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2 Retail REITs to Buy Right Now

The term "retail REIT" refers to any real estate investment trust whose primary tenants operate retail businesses. And for the purposes of commercial real estate, restaurants, bars, entertainment businesses, and service-based businesses are also typically considered to be part of the retail category.

Most retail REITs specialize in a certain subtype of property. While there are many different retail REITs, each with a somewhat different investment strategy, the vast majority of retail REITs can be classified into one of three categories:

  • Mall REITs: As the name implies, mall REITs own and operate shopping malls. These can be indoor or outdoor malls, and some own a combination of both.

  • Shopping center REITs: Some REITs exclusively own and operate shopping centers, which typically consist of an anchor store or two (grocery stores are extremely common) and several attached smaller retail spaces.

  • Net-lease retail REITs: A net lease is a type of lease structure that requires tenants to pay the building's property taxes, insurance, and most maintenance expenses, and is most common in freestanding (single-tenant) commercial real estate. So, when you hear a retail REIT referred to as a net-lease REIT, it essentially means that it owns single-tenant retail properties.

Why were many retail REITs so beaten down in 2020? Real estate has been one of the worst-performing parts of the stock market since the COVID-19 pandemic hit, and retail REITs are one of the worst-performing subsectors.

This shouldn't come as a major surprise. After all, retail real estate is occupied by tenants that mostly depend on people being able and willing to go out and spend money. When the pandemic worsened in March, most non-essential retail businesses in the United States were forced to shut down, and many of those that were deemed essential continued to operate on a limited basis (such as curbside service only).

While the profitability of the underlying retail businesses doesn't directly affect the retail REITs that own them, the disruption caused by the pandemic made many retail tenants unable or unwilling to pay rent. Just to name a couple of notable examples, restaurant chainCheesecake Factory (NASDAQ: CAKE) and apparel retailerGap (NYSE: GPS) both refused to pay rent during the shutdown. And they weren't the only ones. In fact, Commercial Observer reported that just 46% of retail tenants paid rent in May 2020.

Should investors worry about the threat of e-commerce disruption?

The short answer is yes, but there's more to the story.

First, it's important to note that retail REITs were dramatically underperforming the marketbefore the COVID-19 pandemic set in, and e-commerce was the primary reason. Since 2010, the percentage of retail sales that can be attributed to e-commerce has steadily risen from 4% to 11.5%, and this trend doesn't show any signs of slowing down.

However, not all retail is particularly vulnerable to e-commerce disruption. Service-based retail like restaurants and hair salons are an obvious example, as are convenience stores (especially if they sell gasoline), fitness centers, and auto repair businesses. These businesses sell things that can't be sold online. Discount-oriented retail is another type that isn't particularly vulnerable, as businesses like warehouse clubs and dollar stores tend to offer bargains that (NASDAQ: AMZN) can't match.

Furthermore, there's a big difference in e-commerce vulnerability when it comes to the quality of the properties and the tenants. As a simplified example, a national big-box retail chain has more resources to compete with e-commerce giants than a local retail establishment. And retail properties with modern dining establishments, entertainment venues, and other attractions are in a better position to keep foot traffic coming in than retail properties that are somewhat run down and depend mainly on the strength of their anchor tenants. In short, quality isvery important when it comes to the ability to compete against e-commerce.

Retail REITs to buy now

TheCOVID-19 pandemic remains an ongoing situation, but the finish line is now in sight. We now have safe, effective vaccines, and it's only a matter of time before they're distributed to every person who wants one.

While the end of the pandemic should certainly be a tailwind forretail REITs, or real estate investment trusts, there's still quite a bit of uncertainty preventing this subsector from reaching pre-pandemic price levels. In particular, we don't know how long it will take to vaccinate the population to the point where we reach herd immunity. It could happen in March, or it could take well into the second half of the year. So, while many retail REITs have rebounded, two in particular that could still have lots of upside potential once the pandemic finally comes to an end are Tanger Factory Outlet Centers (NYSE: SKT) andSeritage Growth Properties (NYSE: SRG).

This REIT could have avery bright future

Tanger Factory Outlet Centers has performed quite well in recent months but is still down by more than 29% as of mid-December 2020. And to be fair, there are some good reasons for this. For one thing, several of Tanger's top tenants -- such asAscena Brands andJ.Crew -- have declared bankruptcy during the pandemic, leading to a rise in vacancies at Tanger's properties.

However, there are reasons to be optimistic. For one thing, as a more pandemic-friendly type of retail than indoor malls, Tanger'sopen-air outlet centers are actually performing quite well. While there are more vacant storefronts than before, virtually all of Tanger's occupied stores have reopened. And by September, customer traffic had rebounded to more than 98% of 2019 levels.

Second, Tanger has tons of liquidity to not only make it through but pursue attractive opportunities, which -- given the current uncertainty surrounding retail -- should be plentiful in the coming years. At the end of the third quarter, Tanger has about $640 million in available liquidity, a huge amount for a company with a roughly $1 billion market cap.

Finally, Tanger is thinking outside the box when it comes to monetizing its properties, and that's extremely encouraging. The company launched a virtual concierge program to allow customers to shop the outlets from home. It's pursuing leases with more "essential" and recession-resistant businesses, such as furniture retailers (which also take up more space than the typical outlet tenant). And just recently, Tanger leased unused space in some of its parking lots to COVID-19 testing providers, monetizing its properties in a completely new way.

If this retail REIT figures out its finances, the sky's the limit

Seritage Growth Properties is the more speculative of the two stocks discussed but could also produce tons of upside if things go well.

If you aren't familiar, the company was formed for the specific purpose of taking old Sears and Kmart properties and converting them into modern,mixed-use properties with retail, residential, and other elements. And the early results have been promising: Seritage's average completed redevelopment project generates roughlyfour times the rent of the previous (Sears or Kmart) tenant. With plenty of high-potential properties yet to develop, there's tons of value that could be created for Seritage shareholders.

The problem, and the main reason the stock is still down more than 60% in 2020 is financing. Unlike many other retail REITs, Seritage doesn't have much liquidity. It has about $90 million on its balance sheet right now, and its business isn't profitable -- after all, it takes lots of money to do large-scale redevelopment.

Seritage has a $400 million credit line, but it can't access it until it has $200 million of annual non-Sears rental income, which it hasn't reached yet. And to add to the uncertainty, the company is in the middle of trying to find a new CEO.

If Seritage can figure out the financial side of its business, there's massive potential to unlock value from its portfolio. That remains a bigif for now, but if the company can get there, it could be a huge catalyst for its stock. Expect a roller coaster ride

A final thought: While I own both of these REITs and believe they have tremendous potential, I have no delusions that the path higher will be a smooth or quick one. In fact, I'd expect lots of volatility for as long as the pandemic continues and even for some time beyond as retail sales ramp back up.

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