In a real estate sector with few bargains to be found, firms are combing the landscape for deals where others no longer shop. Although the supply is limited, distressed retailers seeking to unload underperforming properties provide a chance for bargain-basement buys.

Acadia Realty Trust, for example, joined forces with Klaff Realty LP and Lubert-Adler Management Inc. earlier this year to invest $300 million in surplus, distressed or underused properties owned or controlled by retailers.

The Acadia partnership will look at properties across the United States. “For a large enough portfolio, we would consider going anywhere,” says Jon Grisham, director of investor relations for the White Plains, N.Y.-based REIT, which owns 62 properties totaling 9 million square feet, mostly shopping centers from Delaware to Boston anchored by grocery stores. But, he notes: “We have a footprint in the Northeast and Midwest so it is unlikely that we will be buying single assets in faraway places like California.”

Buying bankrupt retailers' properties is not a new strategy. Other retail REITs, such as Developers Diversified Realty Corp. and Kimco Realty Corp,. have dabbled here before when there were more opportunities.

“It is a chance for us to play offense,” Grisham says. “We are looking for opportunities where we can step in and make money from a potential bankruptcy situation or a retailer that is looking to reposition its properties.”

Acadia has selected its partners carefully. Klaff Realty LP of Chicago and Luther-Adler Management Inc. of Philadelphia have worked together on distressed properties from such retailers as Service Merchandise, Levitz, Montgomery Ward and Hechingers. When Kmart auctioned off the lease to its vacated stores in 2002, Klaff, in a joint venture with Kimco of New Hyde Park, N.Y., and Columbus, Ohio-based Shottenstein Stores Corp., bought 54 leases for $43 million.

Clearly, investing in centers with problems or distressed retail stores involves more risks. Marcus & Millichap estimates that while Home Depot and Lowe's bought some of the old Kmarts, the beleaguered discounter still has 647 retail spaces ranging from 450 square feet to 87,300 square feet available for lease.

Acadia itself has “above average Kmart exposure” — not a good thing for a company in a partnership shopping for underused retail sites vacated by stores just like Kmart, according to analysts at Citigroup's Smith Barney. Acadia fully owns five Kmart sites and has a 50 percent interest in another.

Grisham says Acadia isn't worried. “Kmart walked away from those leases that were the worst locations,” he says. “We are not going to buy into situations where there are problems.” As for the sites it owns, he says if Kmart moved out, it would be easy to find better paying tenants. “Kmart is paying a very low rent,” according to Grisham. “If we were to get these stores back, we are confident that we could probably lease them again at rents over what Kmart is paying.”

While opportunities are becoming more limited, going after underused space of ongoing or bankrupt retailers remains a viable business, agrees Bernie Haddigan, national director of Marcus & Millichap's retail group in Atlanta — except in smaller towns and tertiary markets as even older Wal-Mart spaces have a tough time getting re-leased. “Lots of older leases are under market value and even though some of the buildings might seem a little tired, there is still equity in those leases,” says Haddigan. “There is a fairly heavy appetite to control the leases and subleases of older space.”

Klaff's list of REIT cohorts includes Beachwood, Ohio-based Developers Diversified Realty Trust (DDR), which along with Lubert-Adler bought the asset designation rights for 227 Service Merchandise sites. The price tag on the 2002 deal was $235 million.

The transaction generated $5 million in FFO (funds from operation), of which DDR received $1.3 million. The company earned another $2.2 million in fees, says Michelle Mahue, DDR vice president of investor relations. “The total proportionate share of fees and revenues since the inception of this deal is $9 million” says Mahue. “When added to DDR's proportionate share of sales and leases of $86 million, it [the Service Merchandise deal] exceeds the company's initial investment plus carrying costs by $15 million.”

Among the retailers now inhabiting the old Service Merchandise locations: Value City Furniture, DSW Shoe Warehouse, T.J. Maxx, Marshalls, Bed Bath & Beyond, Best Buy, Circuit City, Dollar Tree, PETsMART, and A.C. Moore Arts & Crafts.

Another Success Story

Earlier this year, Toys ‘R’ Us Inc. sold 124 of its former Kids ‘R’ Us stores to Office Depot Inc. for $197 million in cash, plus the assumption of lease payments and other obligations. A few weeks later, Office Depot sold 20 of those properties to Petco Animal Supplies Inc. for $45 million plus lease obligations

Most of the money being thrown at retail real estate is going toward high-quality, community and grocery-anchored centers, says Steven Smith, a Klaff principal. “Therefore, there is a lot of capital pressure pushing down returns,” he says. “The competition is extremely high for these well-leased centers. Cap rates are dropping toward 7 percent; we have seen deals below 7 percent.”

Among the most aggressive retailers looking at older big-box space, says Haddigan, are the value-oriented merchants such as Big Lots and the dollar stores. Dollar General, for example, plans on opening 675 stores in 2004; Family Dollar expects to open 500 and Big Lots is planning 100.

Like Klaff, Kimco is no stranger to underused retail property deals, having made an investment in the bankrupt Montgomery Ward chain's 250 stores back in 2001. Since then, Kimco has stayed close to this game, reaching an accord last year with Kmart to joint market 317 of its store locations — many of which are still empty.

More opportunities exist in entire centers. What companies such as Klaff and Kimco try to do, says Howard Makler, chairman and chief operating officer of Excess Space Disposition Inc., is take down a portfolio of underused space. “There are unique risks in these kind of deals, but this is what they do for a living,” he says. “It is not an opportunity for everyone.” Excess Space, with offices in Lake Success, N.Y., and Huntington Beach, Calif., specializes in selling or leasing underused, excess and vacant retail space and has worked with everyone from Fred Meyer and Winn-Dixie to Staples and Borders.

Two years ago, Advance Auto Parts acquired Discount Auto Parts, which necessitated the sale of 110 fee-simple properties. Excess Space represented Advance in the disposition of the surplus real estate and in the first year, three-fourths of the properties were sold, under contract or set to go to contract.

The typical scenario for Klaff, Kimco and now Acadia, says Makler, is to acquire a large number of properties that are either owned by a retailer, or in the case of bankruptcy, to acquire leaseholds at a discount. “Frankly, there are not that many of those opportunities.” Makler suggests that more opportunities probably exist, especially for local investors, to buy at a discount a neighborhood center where the major tenant is gone and is no longer paying rent or where the anchor is gone but is still paying rent.

Federal Realty Investment Trust takes such an approach. It looks for neighborhood or community shopping centers that are well-located, but in need of redevelopment. “We think we can add value over time through re-leasing, re-merchandising and redeveloping,” says Jeffrey Berkes, the Rockville, Md.-based REIT's senior vice president of strategic transactions.

Last year, Federal Realty bought two contiguous shopping centers in northern Virginia; both suffered from deferred maintenance and key tenant vacancies. The South Valley Center, which contains 213,000 square feet, lost Frank's Nursery & Crafts, so it had 16,000 square feet vacant. The Mount Vernon Plaza, at 257,000 square feet, lost one of its anchors, an 80,000-square-foot Ames.

“Since 1995,” says Berkes, “We have dealt with 1.4 million square feet of space left vacant by bankrupt retailers and we have leased 95 percent of that space at cash-rent-increases of 27 percent. You can see this is a real opportunity for us.”

In some areas of the country, there just aren't very many empty big stores. “Not a whole bunch of that is going on now for the most part because on the West Coast the retailers are doing well,” says Richard Walter, president and CEO of Faris Lee Investments in Irvine, Calif. “The only place you'll see empty anchors is at Home Base in the outlying areas where it is difficult to envision who the next tenant might be.”

OPPORTUNISTIC BUYS

HIDDEN EQUITY

Many older leases are below market value. So even if the building looks a little tired, there's still equity left. Retenanting the site and raising the rent can provide a substantial payoff in some cases.

MOVING IN

Value merchants such as Big Lots, Dollar General and Family Dollar are the most aggressive takers of older big-box space.

NEW BLOOD

Developers Diversified turned dead Service Merchandise stores into new homes for Value City Furniture, T.J. Maxx, Bed Bath & Beyond, Marshalls, Circuit City, Best Buy and A.C. Moore.

DEAD ZONES

Opportunities are becoming more limited; sometimes even old Wal-Mart spaces have trouble getting re-leased. It's particularly hard to find good deals on dead space on the West Coast. Empty big boxes are more plentiful in the Southeast and along the East Coast.