This was supposed to be the year the retail REIT rally finally ended.

Cap rates on retail properties have held steady (and even risen in some markets) for the first time since 2001. Analysts and investors have loudly talked about other commercial real estate sectors — like office, hotel and multifamily — having a greater upside and called for capital to be cycled out of retail. And with the housing bubble at its end, volatility in gas prices and mounting debt, concerns about where the consumer is going have been a point of discussion all year.

But retail REITs keep trudging along, seemingly impervious to these trends.

Retail REITs, as a group, are poised to post their seventh straight year of growth. As of Sept. 30, retail REIT's total returns (which factors both stock prices and dividends), were up 16.26 percent year-to-date, according to NAREIT. That figure exceeds 2005's full-year return on the sector of 11.80 percent (though it still trails the back-to-back 40 percent plus returns posted in 2003 and 2004).

Success in 2006 has touched every retail sector. Strip center REITs lead the pack, up 23.11 percent (buoyed in part by several large mergers). Freestanding retail REITs are up 11.55 percent and regional mall REITs up 11.12 percent. In all, retail is once again outperforming the broader REIT universe, which is up about 12 percent for the year, according to NAREIT.

What's behind the continued strong performance of the sector?

REIT managers point primarily to returns they've been able to achieve on new development and redevelopment. There are record-high spreads between the costs of building projects and what the market is willing to pay for stabilized properties. Retail projects today can be built one day and sold the next for nearly twice their construction cost.

“By far, it's the best spread we've seen in the industry's history,” says Scott Wolstein, president and CEO for Developers Diversified Realty Trust. Wolstein estimates the initial returns on development are at 10 percent to 12 percent. Cap rates meanwhile are still around 6 percent for most retail properties.

This spread has come to dictate strategies that many retail REITs are adopting. In Developers Diversified's case, the company has focused on building properties and then selling them into one of its many joint ventures with institutional partners. Developers Diversified recognizes an immediate return based on the spread between the price paid for the completed asset and the development costs. But its partners, who are seeking stabile income-producing assets are also content. Moreover, Developers Diversified recoups fees for continuing to manage and lease the properties in its joint portfolios.

“For REITs that have development capabilities, this is the best of times,” Wolstein says. “When else in the history of this industry have you been able to build a project for $50 million and the day after it's finished it's worth $100 million?”

For similar reasons, Feldman Mall Properties, a REIT that went public in December 2004, is focusing on acquisition and redevelopment of Class B or C regional malls in secondary markets.

“With these malls, we can buy them below replacement cost and even after putting in equity to bring them up, they are still worth more than we put in,” says Larry Feldman, chairman and CEO of Feldman Mall Properties. He points to a property in Harrisburg, Pa., as an example where Feldman purchased the 900,000-square-foot property for $17 million and then spent $80 million to renovate it and attract new tenants (including Boscov's and Macy's). “With that, we've put in less than $100 per square foot, which is well below the $300 to $400 per square foot that a new mall in this market would cost.”

That fact has enabled some developers to pre-sell new projects after they've barely broken ground on construction.

Capitalizing on these spreads is a prime motivator behind the rash of joint ventures retail REITs have been entering. Private investors are willing to pay the high prices for stabilized properties, but also need the management and leasing expertise that REITs offer. That creates the ideal setup for joint ventures.

Feldman Mall Properties, for example, has teamed up with fund manager Heitman. It's also working with private equity firm Lubert-Adler and has joint-ventured with fellow REIT Kimco Realty Corp. Meanwhile, New Plan Excel Realty Trust teamed up with Australian limited property trust Galileo Shopping America Trust last year. Glimcher Properties Trust, meanwhile, teamed with Oxford Property Group in January.

But the kings of joint venturing are Developers Diversified, which has an array of partnerships with both domestic and foreign funds, and Kimco Realty Corp., who has partnered with every kind of investor from private equity firms to other developers and institutional players.

In most cases, the joint ventures are set up similarly to Developers Diversified. Stabilized assets are sold into the joint venture raising development capital for the REIT. At the same time, REITs retain minority equity positions in the joint ventures and charge fees for leasing and property management.

Kimco, though, has other kinds of deals as well. For example, Kimco was part of a group of companies that acquired grocery chain Albertson's for $17.6 billion joining an array of private equity funds and institutional player. Separately, it is also teaming with hybrid center builder Vestar Development Co. to construct the District at Tustin Legacy in Tustin, Calif.

New wave of consolidation?

Despite the emphasis on development, activity has also suddenly picked up among mergers and acquisitions within the sector — primarily grocery-anchored centers and community centers.

In early July, Kimco Realty Corp. acquired Pan Pacific Retail Properties for $4 billion; Centro Properties Group acquired Heritage Property Corp. for $3.2 billion. Then in October, in the second-largest retail REIT deal ever (trailing only General Growth Properties' $12.6 billion takeover of Rouse Co. in 2004), Developers Diversified Realty reached an agreement to acquire Inland Retail Real Estate Trust Inc. for $6.2 billion. (Prudential Real Estate Investments later joined Kimco's bid, contributing $1.1 billion in equity in buying out Pan Pacific.)

That surprised some analysts.

“My reaction, along with a lot of other people's, is that maybe the community center sector is fully priced,” says Richard Moore, a REIT analyst with RBC Capital Markets. “We feel very good about the sector and think there is plenty of upside. The fundamentals are very good and demand by tenants is very good. The deals seem to say otherwise, but my take is that these were unique situations and even though the premiums on these deals weren't that high, it doesn't mean that the rest of the sector can't go up.”

One train of thought is that a cooling in the market for retail properties has driven prices down enough that REITs can justify buying again, after sitting it out and letting private buyers dominate the scene, especially on second-tier properties, for most of 2005 and 2006.

“That part of the market is starting to turn,” says Joe French, senior investment advisor for Sperry Van Ness. “So much is going after the top grocery-anchor strip centers. Buyers are still willing to pay 5 and 6 percent cap rates for those properties. Go to Bs and Cs, and it looks different.”

So far, the bulk of the action has centered on shopping center REITs. There have been no major regional mall portfolio deals since the General Growth/Rouse merger.

The Mills mess

The one dark cloud that remains hanging over retail REITs is the status of the Mills Corp., which has been in trouble for more than a year since it first revealed accounting irregularities. The company's problems have seen it lose a chunk of its senior executives.

Most recently, CEO Larry Siegel stepped down (see Traffic Report p. 16.) the company was able to sell its international properties (Vaughan Mills, Ontario, Canada; St. Enoch Centre in Glasgow, Scotland and Madrid Xanadu in Madrid, Spain) to Ivanhoe Cambridge, Inc. for approximately $988 million. It has also lined up $1.5 billion in financing from Colony Capital and German pension fund Kan Am to fund the $2 billion construction of Meadowlands Xanadu in New Jersey.

In a surprising development, in late October Mills may have found a savior in outgoing Equity One Inc. CEO Chaim Katzman, who purchased 9 percent of Mills Corp.'s outstanding shares and expressed willingness to capitalize the company to the tune of $1.2 billion. The shares were purchased by Gazit-Globe Ltd., an Israeli-based investment company that owns controlling interests of both Equity One.

Any fears that Mills might have been the start of something bigger have proven unfounded, however. Instead, retail REITs have soldiered on and the sector has believers bullish again for 2007.

“While yields may come down a little, you simply can't match them in apartments or office,”Wolstein says. “Keep your nose to the grindstone and you'll do fine.”

RETAIL REIT TOTAL RETURNS (IN PERCENT, 1994 — 2006)
Composite REIT Index 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 (Thru 9/30)
Retail 3.19 5.10 34.65 16.99 -4.94 -11.77 17.97 30.42 21.07 46.77 40.23 11.80 16.26
Strip Centers 1.75 7.36 33.55 21.44 -6.99 -10.71 15.10 29.89 17.72 43.12 36.25 9.27 23.11
Regional Malls 8.77 3.00 45.27 13.69 -2.62 -14.58 23.50 31.88 24.56 52.24 45.01 16.54 11.12
Freestanding -5.49 31.59 30.77 17.77 -6.25 -4.89 8.95 23.95 21.76 35.91 32.87 -0.49 11.55
Source: NAREIT

International Exposure Grows

Retail REITs have continued their international push in recent months. Just days before announcing its acquisition of Inland Retail Real Estate Trust, Inc., Developers Diversified Realty announced a $150 million deal that takes it into Brazil. It acquired a 50-percent stake in Sonae Sierra Brazil, an owner and developer of the second-largest retail real estate portfolio in Brazil with 3.4 million square feet.

Daniel Hurwitz, senior executive vice president and chief investment officer of Developers Diversified, says its foray into Brazil capitalizes on that country's emerging economy. He says the market is fragmented with multiple owners controlling small portfolios.

“Consolidation opportunities are voluminous,” Hurwitz says. “We wanted to access it earlier rather than later.”

Developers Diversified is also looking to Eastern Europe for opportunities.

“In terms of new development, the higher yields are concentrated more in Russia, Ukraine, Bulgaria, Romania and Turkey,” says Scott Wolstein Developers Diversified chairman and CEO.

That's precisely where General Growth Properties Inc. is trying to build. It reached an agreement to enter into a 50/50 joint venture with Hamburg-based ECE Projektmanagement G.m.b.H. & Co. KG, to build projects in Turkey. It also acquired a 48-percent interest in ECE Turkiye Proje Yonetimi A.S., a shopping center management company with six properties in its portfolio.

The first joint project, ESPARK, is in Eskisehir, Turkey, and will contain 430,000 square feet of retail and entertainment center space. The project will open in fall 2007.
DB

BIGGEST RETAIL REIT BUYOUTS 2004-06
Year Acquiror Target Acquirer Type Value Date
2004 Simon Property Group Chelsea Property Group Public REIT $3.0B 21-Jun-04
General Growth Properties, Inc. The Rouse Company Public REIT $12.6B 19-Aug-04
PL Retail LLC (DRA Advisors & Kimco Realty) Price Legacy Corporation Investment Advisor/Public REIT $3.5 24-Aug-04
2005 Centro Properties Limited Kramont Realty Trust Australian LPT $120M 19-Dec-04
The Lightstone Group Prime Group Realty Trust Private Real Estate Company $1.5B 17-Feb-05
2006 Kimco Realty Corporation Atlantic Realty Trust Public REIT $83M 1-Dec-05
Spirit Finance Corporation Sun Capital Partners, Inc. (ShopKo Stores) Public REIT $815M 10-May-06
(Centro Prop. Group & Watt Commercial Prop.) Heritage Property Investment Trust Inc. JV- Australian LPT & Private Equity Firm $3.2B 9-Jul-06
Kimco Realty Corporation Pan Pacific Retail Properties Public REIT $4.0B 10-Jul-06
Developers Diversified Realty Corp. Inland Retail Real Estate Trust, Inc. JV-Public REIT & Institutional Investor $6.2B 23-Oct-06
Source: NAREIT