(Susan Montgomery/Shutterstock.com)

(Susan Montgomery/Shutterstock.com)

Grocery-anchored shopping centers have long been a highly desirable investment due principally to the nondiscretionary nature of purchases made there by consumers, suggesting a durability of performance across economic cycles. In addition, investors have traditionally viewed these centers as relatively safe, defensive investments because the supply of new, competitive centers anchored by dominant grocery brands is limited. This notion of relative safety is being reevaluated, however, given that a large segment of these investments is anchored by traditional grocers that are seeing their business model come under pressure.

The role that stabilized retail product plays in a real estate portfolio and specifically grocery-anchored centers is that of an income producer, given that the majority of the investment’s total return comes from cash flow as opposed to appreciation. It also functions as a stabilizer in the portfolio because the anchor typically is on a longer-term lease and ideally produces 60 to 65 percent of the property’s revenue. The most aggressively sought grocery-anchored retail centers are leased to anchors with strong credit and brand distinction, which furthers the notion of durable property cash flow and, thus, stability.

The most attractive centers are not overly dependent on revenue generated by the property’s in-line stores, such as dry cleaners, nail salons, and restaurants, because their occupancy is much more volatile than that of the anchor given their typical lack of creditworthiness, despite paying a meaningfully higher rent per square foot than the anchor tenant. The triple-net lease structure of the retail lease coupled with percentage rent clauses that increase landlord cash flow makes for a strong inflation hedge, which is another benefit to including retail in a real estate portfolio. But what are the implications of the traditional grocer on this investment strategy?

Traditional Grocers

The grocery business is fiercely competitive, with thin margins. The traditional grocer in this $600 billion industry is essentially represented by only three companies and their associated brands that, according to a report from market research organization IBIS World, control 27.5 percent of the supermarket and grocery store industry. (Kroger accounts for 15.4 percent; Safeway, 6.6 percent; and Publix, 5.5 percent.) The issues facing this segment of the grocery market have been well documented as the “squeezing of the middle”: traditional grocery store formats are losing market share to value-category competitors such as Walmart and other supercenter concepts, while also struggling to compete against the premium grocery formats such as Whole Foods that focus on high-quality produce, meats, and prepared foods. The market share of traditional grocers has declined roughly 40 percent since 1980. With the addition of the developing impact of e-commerce on the grocery business through companies such as Amazon and Instacart, the traditional grocer is being squeezed further.

One outcome of these influences has been significant consolidation among traditional grocers, principally in 2014 with the merger of Safeway and Albertsons and Kroger’s acquisition of Harris Teeter. This consolidation is largely in response to pricing pressure that traditional grocers are feeling from the supercenter concepts, which provide lower prices through economies of scale. This consolidation has increased scale as grocers hope to be more competitive on price.

There is optimism, however, that all is not lost for the traditional grocer. This middle market of the grocery industry has recognized the need to improve its offerings to compete at both ends of the value spectrum. Grocery-anchored centers and their anchor tenants offer consumers convenience, and consumers are willing to pay for that. This willingness to pay for convenience and shop locally—as opposed to heading to the supercenter and loading up the car—is predicated on prices being within 10 percent of those offered at Walmart and the like. Kroger was the first traditional grocer to address this reality when it decided to reduce its margins and compete directly with supercenter formats. Despite this reduction, Kroger’s topline revenue increased, resulting in larger gross revenue and 45 straight quarters of same-store sales growth while Walmart sales have largely been flat.

Walmart has introduced its Neighborhood Center concept, which is intended to provide the convenience of the traditional grocer. However, many believe that the traditional grocers simply are better at executing this strategy than Walmart is. Moreover, this format does not represent a dedicated focus from the company.

Implications for Landlords

Given the struggles of the traditional grocer, what is to be made of the viability of grocery-anchored retail centers that rely on this tenant as an anchor for both the physical and financial asset? Centers with strong operators, including traditional grocers such as Kroger and Safeway, should continue to provide strength to the landlord’s rent roll. Lesser-quality brands should be scrutinized more heavily because a clear divide is developing between those operators that can thrive in the competitive grocery environment today and those that cannot.

A perspective of some within the industry suggests that private grocery chains such as Wegmans, HEB, and Publix are better anchors for these types of centers as a result of store managers possessing a much higher degree of authority to make decisions based on observations from consumers at the individual store. Public companies’ centralized decision making appears to have a negative effect on the ability to focus directly on the consumer in a specific market. Wegmans has been very successful at competing against the upper and lower ends of the grocery market by providing very high-quality produce at reasonable prices in stores that are upwards of 75,000 square feet (7,000 sq m), much bigger than the general average of 45,000 square feet (4,000 sq m). This size differential has apparently provided the pricing power necessary to compete against the lower end of grocery providers. Private grocers such as Wegmans also invest heavily in their stores, creating more of a shopping experience for customers.

Another consideration for today’s landlord relates less to the grocer itself and more to a central tenet of real estate, which is the quality of the center’s location. Centers with infill locations will benefit significantly from limited new supply over time.

“Centers in high-density locations should thrive regardless of changes in format, offerings, or business model of the grocer,” says Lawrence Palumbo, chief operating officer of Falcon Partners, a developer of and investor in retail and multi­­family properties in the U.S. Northeast. “As we saw in the recent recession, a vast majority of retailers proved to be highly adaptive to changes in consumer habits.”

Centers in less desirable locations or with obsolete grocers, however, are much more likely to suffer because these locations will not have the strength to sustain an evolving format.

A number of lessons can be drawn from the technology bubble of the late 1990s relating to the intersection of e-commerce and the grocery business. Companies such as Instacart no longer own millions of square feet of warehouse space or the logistical infrastructure to deliver the product; instead, they opt to use the existing grocery store as a warehouse. Depending on the viability of this concept over the longer term, grocery stores could see their footprints change such that the shopping square footage accounts for a much lower percentage of the total building in exchange for a more traditional warehouse facility. Grocery stores could be reconfigured so that the shopping space constitutes only the produce, meats, and prepared foods, while the staples have been preordered via the web and are picked up at the warehouse component adjacent to the shopping area. In effect, the traditional grocery store center will make the transition to a warehouse whereas the current store’s perimeter will constitute the entirety of the shopping space because consumers prefer to select these products themselves. Once again, location matters because infill centers will be the beneficiary as they essentially become warehouses in the consumer’s backyard versus an industrial park outside the city center.

A great deal has been written about the demise of the traditional grocer, and most of the claims likely are grounded in some degree of truth, but it appears as though the strongest operators from this segment are evolving with the consumer. Owners of grocery-anchored centers should place a high degree of emphasis during the acquisition process on ensuring the highest-quality operator and location because both will provide an investment with the capability to transform itself over time. The biggest challenge for investors is simply finding such product to buy.

Matthew Cypher is the Atara Kaufman Professor of Real Estate and director of the Steers Center for Global Real Estate at Georgetown University’s McDonough School of Business.