For most of the last decade, the investment case for retail real estate was largely defensive: limited new supply, resilient tenants and the realization that e-commerce was not going to eliminate the need for physical stores. Today, the story has become considerably more interesting.

The next leg of the retail story may be less about occupancy and more about repricing existing space.

Consider one data point from Kite Realty’s second-quarter results. Comparable leases where tenants held renewal options increased 6.6 percent. Renewals without options increased 17.7 percent. Same landlord. Same quarter. Same market. The primary difference was whether the tenant had the contractual right to stay without renegotiating the lease.

That distinction matters because the backdrop for open-air retail has changed dramatically from when many of today’s expiring leases were originally signed.

National retail vacancy remained near historic lows at 4.4 percent in the second quarter, according to CoStar. At the same time, new supply remains historically constrained. Just 5.7 million square feet of retail space was completed during the quarter, a new low as elevated construction and financing costs continue to constrain speculative development.

In other words, there is very little available space and very little new space coming. For owners of well-located retail, that is a powerful combination.

The value is in controlling the space

The public REITs give us a window into just how much pricing power exists today. Across the open-air retail REITs reporting second-quarter results, comparable new-lease cash spreads routinely reached double digits, with a median of approximately 23.5 percent. Kimco reported new-lease spreads of 40.4 percent versus 6.1 percent on renewals. Federal Realty reported 34.0 percent versus 5.0 percent. Brixmor reported 31.3 percent versus 15.5 percent.

Those numbers tell us something important: The greatest embedded value may exist where landlords regain control of space and can expose it to today’s market.

That can happen through an existing vacancy or when a lease expires without an option allowing the tenant to remain at a predetermined rent. In either case, the landlord can negotiate against today’s supply-demand environment rather than a rental schedule negotiated years ago.

Many leases approaching expiration today were signed in 2016 and 2017, when e-commerce fears dominated the sector, department stores were under mounting pressure and landlords were often prioritizing occupancy over rent growth. Long lease terms, substantial tenant improvement packages and favorable renewal options were common. Fast-forward a decade and the negotiating table has flipped.

From core retail to value-add

The most obvious beneficiaries are owners of well-located Class A and B+ retail centers. But where the market may still be missing the opportunity is in value-add retail. Rollover has traditionally been underwritten as risk. In today’s supply-constrained market, the right rollover may actually be one of the most valuable things an investor can buy.

Some of the more compelling opportunities today may be properties that do not look perfect on day one. Consider a well-located center that needs facade improvements, parking lot work, updated signage or other manageable capital investment. If the location is right and the real estate remains relevant to tenants, today’s lack of competing supply allows an operator to reposition existing space rather than recreate it from the ground up.

The second opportunity may be even more interesting: a well-occupied center where a significant portion of the rent roll expires shortly after acquisition. A property with 50 percent or more of its leases rolling within 12 to 24 months might historically have been viewed primarily as a rollover risk. Today, that same rollover can represent the business plan—provided those rents are below market and, critically, the leases do not contain options that prevent the new owner from repricing them.

In that situation, an investor is not simply buying today’s NOI. They are buying the ability to manufacture tomorrow’s NOI through leasing.

That changes the underwriting question. Instead of simply asking, “What is my going-in cap rate?,” investors should be asking, “What NOI can this property realistically produce two years from now, and how much capital will it take me to get there?”

Rent growth isn’t free

That last question matters. Federal Realty, for example, reported $57.52 per square foot of tenant improvements, landlord work and leasing commissions associated with new leasing, compared with just $1.23 per square foot on renewals. Kite’s comparable figures were $98.41 and $3.88.

A 30 percent new-lease spread is not automatically better than a 10 percent renewal. The real calculation is the net economic gain after accounting for the capital required to capture it.

That is also why existing vacant space in leasable condition can be particularly attractive. In a market where competing availability is scarce and replacement construction is expensive, controlling an existing box in the right location can provide something developers increasingly struggle to manufacture: immediately leasable square footage.

Buying the rent roll you can change

For investors evaluating retail today, the takeaway is relatively straightforward. Do not stop at occupancy, today’s NOI or the going-in cap rate. Pull apart the rent roll. Understand which leases expire, which tenants control options, where rents sit relative to market, what vacant space can realistically lease for and how much capital will be required to capture that upside.

For value-add investors, the same dynamics may create an even more interesting opportunity: buying good real estate where the current income does not yet reflect what the property is capable of producing. That could mean leasing existing vacancy, investing manageable capital into an under-improved center or acquiring an otherwise stabilized property where a significant portion of below-market leases roll during the first 12 to 24 months.

The key is having something you can actually change.

The opportunity is not simply to own retail because fundamentals are strong. It is to identify the assets where today’s fundamentals have not yet made their way into the income statement.

In this market, the most attractive retail investment may be the property where the real estate is already better than the income it produces today.

John Darrow is executive vice president & managing principal of debt and equity at SRS Real Estate Partners. Ryan Byrne is executive vice president & managing principal of National Multi-Tenant Advisory–South Central at SRS.

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