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2 Key Threats to the Long-Term Outlook for Retail REITs

There has been a tremendous surge in the popularity of publicly listed real estate investment trusts, or REITs. This occurred because of historically low interest rates, which made traditional income-generating assets, such as bonds, poor investments for income-hungry investors.

These extremely low rates also allowed REITs to load up on cheap debt, which was used to expand their property portfolios, boosting earnings and endowing them with the capability to grow their distributions at a healthy clip.

Many REITs including Plaza Retail REIT (TSX:PLZ.UN), annually hiked their distributions over lengthy periods to give them juicy yields in excess of 5%. This further increased their popularity among investors in an environment where government treasuries were yielding 1% of less.

Nonetheless, there are a range of emerging risks which highlight that the long-term outlook for REITs may not be as bright as many investors believe. 

Now what?

A key threat to many REITs with property portfolios heavily skewed towards shopping malls and other retail premises is the rise of internet retail behemoth, Inc. (NASDAQ:AMZN).

The emergence of e-commerce and Amazon’s growing dominance has triggered an industry-wide transformation which is challenging the very existence of brick-and-mortar retailers.

Sears Canada Inc. (TSX:SCC) has already filed for bankruptcy, and Hudson’s Bay Company (TSX:HBC) keeps reporting mounting losses, which grew to $201 million for the second quarter 2017, meaning it is only a matter of time before it suffers a similar fate.

Then there is Amazon’s assault on the groceries and fresh food segment with its US$13.7 billion purchase of Whole Foods Market Inc. This represents a direct challenge to grocery store chains, which, until recently, have been perceived as being relatively immune from the Amazon juggernaut.

If the effect Amazon has had on department stores is any indication, over time, its move into groceries will sharply impact Canada’s largest grocery chains, Empire Company Ltd. (TSX:EMP.A) and Loblaw Companies Ltd. (TSX:L).

All of this is a significant concern for retail REITs such as Plaza Retail.

You see, major department and grocery store chains are important anchor tenants for their properties. They also typically provide a considerable degree of stability to earnings and revenue growth.

Amazon’s assault on brick-and-mortar retailing, along with the forecast exponential growth in e-commerce sales of 40% between now and 2019, is a significant threat to their earnings.

This is weighing on Canada’s largest REIT RioCan Real Estate Investment Trust (TSX:REI.UN), which is down by 11% for the year to date, despite reporting solid second-quarter results with operating income rising by 8.5% year over year. That is because RioCan generates a third of its revenue from brick-and-mortar retailers, including Loblaw, Wal-Mart and Sobeys/Safeway.

Another general danger for REITs is rising interest rates.

Not only do they mean higher finance costs, but they also cause the risk-free rate to rise. That makes equities less attractive investments relative to lower-risk income-generating assets, such as newly issued government treasuries.

This can be highly disruptive for REITs, because to maintain their favourable tax status, they are unable to retain earnings, making them dependent on raising capital to fund the expansion of their property portfolios.

However, with the headline rate at only 1% which is well below the historical long-term average there is little threat to REITs, meaning rates would need to move significantly higher to have a material impact. 

So what?

The rapid growth of e-commerce and Amazon’s relentless assault on brick-and-mortar retailing do not bode for the long-term prospects of shopping malls, which will eventually impact REITs focused on owning and operating retail properties.

Nevertheless, it appears that any substantial negative fallout for REITs because of the threats of the growing uptake of e-commerce and rising interest rates remain some way off.

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Fool contributor Matt Smith has no position in any stocks mentioned. David Gardner owns shares of Amazon. The Motley Fool owns shares of Amazon.

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