Global investment firm Nuveen is betting on the niche real estate subsector

A version of this article first appeared in the CNBC Property Play newsletter with Diana Olek. Property Play covers new and evolving opportunities for the real estate investor, from individuals to venture capitalists, private equity funds, family offices, institutional investors and large public companies. subscription To receive future issues, directly to your inbox.

It would be an understatement to say that retail real estate has had a rough ride. It started with the birth of e-commerce and escalated with the Covid-19 pandemic. Its recovery has been divided, given the diversity of retail sub-sectors, from large indoor malls to large malls to outdoor malls.

It’s the latter subsector that Chad Phillips, global head of Nuveen Real Estate responsible for more than $140 billion in commercial real estate equity and debt investments, says represents the big opportunity today.

“We’ve relied on this flexible outdoor strategy over the last couple of years in a big way,” Phillips said.

These are grocery centers that may have a CVS, pizzeria, and the like. Vacancy rates for these spaces were 7.8% at the beginning of 2016, but fell to 4.4% at the beginning of this year, according to Costar Group data.

“It has survived Covid. It has survived the Amazon effect,” Phillips said. “More than 95% of occupancies within our portfolio of outdoor grocery stores in good locations are leased.”

When a tenant closes, Nuveen is able to quickly refill the space because of that strong demand, Phillips said.

He acknowledged that retail real estate has been suffering from overbuilding for a long time in the United States. Eventually, developers became more disciplined, especially with the birth of e-commerce. This led to a correction that resulted in supply shortages today.

“the [capitalization] “The prices you can buy them at are fairly attractive,” Phillips said. “So the total returns are good. You’re buying at a price well below replacement cost. So, put it all together, and it’s a very basic, flexible real estate need where we can achieve strong, risk-adjusted returns.”

While traffic is increasing at larger indoor malls, especially in upscale malls, Phillips said he likes this smaller segment because it’s “small-sized deals.” You can sell it easily. It’s liquid. Shopping malls are not.

It is also a simple supply and demand factor. Nearly 15 years ago, retail allocations were more than 30% for real estate investors, but that has dropped to 10% because returns have been poor, according to Novin. Now, just in the past 12 months, returns have begun to improve, and investors are looking forward again.

“I can’t say they’re due to flooding, but we’ve had it up for a year now [for] “Convenience-based retail has $1.4 billion of leveraged equity,” Phillips said. “That puts us over $2.5 billion in purchasing power for these types of strategies. So, yeah, I think investors are turning their heads.”

This does not mean that the sector, like any other, is not without risks. After a few years of outperformance, it started to slow down.

“After five years of consistent demand and rental growth, fundamentals are starting to soften,” Brandon Svec, national director of U.S. retail analytics at CoStar Group, wrote in a recent company newsletter, noting that vacancy rates for outdoor space have risen for three straight quarters. (Although it’s still near historic lows.)

But the broader retail leasing environment tells a different story, Svec added.

“With little new retail space expected to be added over the next few years, and availability conditions near historically tight levels, retailers remain active in their pursuit of new locations,” Svec said.

He also said there is concern about the state of the overall economy, consumer confidence and consumer spending.

After strong rent growth in previous years for the outdoor grocery-based subsector, it stalled this year, with annual rent growth the weakest in more than a decade. Svek stressed that this is a clear departure from previous years.

That’s why the strategy requires investors to be particularly selective about real estate, Phillips said.

Consumer confidence ebbs and flows, and this has an impact on whether they will go to these centers for a coffee or a manicure. The existing customer base, i.e. those with higher savings rates and who can tolerate high unemployment rates, is crucial in choosing where to invest.

Phillips said a median household income of more than $100,000 and a well-educated millennial population are among the criteria he looks for.

Competition among investors is rising, but not to the point where good deals can’t be struck, he said, citing low double-digit returns.

Low levels of new construction help keep vacancies low, he added, and the spaces attract consistent crowds.

“I think it has a lot to do with comfort and being on the path to that comfort, and that’s where we want to invest,” Phillips said.