In an instance of “if you can’t beat them, join them,” Tanger Factory Outlet Centers has partnered with rival Simon Property Group to build an outlet center in Texas City, Texas.

The deal comes as a surprise to outlet center industry insiders, as Tanger does not have a track record of forming partnerships. In this case, however, Tanger was facing direct competition from Simon on the site. So rather than engage in a prolonged legal battle or grassroots campaign to drive each other off the land, as developers have often done in the past, the two decided to form a partnership.

“They were going to fight like crazy and I think they correctly decided that rather than do that and create a situation where they would both be spending a lot of money, they decided to pick the best of the two sites” and build one center through a partnership, according to Rich Moore, an analyst with RBC Capital Markets. Moore notes that such gestures of goodwill are rather unusual in the retail REIT arena.

On June 30, Tanger and Simon announced they would develop an outlet center of at least 350,000 square feet approximately 30 miles south of Houston through a 50/50 joint venture. The firms plan to break ground on the project, branded as Tanger Outlets, as early as this month, with Simon taking charge of site development and construction. Tanger will be responsible for management and marketing. If the venture proves successful, the center could eventually be expanded to 470,000 square feet.

Simon referred all questions about the partnership to Tanger. Tanger did not return calls seeking comment.

Coming on the heels of announcements from both firms laying out similar strategies to develop outlet centers in Canada—down to naming the same Toronto submarket of Halton Hills as the site of each venture’s first project—the new deal underscores how similar Tanger’s and Simon’s growth plans have become. And given Simon’s desire to make opportunistic acquisitions during this market cycle and its history of picking up outlet center developers, it raises questions about the prospects of a potential Simon/Tanger merger.

REIT analysts, however, say that the current joint venture was born of necessity and that Tanger has no incentive to partner with Simon on a larger scale. There is growing competition among U.S. firms for outlet center development, with firms such as CBL & Associates, Macerich and Taubman Centers all also targeting the sector. As a result, Tanger and Simon may find forming joint ventures with each other preferable to battling each other while simultaneously warding off competition from other players.

How it all came about

Tanger and Simon both wanted to build an outlet center in the Houston area and had identified sites within about 20 miles of each other. At the beginning of the year, Simon’s outlet division, Premium Outlets, revealed it was developing a project in Texas City called Galveston Premium Outlets. The project was originally scheduled to open in 2012 and would have contained 350,000 square feet of space, according to the a Houston Chronicle blog entry.

Meanwhile, in January, Tanger president and CEO Steven B. Tanger announced the firm was working on three new outlet center projects, including one located in League City, Texas, near Houston. At the time, the project was in the predevelopment stage and Tanger didn’t expect to break ground on it until late 2011, when at least 50 percent of the property had been pre-leased. Nevertheless, the REIT was committed to building a center in the Houston market.

Arizona and Texas “offer the perfect combination of excellent sites on heavily traveled interstates, found in areas where consumers and tourists currently do not have any outlet centers in which to shop,” Steven B. Tanger said in a statement.

With development sites positioned so close to each other, however, the two REITs couldn’t both hope to put together strong retailer line-ups, according to Carol L. Kemple, an analyst with Hilliard Lyons.

The situation might have worked out differently if Simon had squared off against a much weaker operator, allowing it to use its extensive relationships with retailers to get first pick of potential tenants. But Tanger has been developing outlet centers for years and has relationships with many of the same retailers that Simon does. Simon CEO David Simon alluded to the issue during the company’s first quarter earnings call with analysts on Apr. 29:

“We are looking and working in Galveston, Texas, and we think, ultimately, there’ll probably be—the market there can only really support one outlet, and you’ve got that in process,” he said.

Later, Simon added that retailers continue to be very focused on profitability in opening new stores, even in the outlet sector, and “you’ve got competent developers like us and Tanger and others that understand that dynamic.”

In fact, Moore suspects that retailers might have encouraged the two REITs to develop one center because they wouldn’t be able to sign leases with both.

“I think both management teams were smart to get together and participate in the development of one outlet center, rather than split the tenant base,” says Michael Mueller, an analyst with J.P. Morgan.

Start of a beautiful friendship?

The current partnership might end up as a one-off, Moore notes, or at best, get a repeat play in select markets in the United States.

Over the past decade, Simon had acquired two outlet center operators—Chelsea Premium Outlets in 2004 and Prime Outlets in 2010—as well as Mills Corp., whose “shoppertainment” centers also include some outlet center tenants. Simon has also re-affirmed its commitment to outlet center development in recent months, so there is a possibility the REIT might view Tanger as an attractive acquisition target.

During that first quarter earnings call, David Simon talked about how some of the retailers who have been closing underperforming stores in malls, including Abercrombie & Fitch and Ann Taylor, have been looking to grow their outlet store operations. Yields on outlet center development in the U.S. today start at about 10 percent, according to Mueller. That’s at a time when building new malls remains extremely difficult.

As a result, “if Tanger ever did want to sell, Simon would be extremely interested,” says Moore.

Tanger, however, has no incentive for a merger. In the first quarter, the company reported that revenue was up 7.1 percent year-over-year, at $70.7 million. It has no significant debt maturities coming up until 2013. Same-store NOI in the first quarter went up 6 percent and occupancy was at 96.7 percent.

“Tanger has a strong balance sheet and they are able to operate these centers very well,” says Kemple. “They do a good job at what they do. I don’t see them looking to be acquired.”

Much murkier is the outlook on what’s going to happen in Canada. Like Houston, the Halton Hills submarket ultimately may only be able to support one outlet center. But if that proves to be the case, creating a joint venture would be more problematic than in Texas City because it would involve four development partners, instead of just two.

Simon has entered a joint venture with Calloway REIT for its outlet center strategy in Canada, while Tanger has partnered with RioCan REIT.

“There, you have four investors in play, so my initial reaction is it probably makes it less likely for a joint venture than if you just have a wholly-owned Tanger or a wholly-owned Simon property,” says Mueller.

In the U.S., however, we could see a few more partnerships between Simon and Tanger in the future, if they find themselves going head to head on a project again.

“They have a couple of sites in Phoenix that are not too far apart,” notes Moore.