Investors searching for distressed big-box deals are facing competition from an unlikely source—retailers. Large tenants including Wal-Mart, Target, Kohls Department Stores and others have become aggressive bidders in the market for vacant big boxes. The retailers are buying distressed space from owners or banks, often at prices that are 20 percent to 30 percent higher than real estate investors are willing to pay.

As a result, retailers have become large players in the single-tenant market. For example, Matthew Sullivan, managing director with Los Angeles-based investment brokerage firm Lee & Associates Investment Services Group, says about 50 percent of the vacant boxes in California are being acquired by retailers.

For tenants, the incentive is that they can acquire an empty site today at a steep discount to what the asset would have traded for three or four years ago. In the process, they can lock in lower occupancy costs than if they were to lease that same space from a developer. What’s more, they have greater control over their real estate

Economic incentives

Large retailers typically have low borrowing costs and are not looking to the asset to generate cash flow. Consequently, they are able to pay a premium beyond what an opportunistic investor would be willing to bid for the same asset.

“They have an economic reason to buy as opposed to value-add investors or developers,” says Donald MacLellan, senior managing director of Irvine, Calif.-based Faris Lee Investments. Developers are “taking the risk of holding property and trying to find tenants. Users just want to occupy the space, and there are further benefits. That’s why they will pay more.”

MacLellan adds that the strategy is most prevalent involving boxes that are 60,000 square feet or larger. It’s a common practice among retailers that operate in the range of 20,000 square feet to 40,000 square feet, such as smaller supermarkets. “Those retailers usually want to focus on putting their money into operations.”

While retailers most often are buying single boxes, MacLellan says that in some instances they have purchased all or part of entire shopping centers. In those cases, the retailers either occupy entire centers or sublease space to other tenants.

For example, in a deal MacLellan was involved with, a European sporting goods retailer acquired a 130,000-square-foot home furnishing center that was 90 percent vacant in California’s Inland Empire. The asset was a real estate owned (REO) property.

West Coast focus

The strategy has been particularly prevalent on the West Coast, where there is a large amount of distressed retail real estate. According to Trepp LLC, California is the top state for distressed retail CMBS loans. Overall, the delinquent unpaid balance on 276 retail properties is $2.6 billion. (The balance includes all loans 30 or more days past due.) That accounts for 13.9 percent of the total volume of distressed retail CMBS loans in the United States. Arizona ranks second, accounting for 8.1% of the total and Nevada ranks fifth, accounting for 6.5 percent of the total (see table).

Many of the assets trading hands today are former Mervyn’s and Circuit City locations. In addition to the large national players, regional chains, including Hispanic grocers, are active. And West Coast furniture chain Ashley Furniture Industries has been particularly aggressive in snatching up vacant boxes.

For example, Inland Empire-based Hodgdon Group Realty Inc. has worked with Ashley Furniture on at least two acquisitions of vacant big boxes. Ashley acquired a 33,952-square-foot former Circuit City building in Hawthorne, Calif., and a former Wickes Furniture in Victorville, Calif. In addition, Ashley purchased a former Expo Design Center in Phoenix. In the latter case, Ashley occupied a portion of the space and was seeking to sublease the rest.

"Although the real estate market is still challenging, it has provided a great opportunity for Ashley … to acquire vacant big-box spaces such as this former Circuit City building and transform them into great showrooms," remarked Aaron Hodgdon, president of Hodgdon Group, in a prepared statement.

In another example, AutoNation purchased a 69,780-square-foot former Circuit City building in San Jose, Calif., earlier this year, for $11.15 million, or about $160 per square foot. DJM Realty and SRS Real Estate Partners brokered the deal.

With real estate values expected to remain near their current levels in 2011, both Sullivan and MacLellan expect retailers to continue to be active bidders next year. “In fact,” says Sullivan, “I think they could be an even stronger part of the market next year.”