Everybody loves grocery-anchored shopping centers. Private equity investors, shareholders of public REITs and especially brokers who see fat commission checks in all those transactions keep driving prices higher. And who can blame them? Unscathed by recession and seemingly unaffected by the sluggish recovery, these properties are reliable generators of current income and appreciation.

In fact, so much money has sloshed into the grocery-anchored arena that it has become the real estate darling on Wall Street. The stock prices of four of the heavyweights in the grocery-anchored arena — Regency Centers, Kimco Realty, Pan Pacific Retail Properties and Weingarten Realty Investors — had increased an average of 30% year-over year as of late July.

Investor enthusiasm for the sector also is reflected in sales prices. Since 2000, the sales price per sq. ft. for grocery-anchored shopping centers has risen 14% to $121.70, estimates Marcus & Millichap, based on deals the brokerage has closed over the past three years.

But those high values may be unsustainable — current prices for grocery-anchored centers are more a sign of investor demand than of intrinsic value. “A lot of bad decisions are being made as we speak,” says Bernie Haddigan, senior vice president and managing director at Marcus & Millichap. In particular, he cites a lack of discipline among 1031 exchange buyers and private investors. “On marginal properties, where leases or financing are coming due in the next three, five or seven years, you are going to see some owners have some very tough times.”

It all boils down to simple math: When the dust clears, interest rates rebound and other investments, including common stocks, resume normal patterns of income generation and appreciation, the underlying flaws in the grocery-anchored center business will become more apparent. Against that backdrop, the smart money in this business — including REITs — has gone on the defensive, refraining from buying and using the frothy market to unload unwanted properties.

No issue looms larger than the fundamentals of the grocery stores. Retail Forward, a consulting firm based in Columbus, Ohio, projects supermarket industry sales growth to rise between 2% and 2.5% this year and slow to under 2% after that, due to the growing impact of Wal-Mart and other discounters.

“It's clear that the supermarket industry is undergoing a slow and steady shakeout,” says Frank Badillo, an economist with Retail Forward. “There will be fewer supermarkets in the long run, particularly smaller independent stores. There is this fundamental change taking place among consumers shopping for food. They are becoming more attracted to supercenters.”

Supermarkets contribute substantially to a shopping center's bottom line. Among newer grocery-anchored centers, which average about 70,000 sq. ft. of GLA, the grocer typically occupies 45,000 sq. ft. and generates 40% to 50% of the center's income, says Anthony Blanco of Black-Rock Realty Advisors. In older centers, the percentage of income generated by grocers generally drops because the centers are larger.

Here Come the Discounters

Intense competition from a new set of untraditional players is cutting into the market share of the seven largest publicly traded food retailers. That group includes Albertson's, Ahold, A&P, Delhaize America, Kroger, Safeway and Winn-Dixie. Non-traditional supermarket-type sales outlets comprise a 14% share of the U.S. grocery market, according to Merrill Lynch in a report released in June. By 2009 that figure is expected to nearly double to 26%.

Leading the way is Wal-Mart Supercenters, which is on track to expand its share of the domestic grocery market from 7% in 2002 to 16% by 2009. In 2002, Wal-Mart tallied $37 billion in U.S. grocery sales, reports Merrill Lynch, and that figure is projected to reach $55 billion by 2004.

This heated competition has forced some supermarket chains into a retrenchment mode. Albertson's, one of the world's largest food and drug retailers with annual revenues of $36 billion, announced in March 2002 that it would exit four underperforming markets, including Houston, San Antonio, Nashville and Memphis, Tenn. In late July, Albertson's stock price was trading 30% below its 52-week high of $29.80.

“There is some slowdown in new supermarket openings, and we think that's for the best,” says Hap Stein, CEO of Jacksonville, Fla.-based Regency Centers, a national developer and owner of 260 community and neighborhood shopping centers valued at $3.2 billion and totaling 29.5 million sq. ft. “Supermarket chains today are being much more rational. They're looking closely to determine to what extent a new store will cannibalize an existing store.”

A Seller's Paradise

Prospective buyers of shopping centers aren't being as rational, say industry veterans. “If you have the desire to be a seller, then you'd better sell right now. There will never be as many dummies running around with money as there are right now because interest rates are so cheap,” says Michael Pollack, president of Michael A. Pollack Real Estate Investments, one of Arizona's largest independent shopping center owners and operators. Pollack's 4 million sq. ft. portfolio includes roughly 700,000 sq. ft. of grocery-anchored shopping centers in Phoenix and Tucson.

Stiff competition for shopping centers among 1031 exchange buyers, institutional investors, REITs and other private investors over the past 12 to 18 months has created an incredible run-up in prices. Cap rates in California, for example, have dropped 150 basis points over the past 12 months and they now hover in the low 7s. And the trend isn't a uniquely West Coast phenomenon, either. Across the country, owners and brokers say cap rates range from the high 7s to mid-8s for quality, grocery-anchored centers.

“If it weren't for the low interest rates, we wouldn't be seeing cap rates in the low 7s. There's no sense to low 7s,” says Pollack. “Let's face it, in five or 10 years those low-rate loans are going to roll, and if rents haven't gone up significantly to offset the increase in interest rates that's going to be a problem.”

Prices are so high, in fact, that Principal Real Estate Investors, a Des Moines-based pension fund advisor, has sold between $75 million and $100 million in grocery-anchored product on behalf of a fund comprised primarily of U.S.-based pension funds. “The assets we sold were at cap rates between 7% and 8%,” says Greg Hauser, CEO at Principal, which manages $6 billion in private real estate equity. “It's probably a high-water mark in terms of the aggressiveness of those numbers in the past 20 to 30 years.”

Pension funds typically hold assets five to seven years or longer, but the pricing of late has been so high that Principal flipped some of the properties only two years after acquiring the assets. Now, Principal is pouring money into the beleaguered office sector of all places, betting on a recovery in the labor market in the near term. It's not abandoning retail altogether. Principal is scouring the country, looking for value-added opportunities.

Meanwhile, pension fund advisor RREEF last month sold Sheridan Plaza in Miami to Equity One for $75.3 million, at an approximate cap rate of 7.6%, setting the record for the largest grocery-anchored shopping center sale in Florida, according to Black-Rock Realty, the broker representing RREEF. Publix is the grocery anchor in the 451,000 sq. ft. center.

It's not just pension funds that are selling grocery-anchored retail these days. The REITs also are taking advantage of the opportunity to prune their portfolios. Regency Centers, for example, culls 10% of its portfolio every three years. “We're very aggressive at selling those properties that don't meet our criteria,” says Stein. The company sold $186 million in assets to third parties in 2002 and plans to sell another $100 million this year.

But REITs also have to pay dividends to shareholders. So, if they sell a property they need to replace the income that asset was generating by making another acquisition or developing new product. Both Regency Centers and Kimco Realty have undertaken merchant building programs.

In other words, they build shopping centers, sell them to joint-venture partners or third parties and plow those funds back into building more centers, according to Ross Nussbaum, a retail analyst with Salomon Smith Barney. In the joint-venture deals, they typically retain an ownership stake. “They are recycling their capital. If you can build it at 10% cap rate, and sell it at 7%, 8% or 9%, you have made money overnight.”

Regency Centers currently has more than 30 developments and redevelopments under way, representing a total investment of $433 million upon completion. These projects are 75% pre-leased and committed, which reduces the risk inherent in development, according to Merrill Lynch analyst Steve Sakwa in a July 1 research report. Regency expects to receive a 10.5% unleveraged return on these investments, fueled in part by the fact that Regency sells these projects into one of its two joint ventures, he says. Those include Macquarie Countrywide Trust, an Australian listed property trust, and the Oregon Public Employees Retirement Fund.

Insulation from Wal-Mart

Still, the key long-term strategy for these companies is finding a way to survive the superstores. Regency has cooked up a formula that will keep it out of Wal-Mart's sights. The REIT has forged relationships with the top grocery chains and has strict rules about where it will build or buy centers. Preferably the anchor is the No. 1 or No. 2 grocer in a community that has the right demographics: relatively upscale consumers. Middle and lower-middle income shoppers are compelled to go where the prices are lowest; more affluent shoppers will patronize the better grocer for convenience, freshness and variety.

Once Regency finds the right grocer for the right location, it signs the anchor to a 20-year lease, then focuses on getting a solid mix of national chains in the inline spaces. More than 90% of the REIT's grocery-anchored assets are located in the top 100 markets nationally and anchored by dominant supermarket chains — defined as No. 1, 2 or 3 in terms of market share.

Regency's portfolio is currently 95% occupied and has never dropped below 93% since the company went public in 1993. “Our occupancy has been well above 94.5% during the last four to eight quarters when the country has been in an economic slowdown. That points to the stability of the sector,” says Stein.

Supermarket sales at Regency-owned centers are $23 million annually, well above the national chain average of $18.5 million. Furthermore, the average household income surrounding Regency shopping centers is $87,000 vs. the national average of $66,000, according to Stein. That helps insulate it from Wal-Mart, which targets families with incomes of $60,000 and below.

Regency pursues specialty retailers through a program known as the Premier Customer Initiative, which offers national and regional tenants multiple locations and expansion opportunities nationwide. “What we found is that you can combine a Starbucks, Hallmark and Radio Shack and together they'll almost act like a secondary anchor with a Publix or Kroger,” says Stein. Over 75% of the portfolio is leased to national and regional retailers.

Regency's rent growth in the first quarter of 2003 on a same-store basis, including renewals and new leases, was up 9.7% over the same period a year ago. In July, Merrill Lynch projected a 15% total return for the company over the next 12 months, citing Regency's ability to create value through its development program. In 2002, the average unleveraged returns on Regency's development projects were in excess of 10%.

The company generated net operating income (NOI) growth of about 3% annually on a same-store basis between 2000 and 2002. Merrill Lynch estimates same-store NOI to drop to between 2.25% and 2.5% in 2003 and 2004.

Sluggish retail sales have put pressure on earnings, Merrill Lynch notes. “Wal-Mart's superstore expansion continues to challenge the market share of all grocers, including the top-tier players such as Kroger, Safeway and Publix. Earnings growth has slowed for many retail REITs in the past year, including Regency.”

Maintaining an Edge

Like a well-trained athlete, the best-performing properties need to be in tip-top shape. Edens & Avant, a privately held shopping center owner and developer with a portfolio of 232 shopping centers nationwide, plans to spend between $150 and $200 million over the next 12 to 18 months to redevelop many of its centers.

According to CEO Terry Brown, constantly updating centers is an ongoing priority for Edens & Avant. “Our goal is to be the number one or two dominant player in any market that we are in,” says Brown.

In July, the Columbia, S.C.-based company expanded its portfolio by 653,000 sq. ft. when it acquired seven new Giant Food-anchored centers in the Washington, D.C. market. The centers were purchased from GFS, the real estate arm of Giant Food of Landover, Md. Edens & Avant now owns 36 centers in the greater D.C. area. Although Edens & Avant wouldn't reveal the price tag, it indicated that those grocery-anchored centers in that market today are typically trading at an 8% cap rate.

Federal Realty Investment Trust, which last year moved away from developing mixed-use projects, seeks value-added opportunities. Case in point: Federal will soon demolish an AMC movie theater at the 257,000 sq. ft. Andorra Shopping Center, one of its Philadelphia centers. The center's 24,000 sq. ft. theater was, according to Federal, “functionally obsolete.” As a result, the REIT is building gym franchise L.A Fitness a new 36,000 sq. ft. space that will be completed in 2004. The center is anchored by an Acme grocery store.

The Andorra redevelopment cost $3.3 million and yielded Federal Realty a 15% return on investment. “We created a better center here, one that is more competitive. This strategy is about making the most of what we have now,” says Andy Bloeher, Federal's vice president of capital and investor relations. According to Bloeher, newly redeveloped centers can command rents up to 30% higher than older ones.

Federal adheres to a formula for inline tenants, devoting 30% of each center's space to local, mom & pop-type retailers.

Glut On Tap?

No strategy, however, will insulate owners of grocery-anchored REITs from overbuilding. Construction starts for all forms of retail jumped 11.8% nationally in May (based on a three-month rolling average) compared with the previous year, according to Salomon Smith Barney. The expansion of discounters Wal-Mart and Target along with category killers such as Home Depot and Best Buy comprise the bulk of that activity.

But warehouse clubs also are actively expanding, which could more pressure on the grocery sector. Merrill Lynch reports that warehouse clubs like Costco, BJ's and Sam's Club accounted for 5% of all U.S supermarket item sales in 2002. That total is projected to rise to 8% by 2009.

“Our concern is that all this capital is going to lead to an increase in new supply in the shopping center industry,” says Nussbaum. “You may start to see development coming on board that either shouldn't get built, or if it gets built it's going to put pressure on the existing stock of centers.”

Among the major metropolitan statistical areas (MSAs), Las Vegas, Riverside, Calif., and Phoenix stand out as having undergone significant retail activity over the past year. In May, annualized starts as a percentage of total existing stock registered 8.2% in Las Vegas, 4.6% in Riverside, and 4.2% in Phoenix. Conversely, construction activity in metro New York — an area with high barriers to entry — registered 0.9% of existing stock.

“For the last two years, I've been saying that they are overbuilding this [Phoenix] market,” says Pollack. “Lenders continue to give this cheap money and the developers keep continuing to build it.”

Pollack may be right, but investor enthusiasm for the sector shows no signs of slowing down.

LOCAL GROCERY MARKET SHARE ANALYSIS AS OF JUNE 2002

Company Stock Symbol % of Grocery Anchors With Local Market Share Rank in Top 3* % of Portfolio That is Grocery-Anchored
Regency Centers Corp. REG 84.6% 88.6%
Developers Diversified DDR 80.3% 41.6%
Realty Corp.
Kimco Realty Corp. KIM 77.9% 36.5%
Pan Pacific Retail PNP 72.5% 71.8%
Properties Inc.
Heritage Property HTG 68.8% 71.2%
Investments Trust Inc.
New Plan Excel NXL 67.2% 53.6%
Realty Trust Inc.
Federal Realty FRT 64.8% 64.0%
Investment Trust
Weingarten Realty WRI 63.5% 53.9%
Investors
JDN Realty Corp. JDN 63.5% 26.1%
*Weighted by shopping center square footage and percentage ownership. Portfolio is defined as retail assets only. NXL's regional mall and outlet center assets are included, but WRI's and DDR's non-retail assets are excluded from the definition of those companies' portfolios.
Source: Company Data, Morgan Stanley Research