Doron Valero, president of Equity One Inc., knew he had a problem. Two shopping centers in his portfolio were losing Kmarts while Winn-Dixie was pulling out of two others, leaving 50,000-square-foot gaps at each center.

“I can tell you that when that anchor drops on you, it has a significant effect,” says Valero.

But rather than trying to find a replacement big box, Valero chose another route. He took those gaps, divided them into three parcels and gave between 18,000 and 22,000 square feet at each center to Dollar Tree. With its high traffic, Dollar Tree helped bring in other tenants, like Marshalls, Bed Bath & Beyond and, at one property, even another dollar store chain: Family Dollar. And while dollar stores usually ask for below-market rents — Valero puts the figure at about $8 per square foot — they still pay more in rent than a supermarket or Kmart, which pay between $4 and $5 per square foot.

“When you have a dark store, a successful dollar store can bring a lot of traffic,” says Valero. “Especially when we lost Winn-Dixie, and put in a Dollar Tree; it did well because these stores have a lot of food nowadays.”

That attitude is a marked change from the past when dollar stores were shunned by REITs because of the perception that the low-budget stores were dingy and didn't draw the target demographic for the center. But now with cross-shopping more pervasive than ever, dollar marts have lost that stigma. And developers have begun to notice the high traffic and sales volumes and started incorporating the sector into their properties. Not even higher gas prices have stopped them as the big chains, such as Dollar General and Family Dollar, have adopted new initiatives to cope.

Traditionally, dollar outlets were to be found in rural, freestanding locations with double or triple-net leases, says Chad Chadwick, a senior adviser at Sperry Van Ness. However, their aggressive expansion is placing them in shopping centers across the country. Being a major source of foot traffic and open seven days a week, dollar stores can act like a mini-anchor drawing in other tenants.

“Because we are in redevelopment [of shopping centers], we've always seen them as a good complement to bring in,” says Michael Mugel, CEO of Red Mountain Retail Group, a Santa Ana, Calif.-based developer and owner of shopping centers. “They really help to bring back to life, a property with second-generational space.”

With about 65 shopping center properties in seven states, including California and Arizona, Mugel estimates that about a third of his properties have dollar stores.

Everybody Loves a Deal

The dollar store is also now more accepted among all income groups as they have moved into more suburban and urban areas. “We are finding that they are being shopped by all income classifications, even though they are often skewed to lower and middle-class income shoppers,” says Todd Hale, senior vice president of consumer insight at ACNielsen. Nearly one-third of us shop there on a monthly basis, according to a Retail Forward ShopperScape survey. About 50 percent of households making over $70,000 have shopped there at one time.

“Everybody loves a deal,” says Mugel. “You can buy a lot with $20 at a dollar store.” In Southern California, dollar stores, such as 99 Cents Only, can be found in all areas, even close to ritzy neighborhoods like Beverly Hills.

The appeal of dollar stores is becoming greater as higher gas prices squeeze many segments of the population. They are also adding more national brands these days. Right now, 36 percent of Family Dollar's items are national brands such as Tide, Crest and Coca-Cola, compared with 27 percent in 1999. The remaining items are private, no-frills brands. “As we add more name-brand merchandise, we widen our appeal across all income levels,” says George Mahoney, executive vice president of Family Dollar Stores Inc.

While no dollar chain has yet made it nationwide, aggressive expansion at Dollar General and Family Dollar ensures that one of them will probably soon hold that distinction. Dollar General, the largest retailer in the United States. in terms of store count, has 7,200 stores and will add 730 more by year's end. Family Dollar, the second-largest retailer by store count, has 5,600 stores and plans to open 500 to 560 more this year.

Ultimately, the effectiveness of the industry depends on offering quality merchandise at low prices. So how do dollar stores achieve that? Through efficiency, size and low operating costs.

First, their size gives them great purchasing power. It's a strategy similar to Wal-Mart. But unlike Wal-Mart, which buys and sells in bulk, dollar stores sell in smaller quantities. This not only serves the needs of their core customer, who has limited funds, but it also stretches product further.

For example, where a Kroger supermarket might sell a 60 ounce container of Gain fabric softener at $4.99 on sale, Family Dollar will sell about 33.8 ounces of no-frills brand Suavitel softener for $1.75.

Second, the major dollar store chains have their own distribution centers and run them very efficiently. Recently, Family Dollar opened its eighth distribution center in Marianna, Fla. at 900,000 square feet. “It's a very modern, paperless and efficient distribution network,” says Mahoney. “This is critical to our success.” Distribution to individual Family Dollar stores is determined by sophisticated, demand-based software, which ships merchandise to stores based on prior sales.

While major dollar retailers own their distribution warehouses and trucking containers, they contract their drivers from private companies in order to bypass employee costs.

Third, even though they are in more high-end markets these days, they only lease space in older, second-tier centers. Preferring to pay single-digit rents, they won't lease space in “A” locations. “They can be in a ‘C’ class strip center, two blocks away from where Walgreens paid a premium,” says Chadwick.

As the expansion continues, not even high gas prices have stopped them, though it has slowed them down somewhat. Earnings at Family Dollar fell 10 percent to 14 percent last year in back-to-back quarters, as higher prices squeezed its core customer.

In response, Family Dollar rolled out its urban initiative, with about 60 percent to 65 percent of new stores opening in urban areas. This is a different approach from the company's traditional rural/small-town base. “We have higher sales and greater density of customer base here than you have in a small town or rural area,” says Mahoney.

The strategy has been successful in achieving higher year-over-year sales. Comparable sales at Family Dollar grew 4.5 percent in the past quarter and the company expects to reverse its pattern of falling profits by summer.

Dollar General also has responded in kind by creating its Market store, which includes an expanded section of frozen and refrigerated products along with fresh fruits and vegetables. “We are seeing a lot more focus these days in food, beverage and fast-moving goods,” says Hale. “They are trying to make this format more of a planned shopping trip instead of just ‘treasure hunt’ shopping.”

Double the size of its typical stores at 16,000 to 17,000 square feet, Dollar General has rolled out 38 Markets thus far and plans to build 30 more this year. Although overhead costs at the Market stores are higher, so too are annual sales. Market stores can bring in annual sales of about $2.5 million compared with $1.1 million for a regular store.

Supermarkets Beware

However, while many customers may love the low food prices at dollar stores, the shift in strategy spells trouble for other retailers, especially supermarkets. For example, Equity One has a portfolio of 188 shopping centers; 57 of those centers are not grocery-anchored. The ones that have grocery stores usually don't want a dollar store there, increasingly viewing them as competitors. It's easy to see why. According to Retail Forward, 61 percent of Dollar General's mix is now food, compared with 42 percent in 1998.

“If you do a redevelopment deal with a supermarket, we find that they don't want the dollar stores nearby,” says Mugel.

The new emphasis on low-cost food perishables could not only affect supermarkets, but may also impinge on Wal-Mart's supermarkets. “They are the one niche in retail that is not threatened by Wal-Mart,” says Bernard Haddigan, a managing director at Marcus & Millichap. “Wal-Mart is going to have a tough time undercutting them and putting them out of business.”

So if you can't beat them, copy them. Wal-Mart, along with other retailers like Target, has started adding dollar aisles. Even Sears has emulated the dollar store industry by adding a dollar section at its off-mall Sears Grand stores.

However, Wal-Mart cannot match the convenience of the dollar stores. “Seeing what you want from the front door and getting in and out very quickly is a key factor to our appeal,” says Mahoney. That aspect of the dollar mart's appeal is only expected to grow as the American population ages and becomes less mobile possibly not wishing to navigate Wal-Mart's labyrinthine layout.

“Because there are so many and because they've grown so rapidly, it's tough for anyone to compete with them,” says Karl Bjornson, a senior manager and retail operations specialist with Kurt Salmon Associates speaking of the dollar outlets.

It's an industry that is growing larger. The channel adds five new stores a day, or about 350,000 square feet a week. It is also extremely profitable. Selling relatively cheap merchandise in bulk, gross margins are around 40 percent due to high mark-ups. That amount of profit allows for great reinvestment.

ACNielsen estimates that the dollar store channel, currently with almost 30,000 units, could easily add another 15,000. Retail Forward projects market saturation is still 10 years away. “I think they have proven themselves to be a lasting business,” says Valero.

DOLLAR STORES

CHALLENGE:

In a retail environment where the lower, discount end is increasingly defined by Wal-Mart and Target, how do you carve out a niche that appeals to the value-minded consumer?

SOLUTION:

Dollar stores have managed to compete with large discount chains by offering quality merchandise for low prices in a small, more shopper-friendly environment. Their small size offers them greater expansion options.

BUZZ:

Increasingly, shopping center owners have seen dollar stores as a way to revitalize dark centers and bring occupancy rates back up. One REIT owner says he can get $8 a square foot from a dollar store rather than the $4 to $5 he got from Kmart or a supermarket anchor.

DATA:

Next to supercenters, dollar stores are the fastest-growing segment of retail. The industry adds about five new stores a day, or 350,000 square feet a week, according to Retail Forward. Market saturation is estimated to be 10 years away.