The retailing sector of the nation's real estate market has faced several challenges in recent years. In addition to intensifying competition and local market drivers, three primary challenges have emerged at a macro level to impact the market: overbuilding, rapidly changing tenant profiles in response to shifts in consumer demands, and functional obsolescence for many older centers. Despite the longest economic expansion on record, retail property returns repeatedly lagged other real estate sectors.

At the same time, there are numerous examples of retail investments, both large and small, that defy these general statistical trends. Owners ranging from large, national retail REITs to private, entrepreneurial investors have positioned and leveraged their retail assets to increase their Net Operating Income (NOI) and produce exceptional yields, far exceeding market averages.

“After registering a 7.7% increase in the number of sales in 2000 and only a moderate cooling in the first part of 2001, the retail investment market is very much alive,” says Harvey E. Green, president and chief executive officer of Marcus & Millichap. “With the right strategy for each type of retail investment opportunity, investors can indeed compete effectively and meet return requirements. The key is to develop a specific strategy for the investment. The winning formula for investing in a stable center is substantially different from an investment in a value-added opportunity versus ground-up development, and so on,” Green contends.

Over the past several years, a few major common denominators among retail investment strategies producing healthy NOI growth and investment returns appeared. They include an effective tenant mix, a partnership between the owner and each tenant, a properly positioned center to the consumer base, and proactively maximizing the value of the center.

Tenant mix

“Tenant mix is perhaps the most cliché and over-simplified concept in the retail industry,” says Bernie Haddigan, first senior vice president and director of Marcus & Millichap's national retail group.

Owners frequently underestimate the value of a real tenant mix strategy, he says. According to Haddigan, the right strategy will accomplish several things. It will assure a specific tolerance level for high-risk tenants, provide a set target for stable and/or credit tenants, and create synergy throughout the tenant base to assure the highest level of consumer pull and optimum center positioning.

Most experts agree that for the long term, simply filling vacancies with any tenant able to pay rent could actually be detrimental to the operating result of the center.

“The emphasis on first-tier tenants and planning for their long-term needs intensified and will become even more important,” says Michael E. McCarty, president of the community center division of Simon Property Group. “Whether the owner is attracting national, regional or local first-tier tenants is not as critical as this group's collective share of the tenant base and its complementary nature.”

Furthermore, synergy throughout the tenant base will assure success not only in terms of drawing traffic, but also in creating a better customer experience at the center.

Customer satisfaction is highly impacted by available parking, entertainment, and other conveniences such as food service — all of which are driven by tenant synergy. For example, the need for destination tenants has to be balanced with the average time a consumer spends at each retailer. The subsequent effect on parking demand must also be considered.

Partnership with tenants

Owners viewing each tenant as a business partner will ultimately benefit from favorable financial returns as well as increased investment stability.

A partnership relationship creates a joint strategy with key tenants in areas such as advertising, local promotions and community events. “Creating an environment of mutual benefit with key tenants clearly produces results for owners,” Green says. “The owner's commitment to realistic capital reserves and ongoing improvements to the center as well as local advertising and jointly funded promotions are essential.”

Successful owners tend to be proactive in sponsoring quality local community events in the center to draw the right traffic. These initiatives may seem like an expensive approach that would erode the NOI. However, the success of each tenant not only offsets the investment, it benefits the center's long-term performance by increasing tenant retention. “Each of these steps should be considered above and beyond the basic requirements of providing responsive, professional management and services,” Green suggests.

For key tenants, particularly first-tier anchors, the importance of long-term planning is another element of success. “Ten years ago, tenants were often lost to lack of success, whereas today, lack of expansion and flexibility is often the cause of turnover,” says McCarty. “We frequently enter development projects with future expansion in mind, and at times, are prepared to lose shop space to accommodate the growth of a long-term anchor tenant.”

Positioning

Positioning the center and its tenant base to maximize local demographics, expenditure potential, traffic patterns and local consumer behavior are another set of critical factors to the success of shopping centers in today's environment.

“Shopping center owners can no longer afford to leave consumer analysis entirely up to the retailers,” says Haddigan. In fact, astute owners and investors tend to gain a very detailed understanding of the trade area and its characteristics, risks and opportunities as a part of developing a tenant mix strategy. “Targeting and attracting tenants that cater to specific consumer groups within the community and then helping them penetrate that market is the kind of proactive approach necessary to realizing a center's potential,” he says.

Successful shopping center owners are aware of competing centers and the advantages and disadvantages of the investment. Comparisons to peer group properties — conducted by tracking tenant successes and failures in the market — keep owners well informed.

Maximizing investment value

From an investment point of view, a healthy representation of national and/or regional tenants with above-average financial ratings is worth a price premium given the weakening economic picture.

The stability in rents and escalations can often justify a higher going-in price, particularly with longer leases or the ability to negotiate expirations prior to the acquisition. Investors should not shy away from non-anchored centers or centers with a weak tenant roster. These potential money makers could be repositioned to become satellites to owner-occupied anchors.

“Many of our clients frequently take advantage of poorly managed centers that could attract stronger tenants with only minor upgrades or repositioning,” Green says. “For example, satellites to owner-occupied anchors are often passed over when in fact their rent increase potential and synergy with the company-owned anchor produce exceptional results.

“If the center is well-tenanted, positioned well within local demographics/consumer base and proactively managed, macroeconomics will play a much smaller role in the financial results of the investments.”
— Harvey Green

“If the center is well-tenanted, positioned well within local demographics/consumer base and proactively managed, macroeconomics will play a much smaller role in the financial results of the investment,” Green says.

In an effort to survive the cooling economy, it is important for the retail sector to overcome the challenges of overbuilding, changing tenant profiles and functional obsolescence. The approaches and techniques adapted for achieving these results will become increasingly important.

Tess Ferguson is a Los Angeles-based writer.