When he formed GK Development Inc. in suburban Chicago in 1995, Garo Kholamian figured that he was too small and underfinanced to jump into the regional mall business that had been his stock and trade at the old Homart Development Co., a unit of Sears, Roebuck and Co.

Kholamian opted instead to focus on much more modest projects, putting a Restoration Hardware into a high-traffic location on Chicago's North Side, for example. Eventually, however, the entrepreneur figured out an entryway back into the shopping center arena.

In the past five years, GK has become an investor in so-called small malls. The company has nine of them currently spread around the nation's heartland, in towns such as Peru, Ill., Grand Forks, N.D., and Ames, Iowa. Most are less than 700,000 sq. ft. and have little or no other shopping center competition in their markets. Kholamian buys them at a steep discount after local or absentee owners let the properties run down, then invests money in repaving the parking lots, refashioning the facades and recruiting new tenants. The financial returns can be impressive, with cap rates that regularly exceed 10%. Kholamian figures his portfolio is worth close to $500 million.

Giant owners take a pass

Beyond the noisy drumbeat of consolidation among super-regional shopping center owners in recent years, small malls have become a popular investment for niche retail firms such as GK Development, which lack the desire — and resources — to mix it up with behemoths such as General Growth Properties in Chicago and Simon Property Group in Indianapolis. These giant owners prefer to buy and sell million-square-foot assets with marquee names in big cities.

Opportunists such as Lightstone Group LLC in Lakewood, N.J., Coyote Management LP in Dallas and Gregory Greenfield & Associates Ltd. in Atlanta have become expert at following the GK formula in second-tier markets.

In fact, small-mall transaction activity has become a singular bright spot in an otherwise moribund retail investment sales market this year. In the first six months of 2006, according to New York-based Real Capital Analytics, the volume of shopping center sales transactions fell 25% to $19.2 billion. The chief reason: Most major assets have been consolidated into the hands of a half-dozen mall owners and operators who are largely unwilling to divest what they have currently.

“There are plenty of potential buyers who want to invest, but the supply side has been weak this year,” confirms George Good, an executive vice president based in Chicago with CB Richard Ellis, a leading mall broker. Good has become more involved in small-mall deals of late, negotiating the sale of the 466,000 sq. ft. Peru Mall in Illinois to GK Development at a sales price of $31 million last December. He predicts that the small-scale category will continue to attract venturesome investors.

“The smaller markets have less retail competition. These markets are too remote in most cases to interest a company like Simon,” Good says. What's more, small malls have certain advantages, he adds. “Many of these shopping centers have been around 30 years or more and have lots of performance history, so there is less risk in acquisitions of this kind.”

The returns can be enticing. While large-format shopping centers trade hands at initial cap rates of 8% and less, small malls can be acquired for cap rates closer to 9% and 10%. With new tenant lease-up, the cap rates can swiftly rise above 10%. Kholamian, who has financed his mall buying with three funds totaling $140 million in equity raised from high-net-worth individuals, says that his internal rate of return (IRR) has come close to 20% on an annualized basis.

“The cap rates in small malls are higher because the buyers typically have to be prepared to be active managers confronted with a lot of operating detail,” says Kholamian. “You buy a small center that is 20% vacant, and there is your upside.”

Gary Frey, chief investment officer for InvestLinc Group LLC in Chicago, has played a key role in raising GK's equity. He says that small malls appeal to conservative, risk-averse investors, many of them from the Midwest.

“They're wealthy, but they have low-key Midwestern values and low egos,” Frey explains. “They don't need to be invested in a trophy property, and they're not looking for huge returns. What they like about small malls is that there isn't much chance of somebody building a competing mall across the street.”

Turnaround artists

Gregory Greenfield & Associates, formed eight years ago, has amassed a portfolio of 15 regional malls spanning some 10 million sq. ft. and has a disarmingly simple strategy of buying, improving and then selling its assets. The company bought the Broadway Mall in Hicksville, N.Y. on Long Island in 2000 from a fund controlled by JP Morgan. Gregory Greenfield then replaced a JC Penney with Target and installed Macy's on a vacant pad and rebuilt 20,000 sq. ft. of interior space into a lifestyle center.

Greenfield sold Broadway late last year for an undisclosed price to Vornado Realty Trust. Gregory Greenfield, president and principal of the firm, says that he earned a 30% annual return on the Broadway investment. “The return sounds nice, yes, but we also did a lot of work on Broadway Mall to improve it,” Greenfield notes. His firm acquired Broadway for a relatively low price because there weren't many bidders in 2000. “Today, a decent small mall is more heavily bid on when it comes up for sale,” Greenfield emphasizes.

Sales at department stores, the bulwark of any mall, have been declining for years, but Greenfield believes that small malls will always have a place in the retail landscape. “Regional malls are a core component in the retail sector,” he observes. “Retail chains have shown that they are still very committed to malls.”

Lightstone, meanwhile, launched into small malls in 2004 with the acquisition of five enclosed centers for $110 million from the Pennsylvania Real Estate Investment Trust. Typical for any buyer like Lightstone, each of the malls had long suffered from neglect. Bradley Square in Cleveland, Tenn., spanning 450,000 sq. ft. and nearly one-third vacant, hadn't signed a new lease in nearly five years at the time of the transaction.

Lightstone added an Aeropostale, Finish Line and Pacific Sunwear, among other new tenants, and raised occupancy above 85%. In addition, Starplex Cinemas is close to signing a deal that would bring 14 screens to the property next year and spur restaurant development. Rents at Bradley have risen 25%, or about $5 per sq. ft. on a net basis in the past two years, according to Scott Benjamin, director of leasing for Lightstone.

“The former owners of Bradley Square didn't have Aeropostale and other national chains like that, and didn't lift a finger to recruit them,” Benjamin says. “That's common at small malls owned by big REITs. A public company with a large shopping center portfolio wants to invest its money in its properties with the highest returns. That often means the Class-B malls get lost in the shuffle.”

True, but the investment to turn around properties can be daunting. The 700,000 sq. ft. Brazos Mall in Lake Jackson, Texas, 60 miles south of Houston, was acquired by Lightstone in 2004 as part of a $48.2 million purchase. The new owners poured more than $10 million into an extensive rehab, eventually attracting tenants such as Steve & Barry's University Shop and Ross Dress for Less along with a 20,000 sq. ft. food court. Once 30% vacant, the mall today is more than 95% full.

Financial community takes notice

In recent years, Wall Street conduit lenders have warmed up to small malls, says David Lichtenstein, chairman and CEO of Lightstone. “That's made some of our projects and work more financeable. We look for assets that have been mismanaged. Yet we aren't interested in something in an emergency room situation,” Lichtenstein explains. “It's too much work to turn around a really bad mall.”

Still, there are small-mall investors willing to take on riskier assignments. Cullinan Properties Ltd. of Peoria, Ill., which has a portfolio of 30 properties including several small malls, paid $5 million for the 450,000 sq. ft. Shoppes at College Hills in Normal, Ill., two years ago when the in-line retail space was nearly 75% vacant. Cullinan negotiated lease terminations on the remaining small tenants and then bulldozed the enclosed section of the mall, replacing 180,000 sq. ft. of lost space with 130,000 sq. ft. of lifestyle tenants, ranging from Coldwater Creek and J. Jill to Ann Taylor Loft and Jos. A. Bank. The construction cost more than $20 million, but today the center is thriving.

Next up for Cullinan is the revitalization of the Quincy Mall in Illinois, a 532,000 sq. ft. center acquired in April from a family trust for $20 million. It has solid anchors in Sears, JC Penney and Bergner's department store, but the interior space was only 45% leased at the time of the deal. The new owner has already negotiated nine leases with retailers such as Finish Line and TGI Friday's.

“There's no reason we can't get the center to 97% or 98% leased within 24 months,” says Jeffrey D. Giebelhausen, president of Cullinan. “The No. 1 thing we look for in a mall like this is the anchors. Are they stable? Will they stay around? If so, then we can build around them.”

What's the reward for the company? Cullinan's first-year cap rate on Quincy is 8.2%, says Giebelhausen. “As we re-tenant we hope to get that cap rate to 10% or 11%. Then we'll do some more external development of new restaurants and other stores outside the mall. That could represent another 100,000 sq. ft. and cost us $7 to $9 million in construction. But the return will probably be close to 20%.”

New entrants beware

Such lofty returns are finally attracting the attention of big mall owners. Coyote Management in Dallas once had eight centers in its portfolio, but it's down to just one after the company sold a 570,000 sq. ft. mall in Wichita Falls to General Growth and another 940,000 sq. ft. center in Tulsa, Okla., to Glimcher Realty Trust.

“There seem to be more public REITs and large funds out bidding on small malls lately,” says John Desco, senior vice president of asset management at Coyote. “We're trying to build our portfolio back up, and we've been bidding on all the good mall offerings of late, but we haven't been successful. Some ugly assets have been attracting incredibly high prices.”

Has the easy money already been made in small malls? Perhaps so. It's clear that Class-B centers are being discovered, and the quiet, largely ignored marketplace of a year or two ago is suddenly getting more crowded with buyers seeking to juice the returns in their retail portfolios.

But small malls require lots of tender loving care before they can start to return substantial profits, and investors without far-reaching retail connections who could be operating on short fuses may well end up disappointed. Experts such as Coyote and GK and Lightstone have all made money in the sector, but they've had plenty of practice by now.

Small malls do fail every once in a while. When a local factory shuts down or the corn crop is battered by bad weather, the fortunes of a small town can turn bleak overnight.

To hedge its bets, GK Development has embarked on the development of power centers lately. “Good small malls remain difficult to find,” says Kholamian. In the next breath, he says he intends to keep looking for shopping centers in secondary markets. Lightstone, Coyote, Gregory Greenfield and Cullinan all vow to do the same. The marketplace, it's clear, is heating up.

Lee Murphy is a Chicago-based writer.