Mark Toro walks a short three blocks each day from his home to his new office in Atlantic Station, a sprawling mixed-use development on the western edge of Atlanta's Midtown area.

As managing partner for North American Properties (NAP), Toro is responsible for polishing the tarnished gem that was, only three years ago, a gleaming example of one of the largest brownfield redevelopments in U.S. history.

After years of neglect and a lack of significant marketing efforts thanks to owner AIG's financial woes, Toro and his team are now tasked with the daunting challenge of turning the property around. “It was starved for capital,” says Toro.

The same can be said for countless shopping centers and regional malls across the country today, as owners struggle with cash flow problems brought on by continued high vacancies.

In the case of Atlantic Station, a joint venture between Cincinnati-based NAP and Los Angeles-based CB Richard Ellis Investors closed on the purchase of the 534,000 sq. ft. retail component for just $78.5 million on Dec. 31, 2010.

That was a huge discount considering the initial construction cost was pegged at more than $100 million upon completion in late 2005.

Holding at 88% occupancy at the time of the sale, the property itself was not technically “distressed,” but its reputation had taken a significant hit in the past two years as it failed in its initial mission to become a regional mall-type destination.

“It tried to be all things to all people. It wanted to be a mall, but it's not a mall,” says Toro.

The plan is to re-merchandise much of the retail mix to better engage the nearby Generation Y residents, most of whom were born after 1981.

Toro solicited feedback from Midtown Atlanta residents through social media channels including Twitter, Facebook and blogs. The hundreds of comments contained several core themes, including a need for heightened security. To combat the perception that Atlantic Station had developed a “nightclub” scene, Toro closed The Geisha House restaurant in March.

Residents also wanted a trendier vibe, a shopping experience tied to the hip, younger Midtown scene. The evolution kicked off in January with the closing of upscale fashion retailer White House/Black Market. Toro also plans to change as much as 75% of the restaurant lineup, and is searching for innovative concepts from Austin, Seattle and Denver.

“We're taking retailers that don't belong here and cutting them loose to bring in new retailers and restaurants that resonate with the market,” says Toro. “This Gen Y creative class group in Midtown is anti-mall and pro-experience. So, whether it's a Friday night jazz trio or a Tuesday afternoon juggler, the experience of being on this property is a critical component to its success.”

Local market observers are taking note. “I am glad to see someone take an aggressive posture on that property,” says Bernie Haddigan, principal of Haddigan Capital, an Atlanta-based real estate investment adviser.

“They're going to have to work hard and do some heavy lifting, but if there's a hands-on branding and management campaign it will come back.”

Straying too far

In scouting for the Atlantic Station deal, Toro reviewed hundreds of retail projects from coast to coast over the past two years and found a common theme.

“Occupancies continue to decline, rents continue to decline, retailers' sales are limping along and retail is in for a long slog when it comes to recovery, especially in those communities where retail was overbuilt,” he says. “And that is virtually every suburban community in the U.S.”

Retail distress hit suburban and secondary markets hard where developers used easy money in a rush to build ahead of residential construction.

“When developers were given high loan-to-values they tended to build too much,” says Kris Cooper, managing director of retail capital markets at Chicago-based Jones Lang LaSalle.

“Normally retail follows house tops, and I think we got inverted before the crash where retail preceded the house tops in some cases and those centers got killed,” adds Cooper.

Developers strayed too far from the urban core with too many projects, says Spencer Levy, executive managing director of capital markets for Los Angeles-based CB Richard Ellis. “What is troubled are many developments that were done one or two rings too far outside the dense demographic cores.”

Chris Macke, senior real estate strategist at researcher CoStar Group in Washington, D.C., says those trends are expected. “Developers pushed the envelope, again. That happens in every cycle.”

The barbell effect

Many analysts characterize the current state of the retail property market as a “barbell.” At one end properties like Atlantic Station are clinging to health and can be purchased for a substantial discount. At the other end of the barbell are the robust trophy assets that command high prices from institutional investors looking for consistent cash flow.

“A lot of people are looking for the core assets that are performing and well located, well leased, that have staying power and have cash flow going forward,” says Gerry Mason, executive managing director at New York-based Savills, a global real estate advisory firm.

Institutional investors, in particular, have been actively acquiring retail properties in core markets, says Levy. But with prices still climbing, institutions are casting a wider net.

“I would argue that you can get a better risk-adjusted return in some of these secondary markets,” says Levy.

Just what the doctor ordered?

Fountain Village Shopping Center, a neighborhood retail center in Desoto, Texas, south of Dallas, had become obsolete. Built in 1986 and renovated in 2000, the 37,000 sq. ft. center saw its occupancy plunge to only 25% by early 2011.

Enter Baceline Investments LLC, which purchased the foreclosed property in April 2011 from a special servicer for just $1.2 million, or 60% of the property's loan value. Baceline, a Denver-based private equity real estate investment management firm, has holdings in the Midwest, Southwest and Rocky Mountain states.

David Puchi, a principal in the firm, says Fountain Village's prime location in a densely populated area makes it an ideal fit for the company's distressed property initiative, a program designed to transform distressed retail centers into low-cost medical office space.

Fountain Village is Baceline's fourth distressed property acquisition in the past year as part of its initiative. The firm's capital is sourced through private high-net-worth individuals and families.

Baceline also is looking at a similar deal in Cincinnati and scouting for more properties in the Dallas-Fort Worth area.

Baceline has been targeting commercial real estate in stable metropolitan areas throughout the nation's heartland that have a history of growth, says Puchi.

Last year, Baceline acquired University Commons, a 100,000 sq. ft. multi-tenant retail center in South Bend, Ind. It sold the property to a group of doctors eight months later after converting it to medical office use, turning a 117% profit.

“They were looking for convenient, inexpensive medical office space that had parking that they could build out the way they wanted. There is a lot of density in the neighborhood, so we saw similarities in converting the Desoto property into medical space,” says Puchi.

Rather than target major coastal markets, which Puchi says are getting overpriced, he plans to tackle the markets that lie in between. “There is a lot of real estate in the heartland, so we look forward to doing quite a few more of these,” he says.

Puchi says he shuns properties marketed by large brokerage firms or which have received too much publicity, fearing they will carry a higher price tag.

That was the case with Fountain Village. “It was not heavily marketed and was a little bit off the radar. If it's being heavily marketed, then it's going to be a different ballgame.”

Demolishing the malls

When it comes to the major leagues of retailing, the star players are malls. The International Council of Shopping Centers says about 1,300 malls remain in the United States, and many are struggling to remain relevant in their markets.

Regional mall vacancies spiked in the first quarter of 2011 to an all-time high of 9.1%, a jump of 40 basis points from the previous quarter, according to Reis. That surpassed the previous high of 9% in the second quarter of 2010. Reis began tracking the sector in 2000.

Distress in the mall sector is easily seen in the recent sales activity. In 2010, Jones Lang LaSalle brokered the sale of five malls, and four of them were distressed and located in tertiary cities.

“That was the correct ratio of what transacted in the mall sector last year,” says JLL's Cooper. “There will continue to be secondary and tertiary mall sales from the special servicers the banks and potentially the REITs.”

Thankfully regional mall construction has ground to a virtual standstill in recent years. But Savills' Mason expects 300 of the existing regional malls to either go dark or be redeveloped. “A lot of them are just going to be torn down.”

They might also be sold first. In April 2011, several of the largest real estate investment trusts (REITs) put 40 average or under-performing malls up for sale, hoping to cash in on the improved commercial real estate investment market.

It is a case of the “haves” and the “have-nots” says CoStar's Macke. “Either you're the mall or you're not. What typically happens is the new mall is newer and often better located. People like anything new, so they steal the best tenants from that existing mall and that existing mall goes downhill.”

Shopping for the right fit

Adding to the woes of many secondary market and older malls are the movements of traditional mall anchor stores to trim their space needs. Major mall anchors like Macy's, Dillard's, Sears and JCPenney are all busy calculating how to do more with less.

In many ways the “bigger is better” concept may be past its prime. “In general they all need less space, and it is going to disappear in front of our eyes nationwide and it's going to be a hard retrenching,” says Mason.

As many larger retailers reduce their store size, other retailers are eying new mall entry points. Fitness centers, for example, have become increasingly expansion minded, and often the 40,000 sq. ft. anchor box is a good fit.

In early 2011, Gold's Gym announced expansion plans into Oklahoma, taking over two boxes left dark by a former Circuit City store and a former Sportsman's Warehouse.

Across the state in Tulsa, Sky Fitness and Wellbeing leased the 40,200 sq. ft. former Mervyn's space at Tulsa Promenade Mall in April 2011.

“We are buoyed by the fact that many retailers are still expanding, but many lenders and borrowers are in denial about the underlying issues and the distress their properties are in,” says Brad Hutensky, a general partner with retail investment firm Hutensky Partners.

“I talk to some borrowers who are 90 days behind, and they still think everything is fine,” adds Hutensky.

More pain and heavy lifting will be the order of the day as retailing struggles to recover.

“It's not the rising tide lifts all boats this time around,” says Hutensky. “There will be selective opportunities at the same time when other properties may be suffering.”

Retail Recovery is Still in the Early Innings

Most analysts believe that any recovery in retailing will be a slow grind. While national sales jumped by 8.1% in the first quarter of 2011 compared with the same period a year ago, retailers are still struggling to remain financially viable. Translation: Any recent improvement in sales has not trickled down to the property level.

In the first quarter of 2011, the national retail vacancy rate held steady for the fifth consecutive quarter at 10.9%, according to New York-based researcher Reis. The rate reached its all-time high of 11.1% in 1990.

“I really don't think the recovery in retail is so smooth,” says Victor Calanog, vice president of research and economics at Reis. “Vacancies are still going to be in bouncy territory over the course of this year at least.”

That sentiment has many questioning just how far the recovery has progressed. “For distressed retail, we are probably in the third inning of a nine-inning game, which could go into extra innings,” says Gerry Mason, executive managing director at New York-based Savills, a global real estate advisory firm.

The extra time may be a result of a surprisingly robust construction pipeline. Reis is projecting some 14 million sq. ft. of neighborhood and community centers to be built in its 80 major markets in 2011. That is more than triple the amount that came on line in 2010. “That's a fairly big shock to the system,” says Calanog.

He notes that about 7 million sq. ft. of the projected new starts were delayed from 2010. “It's this funny delay and cancelation game that developers play because they know if they open their center in the debacle that was 2009 and 2010 they'd find no tenants. So, they tried to delay as long as they could.”

In the next two to three years, the volume of distressed retail properties coming to market could potentially spell trouble for the entire industry. “We have a 24- to 36-month pipeline of distressed retail loans,” says Tom Fink, senior vice president of New York-based researcher Trepp LLC. The firm tracks loan delinquencies in the commercial mortgage-backed securities (CMBS) market.

While the volume of distressed CMBS retail loans that are maturing is particularly large in 2011 and also in 2016 and 2017, the pace of loan workouts is now matching the pace of new delinquencies.

A fresh batch of loans in the retail sector totaling $1.9 billion became delinquent in the first quarter of 2011, while workouts totaled $1.5 billion, for a net addition to distress of about $350 million, according to New York-based Real Capital Analytics.

Although the delinquency rate on retail CMBS loans ticked up slightly to 8.15% in April 2011 from 7.72% in March, is the retail sector nearing an inflection point? “Yes, because you are going to start seeing the delinquency rate come down in the next three to six months,” says Fink. “But there is still a lot of work to be done to get rid of all this garbage in the system.”

Ben Johnson is a Dallas-based writer.