share price of REITs should broadly reflect the underlying value of the assets they hold (their net asset value, or NAV), this is not always the case.

At the end of 2018, S&P estimated that the average discount to NAV in the US REIT segment had widened to 17.7%. Not all sub-segments are performing the same. At the bottom of the pile are, perhaps unsurprisingly, regional mall REITs, which traded at an average 38.2% discount to NAV, while shopping center REITs in general were 27.8% below par, reflecting investor sentiment after years of commentators calling the “death of the mall.” Conversely, self-storage and healthcare REITs traded at average 2.2% and 4.9% premiums respectively.

NAV discounts are conducive to M&A so long as they are not too steep, which can make boards and management teams loath to sell too low. Such deals represent an attractive value play for acquirers. In 2018, there was US$76.3 billion worth of US REIT merger activity, the highest mark since 2007, according to trade group Nareit.

If investors see the retail real estate sector as successfully repositioning itself over the long term, these NAV discounts could prompt deal activity between REITs this year and beyond.

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