Grocery-anchored centers, long considered recession-proof investments, are proving fatally vulnerable as Wal-Mart and Target roll out their “supercenter” concepts. When the discount retailers come to town selling food, existing grocery stores feel the pinch. In some cases they fail and take entire centers down with them.

Prudential Real Estate Investors cited the danger in a recent Market Perspective Report. New Wal-Marts and Targets, complete with 70,000 square feet of grocery space, have “increased the risk of owning grocery-anchored centers,” the report warned.

So far, the danger has not affected sales of grocery-anchored centers. With strong demand for the presumed safety of grocery-anchored properties, prices have risen steadily. Capitalization rates for neighborhood centers fell to 9.97 percent in 2001, when 158 centers sold, from 10.11 percent in 2000, when 165 centers changed hands, according to New York-based Grubb & Ellis. As of mid-October last year, 106 centers had sold, and cap rates had dropped to 9.78 percent, indicating continued aggressive bidding.

According to Marcus & Millichap's 2002 National Retail Report, the average price for standalone supermarkets and supermarkets within shopping centers climbed to $100 per square foot in the second quarter of 2002 from $95 per square foot at the end of 2001. Prices are expected to continue to rise, says Bernard Haddigan, managing director of Marcus & Millichap's national retail group.

The disconnect between rising prices and rising risk in grocery-anchored properties alarms Morgan Stanley analyst Matthew Ostrower. “We're concerned that they're far from bulletproof,” he says.

By Morgan Stanley's estimates, Wal-Mart's Supercenter brand has become the No. 1 grocer by national market share. And it got there largely by undercutting prevailing prices — a most unwelcome development in an industry known for thin margins and already racked by market-share wars among the top chains.

Last fall, the nation's largest grocers all began warning of falling profits. Kroger, now the No. 2 chain, according to Supermarket News, recently reported a drop in third-quarter earnings and projected zero growth for 2003, compared with previous full-year estimates of 10 percent to 12 percent earnings growth. No. 3 Albertsons reported disappointing third-quarter earnings, while Safeway, No. 4, issued warnings about the fourth quarter.

Factor in some new competitors and their outlook could grow dimmer: Wal-Mart plans to add or expand 200 to 210 Supercenters in 2003, and Target and Costco are putting more emphasis on groceries, too.

When supercenters arrive, the impact on existing supermarkets is usually immediate and sometimes fatal. Take Decatur, Ill., a town of 85,000, for example. Wal-Mart opened two Supercenters there. Two years later, St. Louis-based Schnucks closed its 62,000-square-foot high-end supermarket in Decatur's Northgate Plaza shopping center, citing competition from supercenters as a primary reason.

“What the supercenters did was really drive the prices down,” says John Cardwell, CEO of Commercial Realty One, a local broker and developer. Decatur lacked the high-end shoppers who might have sustained the higher-priced Schnucks, he adds. Now, the grocery store is dark, and the remaining tenants, including OfficeMax and Hollywood Video, might close, too. The center also includes a shuttered 55,000-square-foot Kmart, which makes it harder to fill the Schnucks space, Cardwell says.

This is no isolated incident. In Shawnee, a growing suburb of Kansas City, Kan., Price Chopper closed a 60,000-square-foot store after Target and Wal-Mart opened supercenters within about one mile of the grocer. Now some 77,000 square feet of the 92,000-square-foot shopping center sits vacant.

Haddigan of Marcus & Millichap says that investors are beginning to recognize the supercenter threat. When a property with a grocery tenant comes on the market, the first question asked of brokers is whether Wal-Mart is in the market or is expected to be. “Any investor who knows what he's doing has asked this question a lot over the last few years,” he says. “Now everyone's asking it.”

Heritage Property Investment Trust, a Boston-based REIT, is focused on the issue. Some 80 percent of its 25 million-square-foot portfolio is in grocery-anchored strips and, says Heritage COO Gary Widett, there are no plans to veer from the core strategy. The company, however, now spends more time scrutinizing the position of the grocery anchor in any deal. It looks for grocers that have strong local appeal — and will win back customers who are momentarily attracted by Wal-Mart's pricing.

“Obviously grocers are still in existence and thriving,” Widett says. “But they need to do everything they can to compete with Wal-Mart, and do it better.”