Investors searching for distressed big-box deals are facing competition from an unlikely source — retailers. Large tenants including Walmart, Target, Kohl's 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.

“If you have a financial model that suggests that the location is going to be successful in every aspect for many years to come, there may well be a case to owning it rather than leasing,” says Geno Coradini, managing director of corporate retail solutions with Jones Lang LaSalle. “It's not happening on a mass scale, but conversations are occurring.”

As a result, retailers have become larger players in the single-tenant market than in the past. 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 for years to come and won't be affected if, say, there is a large spike in rental rates as the retail market continues to recover.

In addition, there is possible upside on the exit as well if retailers are able to sublease or sell the boxes in a market where real estate values have recovered from today's depressed levels.

Part of what is making this trend possible is that the healthiest big-box tenants have cash on hand or access to cheap capital.

Over the past few years, as a response to the credit crunch, retailers have put a focus on cutting costs and building up cash reserves. That has allowed many of them to amass considerable war chests, industry sources say. Consequently, they are able to pay a premium beyond what an opportunistic investor would be willing to pay for the same asset. And now that many are beginning to think about expansion, this is the perfect time to deploy their money while the market continues favoring the buyers

In addition, large retailers, like Walmart, typically have lower borrowing costs than real estate investors because of their pristine credit ratings.

Moreover, since retailers are not necessarily looking to the asset to generate cash flow, they are not as sensitive to price nor trying to strike the biggest bargains when bidding for assets. Lastly, another difference is that a retailer is buying a space to occupy it whereas an opportunistic investor has no guarantee of a tenant when buying an empty box. It's a different risk exposure.

Add that all up and it means that large retailers, when going after vacant big boxes, are able to pay a big premium beyond what opportunistic investors are willing and able 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 when it involves boxes that are 60,000 square feet or larger. It's not as common a 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.

However, there are risks as well, Coradini says. “If a retailer ends up purchasing a site and finds it is not successful in their business, now disposition becomes a concern. Plus, you still have the exposure to insurance and taxes, for that property.” At that stage, the retailer needs to sell the property or lease it to another tenant. And that process can get tricky because a retailer may not want to sell or sublease to a competitor. This ultimately limits the number of potential end users.

West Coast focus

The strategy has been particularly prevalent on the West Coast, where there is a large amount of distressed retail real estate in the region. 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 percent of the total and Nevada ranks fifth, accounting for 6.5 percent of the total (see table).

Nationally, the CMBS delinquency rate rose to 8.93 percent in November up from 8.58 percent in October, according to Trepp. Multifamily surpassed lodging as the sector with the highest delinquency rate. The multifamily rate is at 15.80 percent (up from 14.63 percent in October) while the lodging delinquency rate fell to 14.56 percent from 14.92 percent in October. The lodging delinquency rate peaked at 19.33 percent in September. The delinquency rate for industrial properties fell from 6.27 percent to 6.64 percent. It rose for office properties from 6.68 percent to 6.95 percent.

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 this year.”

DUBIOUS TOP FIVE

States with the highest concentration of retail CMBS loans in special servicing

State Properties Balance Pct of Total
California 276 $2.61B 13.90%
Arizona 165 1.51 8.10
Florida 164 1.49 7.90
Texas 367 1.29 6.90
Nevada 78 1.22 6.50

Source: Trepp LLC