After more than a decade of consolidations and bankruptcies, retailers are now healthy enough to afford higher rents. With vacancies now tight, they will need to.

The Global Financial Crisis set off what was to be more than a decade of headwinds for retail real estate in the U.S. A severe supply overhang from overbuilding in the 2000s weighed on property performance just as e-commerce accelerated, only to be exacerbated during the throes of the COVID pandemic.

Now the sector is much healthier. Some creative destruction is still ongoing (as is always the case) but tenants generally are expanding. Retail occupancies are the highest they have been in decades, as shown in Exhibit 1. As of fourth quarter 2023, neighborhood, community and power centers included in the NCREIF Property Index were 94% leased, a hair shy of the previous peak of 94.4% recorded in 2000. We expect occupancies to rise further.

This has been supported by a cycle of little new supply. Developers and banks have limited their exposure to large-scale speculative retail projects, meaning that what little construction is being completed is largely preleased, keeping overall occupancies high.

Now that space markets are tight, the question is - can tenants afford to pay more? We believe there is scope for higher rental growth outlook than the market may be assuming.

Rental growth for retail space has been weak for nearly two decades. Adjusted for inflation, real rents for retail space are 13% below where they were at the end of 2006, according to CoStar. At the same time, real sales per square foot (PSF) has trended up, even accounting for sales lost to e-commerce.

By comparing the two measures, we have created a Retail Affordability Index. A rising index implies increasing affordability and a declining index implies the opposite. As shown in Exhibit 2, the index has trended upward since 2008, implying increased affordability of retail space.

Assuming baseline rental growth forecasts of 2.4% p.a. (in line with multiple third-party forecasts), that ratio between sales PSF and rents PSF would remain historically high from 2024 to 2028. This indicates potential upside to the outlook, particularly given space markets will be as tight as they have been in at least 20 years. Even assuming rental growth of ~3% p.a., the affordability index would remain above levels that prevailed from the 1990s and 2000s.

Moreover, we identify markets where this measure has improved the most in recent years to judge whether certain markets may have greater upside to their rental outlook than others. In Exhibit 3, we show the markets with the highest projected occupancies and call out those markets that have seen retail sales PSF outpace growth in rent PSF to a greater degree.

The list is a diversified mix of markets from different regions. Of note are the presence of all three major metros in Texas, arguing for healthy rent growth in that state. Additionally, the New York/New Jersey metro area and Boston are both highlighted, pointing to a positive outlook for the Northeast.