With values improving and the number of buyers increasing, investors and brokers are enthusiastic about most types of retail properties. However, some fear that the industry is becoming oversupplied and that a shakeout is imminent.
The past year has brought a major improvement in outlook for shopping center investment. Although difficulties remain and acquisitions require both extremely careful selection and equally careful scrutiny, now appears to be a good time to buy. According to most sources, markets throughout the country have bottomed out and begun an upward swing. In some regions, the trend is fairly advanced. In others, such as California, it has just begun.
Whether it is a good time to sell, however, is open to question. Buyers are definitely out there, but enough REO and distressed properties remain available to depress prices for all but the highest quality and best-located centers. The depressed prices obviously make properties attractive to new investors, but unless owners acquired their holdings prior to the inflated market of the '80s, selling may not make sense.
"We're pretty high on future [retail] acquisitions," declares Donn Fuller, senior vice president of Dallas-based MEPC American Properties, which confines its able, with few purchasers willing to bid up prices in order to close a deal. The separation between winning and losing offers, they report, is often small and may hinge as much on the specifics of a contract as on the actual dollar amount. On the other hand, correctly priced centers interest in retail to regional malls that dominate or have the potential to dominate their markets.
Investment advisers and brokers reveal a similar enthusiasm for other types if retail, including neighborhood, community and power centers, as well as free-standing leased buildings and higher-end specialty centers in more traditional urban locations. However, not everyone agrees on the merits of any particular category, and virtually all limit their recommendations to select choices within each category.
"In the past 12 months, we've seen a dramatic improvement in the market for retail properties," says Chris Kostanecki, a senior agent specializing in the sale of retail product with the San Francisco office of Marcus & Millichap. "Cap rates are being bid down, and prices are beginning to get bid up. Value has definitely improved. The number of buyers is increasing."
Contrary to Kostanecki's experience, most observers say a significant difference between today's market and that of the '80s is the reluctance of buyers to compete aggressively for the product available with few puchasers willing to bid up prices inorder to close a deal. The separation between winning and losing offers, they report, is often small and may hinge as much on the specifics of a contract as on teh actual dollar amount. On the other hand, correctly priced centers tend quickly to find buyers willing to pay the asking price, or close to it.
Nonetheless, Fuller cautions that the scenario is not all rosy: "One concern we have as an investor is there's got to be some kind of shakeout. There's too much retail competing for the same market. The key is to know what you're doing."
Especially adamant about the need for prudence is Ira Kalish, senior economist with Management Horizons in Los Angeles, the retail consulting division of Price Waterhouse. While agreeing the market offers strong opportunities, he believes pitfalls abound.
"Retail real estate overall is troubled," he maintains. "The country is seriously overstored. Strip centers are definitely doing better than malls, but there are too many of them, too."
"Total retail construction is once again on the rise and investors should take notice," states a report by Nomura Securities International Inc., New York. "The proliferation of new retailing value-oriented formats has accelerated the development of new retail space.
"At least for the near term," the report continues, "many untapped markets throughout the country, especially in the middle markets, await the new retailing concepts and, at least so far, there are no glaring signs of over expansion."
Regardless, numerous retailers continue to expand, some at a remarkably rapid rate. Among the fastest growing categories are computer electronics; home-related merchandise, including furniture, linens, home entertainment, hardware and pet and gardening supplies; quality and ethnic fast-food, coffee/bakery and family or theme restaurants; athletic gear and fitness facilities; and entertainment including cinemas, music and video stores, bookstores and interactive game centers.
Apparel sales, especially at the higher end, continue to decline. Particularly hard hit are full-price clothing retailers and those catering to teenagers. Practical clothing and merchandise suitable for several different types of occasions are holding up best.
A strong thread of entertainment runs through almost everything. While barebones warehouse stores continue to draw crowds in certain categories, the general trend is to make stores fun and exciting, whether achieved through participatory or theatrical activity or through artful display and graphics. Even supermarkets need to put on a show by presenting merchandise in creative ways.
The future appears to hold even greater emphasis on entertainment, with both successful regional malls and urban centers becoming major amusement centers.
"That's exactly what's going to be happening over the next 10 years," contends Nick Javaras, president of Terranomics, a retail development, leasing and management company in San Francisco. "Entertainment is exploding. It's probably the hottest thing going, and I don't think it's just a short-term trend."
The long-term outlook for regional malls appears to be mixed. Overall, mall sales have been in decline for several years, and hardly anyone expects the direction to reverse. The overall judgment, however, does not necessarily apply to individual malls, many of which have maintained their position or even enjoyed substantial sales increases. Those malls that continue to do well, analysts argue, will cash in on the trend to entertainment by adding movie theaters, video game centers, entertainment-oriented retailers, restaurants, nightclubs and promotional events.
Outlook mixed for regional malls
"On the whole malls are losing market share, and strip centers seem to be benefiting," asserts Richard Wolf, director of corporate services for New America Network in Chicago, a network of 160 independent real estate brokerage firms throughout the nation. "But there are definitely exceptions."
These exceptions, says G. Andrews Smith, principal of the L&B Group in Dallas, constitute probably the best real estate investment of any kind available today.
"Enclosed malls aren't as volatile as other forms of retail," he says, making it clear he's speaking not of malls in general but only of prime properties. "It's been our experience that malls perform the best both in up cycles and down cycles. The rate at which they increase may slow, but I can't think of any period where they actually lost value."
According to Smith, L&B has approximately 20 million sq. ft. of regional mall GLA in its portfolio, with another three properties under letters of intent.
"We like very large regional shopping centers because usually they require a lot of land, and it's going to be hard for anyone else to find enough land in the same area to compete," he explains.
Other criteria include high population and income levels. "It takes two things for a shopping center to work, people and income. If you've got those, unless the center is poorly managed or undercapitalized, you've got it made", Smith says.
While both men caution against investing in new centers in outlying areas, Smith says they can make sense if future demographics look good, but they involve more risk. In addition, he points out, short-term return from income is likely to be lower.
"We generally want to see two-thirds of the return from income, but if you have patient capital that will go with 50% in income rather than two-thirds, a new center might be a good deal. It's a bigger risk, and the cap rate should reflect that," he says.
The majority of malls do not fall into the elite category. Smith estimates there are perhaps 250 total in the United States that meet the criteria, with another 100 to 150 nearly qualifying. Although few Cadillac-quality properties come available in a typical year, Fuller reports there are more acquisition opportunities in regional malls than ever, with "well over 100 centers out there" for sale.
The long-term outlook for secondary and tertiary malls is not strong. Several factors converge to spell trouble for this market segment.
"A lot of malls out there are too big," maintains Javaras. "Many of the specialty stores that formed the backbone of the mall economy have gone out of business, and there's no one to replace them."
In defense of the malls, Phillip E. Stephens, president and CEO of Atlanta-based Compass Retail, which manages 32 centers across the country -- most of them regional malls -- says: "Folks who predicted the demise of the department store four or five years ago have been proven wrong. Department stores are healthier than they have been in years."
A big problem, Javaras says, is the rising population of large-store formats that don't lend themselves to mall configurations. "We're going through a period of functional obsolescence and restructuring, and the enclosed mall in particular is poorly equipped to handle this," he notes.
Wolf agrees, commenting: "The arrangement of an enclosed mall is generally inflexible. If you want to make significant structural arrangements, it gets very expensive." In addition, he continues, when one of a mall's department store anchors goes dark, it typically takes 18 months to three years to find a replacement. In a strip center, you can have a replacement anchor in place in 120 days. There's a plethora of candidates who can fit in without cannibalizing other tenants," he says.
Despite the generally gloomy outlook, secondary properties are not always poor investments. Both Fuller of MEPC and Smith of L&B indicate their respective companies will consider an underperforming project for purchase if they believe it has the potential for significant repositioning. The trick is to separate the wheat from the chaff.
"Problem properties tend to fall into two categories," says Smith. "Either the owner's distressed and the property isn't, vacant when sold, its location in the heart of the densely populated and high-income San Francisco Peninsula attracted the interest of four competing bidders.
"I do see some new development of regional malls," says Stephens. "Most will occur where there is a smaller and older regional mall that is not serving its market base adequately or in fast-growing parts of the United States that are seeing demographic shifts."
Stephens also says there will be more renovations and expansions of existing malls. "People who shop are looking for something new; that applies to surroundings as well as merchandise," he says.
Regional shopping centers are seeing select new development, as well as renovation, expansion and acquisition.
MEPC's largest mall, the 1.5 million sq. ft. Northridge Fashion Center in Los Angeles, will reopen this summer following reconstruction from damage suffered in last year's earthquake.
The Woodlands Mall, which opened last Oct. 5, was the first regional mall to open in the Houston market in 10 years. Owned by a joint venture of Chicago-based Homart and The Woodlands Corp., the 1 million sq. ft. mall was 95% leased as of mid-December with Dillard's, Foley's, Sears and Mervyns as anchors.
Also in October, Homart opened the 1.2 million sq. ft. redevelopment of Natick Mall in Natick, Mass.
And this April, Homart announced that it had purchased 130 acres in Ocoee, Fla., to develop West Oaks Mall, a 950,000 sq. ft. regional shopping center that is scheduled to open in fall 1996.
The Hahn Co., a San Diego-based subsidiary of Trizec Corp. Ltd., is planning a September 1996 opening of the 1.5 million sq. ft. Park Meadows Mall in Denver, Colo. Nordstrom and Dillard's are two anchors stated for the $164 million project. Union Bank of Switzerland will be providing $132 million in financing, with Trizec furnishing the remainder.
"Developers have learned from the '80s, hopefully the lenders have learned as well," says Bruce Kaufman, managing director of Finard & Co., Burlington, Mass. "A lot of development has been taking older properties and recycling them to meet the large-space requirements of today's tenants."
The jury is still out on power centers in terms of long-term investment value, says Kalish, though Upton reports the demand from retailers remains high.
"It's probably one of the more active areas for development. It's difficult to get the [superstore retailers'] requirements met in existing centers, so it's something that has to be created," Upton says.
"I see further growth [of power centers] for a few more years," says Stephens of COMPASS Retail. "Even if there is a shakeout among tenants, there will be more tenants to replace them."
The strongest retailers today are the kinds of tenants who prefer power centers, so the real question is the long-term viability of large-format discount retailing. But even should the retail market undergo a dramatic shift, the adaptability of power centers offers myriad potential income-producing alternatives with minimal capital outlay.
The institutional investors have moved into power centers but not aggressively, observers note.
Strip centers present opportunities
"For the smaller investor, there are great opportunities in strip centers and neighborhood shopping centers", declares Kostanecki. "There's still a fair amount of REO activity, but the prices are right. or the property's distressed but the owner isn't necessarily. Many centers are just poorly managed or undercapitalized, and the owner is not in a position to do anything about it, for whatever reason. If that's the case, it might be worth looking at."
Robert Upton, a principal in the San Francisco office of Knight Frank Baillieu, believes secondary properties have considerable potential.
"Set against the negatives is the fact that older centers are in mature locations. They cottoned on to the best intersection a long time ago. The population is usually much denser", he says.
The drawback to these investments is the need for additional capital. Fuller reports MEPC put $65 million into renovation and expansion of The Boulevard in Las Vegas, which enabled the firm to take the center from No. 3 to No. 1 in the market.
In another example, Sandhill Properties of Menlo Park, Calif., recently paid $29 million for the struggling Fashion Island shopping center in neighboring San Mateo with the intent of spending even more to raze the majority of the structure and replace it with 500,000 sq. ft. of big box retail and a 700,000 sq. ft. build-to-suit office building. Although the 20-year-old, 900,000 sq. ft. project never performed up to expectations and was 60% Rents have been beaten down and marketwide vacancies have devalued properties to a point where they are very affordable."
Kalish says strips anchored by at least one category killer in addition to a supermarket and drug store or those with a Wal-Mart-type anchor are the strongest. Also strong are centers with the new breed of large supermarket/drug combination.
Upton points out, however, that in cases where the developer sold off the supermarket portion of the site to the retailer to handle its own development, investors should think twice. "The toughest part of retail leasing has been the small shops. That market just about went away, and while it's improved a bit, if that's all you've got, you're not in a very solid position," he says.
Outlet centers waning
"I'm definitely negative about outlet centers. We're already at a point where there are too many of them," asserts Kalish, noting that those in outlying areas are particularly vulnerable. "People used to be willing to travel 50 or 100 miles to go to these because of the steep discounts. Now there are factory outlets closer to home, and the discounts, originally averaging about 50%, are closer to 20% and 30% and available in many different kinds of stores," he argues. In addition, he says, all-day shopping is on the decline as well, another factor that makes factory outlets less attractive.
Wolf sees more opportunity in so-called mills centers, which combine conventional discounters, retailer outlets and factory outlets. These are being built closer to urban areas because they include types of retail that can attract frequent shoppers as well as "recreational" bargain shoppers. In January, Concord, Calif.-based Reynolds & Brown sold its five-year-old, 167,000 sq. ft. Marina Square to Gateway Buena Park Inc. of Buena Park, Calif. for $29 million. The project is fully leased to such tenants as Nordstrom Rack, Marshall's, Old Navy Co. and outlets of Eddie Bauer, Talbot's and others.
Urban retailing is big surprise
If there is a surprise in the investment scenario, the return of urban retailing is it.
"The urban market has certainly come back and will continue to get better," Kalish states, elaborating that cities are particularly suited to becoming the kind of entertainment centers consumers seem to be longing for. "I see urban centers are becoming mini Disneylands. It used to be
Single tenant investments (also known as "NNN" or triple net leased investments) are winning widespread appeal among investors because of higher yields and reduced risks, compare dto other investments such as bonds or mutual funds, according to Marcus & Millichap Real Estate Investment Brokerage Co., Palo Alto, Calif.
A key aspect of this type of transaction is the fact that investor participation in a single tenant deal is not management intensive. This factor translates into a great investment opportunity for investors who lack time and real estate property management experience.
"While REITs and multifamily investments have garnered headlines of late," says William A. Millichap, president of Marcus & Millichap, "we've seen a significant increase in demand for a relatively little-known investment option, the `single tenant investment,' or STI.
"Investors are discovering the STI delivers a component of stability in terms of predictable income," Millichap continues, "with minimal to no property management needs, and after-tax yield that are generally 1.5% to 3% over competing money market investments."
According to Millichap, single tenant investments may be acquired for as little as $150,000 or as much as $20 million. Since 1991, Marcus & Millichpa has closed $245 million of STI transactions across the country. The national real estate firm attributes the growing interest in the STI to the solution it provides for three increasingly prevalent situations:
1) the changing investment cycle of the "growth-oriented" investor whose investment strategy required capital appreciation, to a position of capital retention and the ability to generate supplemental income:
2) a desire to scale back on the amount of time needed to devote to property management, coupled with the increasing amount of skill needed to manage those properties; and
3) loss of personal income due to declines in all credit categories, including Treasury bonds and junk debt.
With tenant representation of STIs ranging from Mobil Oil, Blockbuster Video and Jiffy Lube to Burger King, Fresh Choice and Lyons, Marcus & Millichap has seen a burgeoning market as investors have discovered the benefits of long lease terms held by stable, nationally recognized and publicly traded tenants.
As with any investment, there are a number of points to consider, and Millichap recommends that any investor looking to add an STI to their portfoilio arm themselves with questions for their financial planner or investment counselor. He suggests potential investors pay close attention to the credit of the tenant, the conditions and terms of the lease, the frequency and amount of rental increases over the life of the lease, building specifications, quality of the location and putting together a lease that spells out all responsibilities for both tenant and investor, relative to being truly management-free.
"With an STI," Millichap says. "the low management time needed seems to be a real plus -- one day these future mature investors will be free to pursue the activities they always dreamed of for their retirement, while their investment provides the return." the large suburban mall was the place to be. Now it's people from the suburbs coming back downtown."
"What we really like now is specialty retail, the kind you find in urban locations," Smith says, specifically mentioning North Michigan Avenue in Chicago, upper Madison Avenue in Manhattan, Union Square in San Francisco and the town centers of wealthy suburbs like Mt. Lebanon, Penn. "High-end retail in major cities looks very interesting. What you have there are a lot of people with high incomes and no place to go."
Richard Seligman, of New York-based Edward S. Gordone * Oncor International, cites four reasons for the return of urban retail: the return of residential neighborhoods to urban areas; ground that has been lost by regional malls; the number of European firms that have come to the United States to diversify their base; and the trend of upper-end manufacturers going into retail.
"Regional shopping centers put a lot of product under one roof, but not much convenience," says Seligman. "You've got to make shopping a lifestyle experience for it to be a valid experience. Downtown stores can do that well."
Javaras reports that Terranomics is preparing a conceptual plan for a new town center in Sparks, Nev., that will have a major retail emphasis. The firm is also working with The Martin Group of San Francisco on a town center project in suburban Pleasant Hill, Calif. "If you do these things right, they'll be a good investment opportunity," he advises.
Smith notes that urban retail investment can be tricky because existing buildings often include office or residential uses and land prices and the complexity of construction dictate highly intense uses for new projects. "Often you're really buying two assets -- a retail building and an office building, for example -- packaged as one, so you have to be sure each justifies the investment," he warns.
Financing available at all levels In contrast to the past few years, money is available at all levels: equity, construction and permanent.
"Generally, there is a lot of money out there," says Upton, listing institutional, REITs and off-shore investors as particularly interested in well-located retail properties.
"The lending market is really helping transactions at this time," Kostanecki affirms. "We have a lot of lenders looking to make deals. Underwriting of permanent financing is loosening up, and that's helping sustain the value of properties."
According to Upton, the pool of equity money is also growing. "There is a fair amount of entrepreneurial capital. A lot of people are putting together pools of domestic money both to buy and to back investment," he says.
"Financing is very difficult," says Richard A. Baker, senior vice president of Purchase, N.Y.-based National Realty & Development, which has several centers under way throughout the Northeast. "It's available, though, from high-quality institutions for high-quality developers.
"For new developments," he continues, "you have to invest tremendous amounts of cash -- more cash than in the 80s.
"Financing is changing, with different ways of getting financing and different players involved," Baker says. Wall Street has introduced conduits and bond financing, and "pension funds will continue to be involved in real estate as long as it's a certain quality," he adds.
Cap rates obviously vary according to the type and quality of center and to a lesser extent according to region, but the range appears to average from 9% to 10.5% for neighborhood and community centers and around 9% for malls and prime freestanding net-leased properties with well-established credit tenants. Smith says he is seeing cap rates for malls in the 7.5% to 9% range, with the very best regionals as low as 6% to 7.5%. On certain extremely troubled properties, cap rates can head into the teens, but these transactions are only for high-risk investors (or the gullible) who are not dependent on conventional lender financing.
Cap rates for power centers depend heavily on the situation. Typical power centers trade in the 9% to 10% range, but some effectively trade as regional malls. These tend to be properties originally purchased for development as a mall and usually include at least three national anchors with 100,000 sq. ft. stores along with several lesser superstores and entertainment and food components. Certain super-community centers with the equivalent of a Wal-Mart or Super Kmart and at least one superstore of the Home Depot variety can also come in under 9%, but rarely.
"I think you're going to see steady appreciation on retail properties from now on," predicts Kostanecki, who says opportunities will continue to open up in all retail investment categories.
Nonetheless, respondents recommend a generally cautious approach, taking things on a case by case basis. There is no simple class of properties, they say, that offers guaranteed returns.
Not only do property classes vary, but retail market health varies from location to location as well.
Overall, Grubb & Ellis' 1994/95 Real Estate Forecast says: "Vacancies in retail properties improved, falling to 8.5% in 1994, over 9.1% posted in 1993. Lease rates for anchored retail centers also posted gains, now averaging $14 per sq. ft."
However, "ultimately, retail is a local business," says Finard's Kaufman.
A study by the Urban Land Institute, Washington, D.C., places Portland, Ore., as the market expected to see large rental increases in both regional mall and strip center segments in 1995. Markets where ULI expects to see moderate rental increases in both regional mall and strip center segments are Atlanta, Colorado Springs, Colo., Richmond, Va., and Salt Lake City. ULI expects to see moderate rental increases in the regional mall segment in New Orleans, and moderate rental increases in the strip center segment in Indianapolis and Nashville.
Of the markets included in Viewpoint 1995, a report by Minneapolis-based Valuation International Ltd., the highest retail vacancy rates are found in Miami (25%) and New York (23.4%). The lowest vacancies, according to the report, are in Hartford, Conn. (2.3%) and Portland, Ore. (4.3%).
In general, Kaufman says, locations near the Canadian border are having a tough time due to the drop-off in Canadian traffic because of the drop in the Canadian dollar.
"Retailing has become very changeable," says Upton. "The evolution in the industry has been quicker in the past five to 10 years than we've seen in history. It's absolutely necessary for the investor to be vigilant and stay up with trends. A lot of retailers have essentially come from nowhere. It wouldn't be surprising to see them fall by the wayside just as fast."
"Retail continues to be both vibrant and fiercely competitive," says Kaufman. Developers, lenders and retailers have to listen to what consumers are saying. The consumer is king."