In contrast to two years ago, when retail seemed to be everybody's favorite investment, the category has decidedly fallen out of favor. Some analysts, in fact, believe the retail real estate market is headed for a real fall.

Nina J. Gruen, a principal of Gruen Gruen & Associates, an economics and real estate consulting firm in San Francisco, predicts a major bust, speculating 1996 and 1997 will be to new retail development what 1987 and 1988 were to new office construction.

Mark H. Tanguay, president of Tanguay-Burke-Stratton Comprehensive Real Estate Services in Chicago, concurs, saying, "The retail real estate industry is showing symptoms similar to those that sparked the office market meltdown in the early-'90s - overbuilding and poor tenant credit."

Although other analysts express less pessimism, most regard the market as troubled, the primary reason being the uncertain performance of retailers in general. As Tanguay points out, retail sales suffered in the second half of 1995, with one of the poorest holiday shopping seasons recorded in years.

"There is no question there has been a lot of publicity about general retail malaise. There have been quite a few Chapter 11s. There probably will be more," says Stephen Wehr, managing director of acquisitions and dispositions for Terranomics Retail Services in San Francisco. "When you look at median income being the same today as in 1987, somebody is going to be a casualty."

According to John Bell, vice president and director of leasing for Draper and Kramer Inc. Retail Property Services, says these Chapter 11s were filed "in an effort to reorganize and dispose of nonprofitable locations which, of course, has adversely affected shopping center owners."

Despite sales stagnation, retailers took an exceptionally aggressive stance over the past few years as new companies and new formats attempted to stake out a position for themselves at the expense of their competitors.

"It has been apparent for several years that many retailers were just following market leaders instead of creating their own concepts and market niches," says Gerald Divaris, president of Realty Resources, a nationwide network of real estate brokers who specialize in retail. "As a result, some of these stores emerged with only a minor differentiation - in some cases, only their names. This problem has permeated the entire industry but has been particularly evident in the apparel industry. It is also likely that we will see a similar shakeout in the discount department store sector, home improvement, music, video stores, warehouse stores and footwear."

Few mass-market retailers can call themselves truly secure. Companies rocket to success then crash and burn with alarming regularity.

The success and failures of the merchants themselves is a tremendous concern," says James Steuterman, executive vice president and head of acquisitions for New Plan Realty Trust in New York City. "There are new ones coming up the ranks. There are seasoned ones that are struggling. You see a constant state of change. It's very unsettling, and it makes it much more difficult to make sound investment decisions. You have to be very careful and diligent."

A growing source of concern among investment analysts is the evolution of computer shopping.

"We are becoming somewhat concerned about the advent of home computer shopping, which we think has the potential to impact businesses that are high-volume, low-margin," says Craig Severance, a principal of AMB Institutional Real Estate in San Francisco. "To the extent that home computer shopping takes off, those businesses that have very low margins won't be able to afford to operate."

Particularly affected, he says, will be many of the power center-type tenants. He specifically mentions the sales of cameras, stereos, automobile supplies and accessories and certain categories of clothing like underwear, socks and even shirts that do not have to be tried on for fit.

"Retailers in the apparel market are also vulnerable, as well as retailers of other `hard good' types of products, such as electronics and appliances, all of which can be both through catalogs, via computer and over the telephone," says Andrew B. Hascoe, president of Greenwich, Conn.-based Bryant Development Corp. Inc. "This method of purchasing will eventually become standard for those types of goods."

"Those we don't think will be impacted so severely are businesses like standard grocers or businesses that are service oriented, like dry cleaners, or those that have a convenience orientation," Severance says.

The upshot of all this is a strong bias in favor of neighborhood and community centers and a shift away from power centers and regional malls. As respondent after respondent notes, no matter what happens with the economy in general, the need for basic goods and services remains. People still buy food, get medications, have film developed, take clothes to the cleaners and pick up a pizza for Friday night.

"Computer shopping is a growing trend and certainly provides a convenience," says Alan Perlmutter, senior vice president of Henderson, Nev.-based American Nevada Corp., "however, I feel the need for neighborhood and regional shopping centers will always exist."

"Utilitarian goods - supermarkets, drugstores, dry cleaners, hairdressers, shoe stores, video stores, photo developing, etc. - will always do well because they provide staple items," agrees Hascoe. "People cannot buy their staple items through a computer or a television. These are products that must be readily accessible."

The popularity of urban infill projects is also rising, while interest in developments at the suburban edges has slowed. The demographics for urban projects are strong, with relatively dense populations, surprisingly high incomes and often underserved markets. New suburban development, long a mainstay of the industry, now has to wait until residents are in place. There is no building in advance of population.

Given these circumstances, investment today requires assiduous attention to details and selectivity.

"We do believe today you need to be very, very selective in terms of the property you're buying," says Thomas Caputo, a principal with the RREEF Funds in New York City. "What we look for is a combination of location, which has become more important than ever, and the anchor tenants. The presence or absence of competition and whether there are barriers to entry for new projects are also important factors."

According to Wehr, cap rate and yield are no longer sufficient gauges by which to evaluate a property. "For the first time in a number of years, people are really starting to pore over the balance sheets of the product they are going to buy," he says. "The investor market is getting very picky, very analytical and very demanding on not only the types of yields they're getting but the substance of those yields."

By substance, Wehr means such factors as the overall stability of particular retailers and the potential for new competition. An individual store may be performing very well, but if the retailer's overall sales are down, it could end in closure of the entire chain. A center may have a video store with strong sales but, if a Blockbuster goes in a quarter mile up the road, the store may end up struggling.

These considerations take on particular importance for new centers, says Wehr. "Just because I get lucky and create a feeding frenzy in the short term and lead all these sheep to slaughter and fill my center, it doesn't mean they're going to be there in 12 months," he warns.

The general situation does have a plus for investors. A lot of properties are available. Those who pick wisely can do very well.

"There are more malls on the market than there have been in the past five or six years," says Richard W. Latella, senior director of Cushman & Wakefield Inc.'s Retail Valuation Group in New York. "People are trying to divest themselves of retail and reallocate to hotel, industrial and even office properties."

The problem is the majority of properties are not prime quality and, as Nelson C. Wheeler, first vice president of CB Commercial Real Estate Group Inc. in Los Angeles notes, investors primarily want Class-A and A+ properties. "Those properties that are not well located or well anchored and lack visibility will continue to trade at declining values through the foreseeable future," he says.

However, Mark Toro, managing director/retail development of Charlotte, N.C.-based Faison, says: "There is opportunity for people in other markets. We're always looking for the A opportunity over the B, and we're looking at other markets that aren't overbuilt."

"New center development will continue," agrees David Brotman, vice chairman of Baltimore-based RTKL Associates Inc., "but only in those markets that are presently underserved."

Regional Malls

"Nobody is buying on the regional mall side," declares Latella, with obvious hyperbole. Nonetheless, the statement fairly accurately reflects the tenor of the market.

Although according to a report from Valuation International Ltd. in Atlanta, the average mall vacancy rate was only 5.9% last year, compared to 8.4% for non-mall properties, the former figure represented a 1.1-point rise from 1994, while the latter represented a 1.3-point decline.

"I'm going to guess there are 100 or more malls either quietly or directly up for sale," says Greg Kraus, director of acquisitions for the L&B Group in Dallas. "I've never seen anything like this in terms of pure numbers. You can set whatever price you want because nobody's going to buy anyway."

In his view, the reluctance is an overreaction. "If you're opportunistic, right now presents some very good investment opportunities. Properties are selling below historical values. Being very selective and using discipline as a starting premise can lead to some unusual opportunities," Kraus says.

His seems to be very much a minority view, however, and even he admits L&B prefers a "dominant, successful retail mall in a stable, growing economy" - in other words, a Class-A or A+ property.

"A lot of malls are poised for redevelopment and probably won't look like a mall a year from now," says Latella. "Many of the malls now for sale are no longer viable regional malls. They are prime candidates for redevelopment or will be regenerated for some other use entirely."

Wehr agrees. "We're going through a transition now where the have-nots will probably fall off the turnip truck," he quips.

He points to the decline of Vallco Park in San Jose, Calif., and the nearby Sunnyvale Town Center in Sunnyvale, Calif., as prime examples of the fallout among regional malls. Both, he says, lost out to the larger and stronger Valley Fair Mall, which straddles the border between San Jose and the neighboring town of Santa Clara, Calif. "[The decline] is done in concert with category killers that have taken the business that in-line mall tenants would have provided in the past. The same scenario is happening all across the country."

Greg Greenfield, president and COO of COMPASS Retail Inc. in Atlanta, says, "Times are fairly difficult to some large degree, and we have adapted to that by finding alternative uses for our properties."

"We're quite bullish on regional malls as an investment," says Greenfield, "because if you put services, entertainment and shopping in a safe, well-located environment people will want to go there." He adds, "We are trying to re-invent the mall into its original concept."

The shopping center will go through dramatic reconfiguration and will turn back to becoming an 'everything' place rather than simply a fashion place," says Brotman of RTKL Associates. "Part of the solution lies in 're-imaging' existing centers as well as adding new entertainment facilities, perhaps in spaces previously occupied by anchor department stores."

New malls stand minimal chance of development, says Tom Melody, executive vice president of L.J. Melody & Co., a commercial mortgage banking company in Houston. "Any mall getting done today needs to have deep pockets," he says, noting this applies both to new development and redevelopment.

"It's going to involve a preeminent developer teaming up with a very viable money source. With that, the banks are willing to go in, because you have a substantial amount of equity and you have anchors lined up," Melody says.

Melody points to two Houston area projects that his company financed as examples of new developments that work. One, First Colony Mall by Hines Interests and Cigna Insurance, is part of a masterplanned community 25 miles south of Houston. The other, Woodlands Mall by General Growth Cos. and the Woodlands Corp., is in another master-planned community 40 miles north of the city.

What both projects have in common, says Melody, is a location in a high-income, new-growth region with minimal retail. Development did not occur until the population was sufficient to support a four-anchor mall. "A three-anchor mall was never considered," he emphasizes. "Four anchors is the minimum necessary to be considered for financing."

Power Centers

The darling of the industry just a few years ago, power centers today meet with great skepticism.

"Power centers are without a doubt out of vogue," says Melody. "The reason is most of them don't have any power. When you have a power center and one of the anchors goes dark, it makes that portion of the property unfinancable."

The problem is the perceived instability of many power center tenants. This segment of the industry more than any other is going through a shakedown that will likely see the demise of many of today's most prominent promotional tenants. Some will be absorbed by their more successful competitors. Others will simply disappear.

Lou Ceruzzi, president of Ceruzzi Properties Inc., asks the question, "How big can the box get, and how many players are left to fill it?"

He suggests that one problem many power center developers face is filling the center with well-performing retailers. Ceruzzi sites the development of Roosevelt Center in Westbury, Long Island as a perfect example of this. The nation's largets retailers were already present in the area and potential anchors from outside the northeast were being acquired by retailers that already had a strong presence there.

The solution to this problem is to tap existing relationships with retailers. "If power center developers are careful in crating a dynamic mixture of proven endeavors and new ventures, and if the retailers are careful to offer value and service to their customers," says Ceruzzi, "the future of big box development will continue to be bright."

"Increased competition for high-quality tenants will drive the brokerage business as more owners are looking for real estate companies with established relationships and national network capabilities," agrees Tanguay.

Latella points to the situation currently occurring among discount department stores as typical of the problems awaiting power centers. "Jamesway fell out already, and there's a lot of talk of the possible merger of Bradlees and Caldor. You have Ames and Hills struggling. It's a difficult niche to operate in, and clearly many stores are going to fall by the wayside," he says.

Wehr describes a center in Denver that was recently offered to Terranomics as too typical of the weakness of the general run of power centers.

"You had a Best Buy, a Media Play and Home Express. Home Express isn't going to be a survivor, Best Buy isn't making money, and I don't even know why Media Play is in business. OK, it's 100% occupied. So what? Somebody buys this center, and before long he's left with 140,000 sq. ft. of vacant space. You've got to be crazy to take that on," he says.

All this does not mean there are no good power center opportunities, just that the investor has to be inordinately careful. Caputo reports RREEF, acting on behalf of a municipal pension fund, closed in November on a power center in Lewisville, Texas, a North Dallas suburb. The 545,000 sq. ft. property includes Target, Circuit City, Marshalls, Old Navy and Linens N Things. The fact that all the tenants are solid performers is what made the deal attractive, says Caputo.

Steven Schmidt, senior vice president of Heller Financial Inc.'s Credit Tenant Property Group in Chicago, reports his firm recently did a major deal in Los Angeles with T.J. Maxx and Linen N Things, again because the two tenants have solid records and do not appear to be in trouble.

"Power center tenants will move into the malls," says Greenfield of COMPASS Retail, adding that the power center market is very difficult right now, and if you buy a power center, in order for it to survive, it must be in a location with solid demographics and be very visible.

Probably the best investment bet in this category, suggests Latella, is the hybrid power center/community center. This type of property usually contains a supermarket and drug store along with a Target or Home Depot-type retailer (or both), a Blockbuster Video or equivalent, a number of fast food and family restaurants and several small service tenants like dry cleaners, shoe repair shops, florists and the like. There may also be a multiscreen cinema. The range of tenancies and the reliance on basic merchandise, he explains, helps protect against the problems that plague pure power centers.

Community & Neighborhood Centers

Without question, the cream of the crop of retail investment today is the neighborhood and community center.

"Neighborhood centers will continue to be attractive to investors, for good reason," says Toro, "because they are anchored by credit-worthy stores and have locations in solid demographic areas."

"REITs in particular have had a strong appetite for well-anchored neighborhood centers and strong community centers, and with good reason," says Latella. "They are consistent performers."

Severance reports that AMB has a "strong preference for neighborhood centers," although, he adds, "We do buy community and power centers. AU three types have in common that they are not enclosed malls. But of the three types, our preference is definitely neighborhood centers."

AMB has spent $800 million to buy more than 40 shopping centers over the past 10 years, most in the past couple of years, according to Severance. "All are open-air centers that range from 100,000 sq. ft. to 500,000 sq. ft.," he says.

The reason for AMB's bias toward neighborhood centers is the viability of supermarkets and drug stores. "We think the anchors for neighborhood centers are in good shape and have done well all through this whole time frame," says Severance.

New Plan was among the most active retail investors last year. The majority of purchases, according to Steuterman, fit the neighborhood or community center category. Among the REIT's purchases was a portfolio of properties in Michigan, New York and Ohio with an average size of 180,000 sq. ft., located across from an enclosed mall and anchored by a supermarket and either an electronics, office products or sporting goods store.

Other purchases were a 250,000 sq. ft. renovated center with an expanded supermarket and a 100,000 sq. ft. unrenovated supermarket/drug center in suburban Philadelphia.

Steuterman says he likes the basics of this category. "We've never believed there was such a thing as a credit tenant. We always felt we were buying real estate," he says.

Higher returns is one reason some choose to invest in neighborhood centers. "I look for much higher returns in real estate as a whole from properties that provide upside through redevelopment and expansions," Hascoe of Bryant Development says. "That is why I am continually seeking community/neighborhood centers to purchase which offer both intriguing opportunities for the investor and added value to the community."

Entertainment and Specialty Centers Although entertainment and restaurant elements have become pretty much de rigueur at any large retail project today, in the past couple of years a format based almost exclusively on these two uses has appeared.

The jury on these projects is still out, and few analysts recommend this category.

"I put them in the unproven category," says Toro of Faison. "Because it is entertainment, it makes it exciting and sexy, but it has yet to be proven as a good way to make money."

Gruen, in fact, warns investors to stay away. "Beware of the excitement surrounding entertainment. It's an amazing fact of life that the real estate industry is able to overbuild a product that hasn't as yet been adequately defined, she says.

"Everybody is on the entertainment bandwagon, but only a few have been great successes," says American Nevada's Perlmutter. "The developer must really understand the entertainment concept."

On the other hand, by switching to this format, several floundering specialty complexes have regained solid footing. Jack London Square in Oakland, Calif., had difficulty landing tenants for its first six years. But according to Barbara Szudy, commercial representative for project owner The Port of Oakland, since signing a lease for an eight-screen cinema in late 1994, virtually all of the space has been taken, and there is talk of an expansion. Francine Principe, retail representative for the San Jose Redevelopment Agency, reports a similar outcome at the Pavilions, a downtown specialty center developed by the Indianapolis-based Simon Property Group and San Jose-based Kimball Small Properties. Concentrating on food and entertainment brought leasing from under 50%, where it stood for five years, to close to 95%, she says.

"Entertainment will gain legitimacy as a major retail component of shopping centers," says Bell of Draper and Kramer Inc.

Urban Retail

"The latest hot ticket is to bring the marketplace back downtown," says Dave Williams, a senior manager in the New York office of San Francisco-based E&Y Kenneth Leventhal Real Estate Group. "For many people, the mall has become pretty much the same kind of place, and people are looking for a much more enriched atmosphere."

Strong demographics and reliability are the prime movers behind the resurgence in urban retail.

"Density is a huge driver," says Schmidt, noting that a Target that opened near his home in Chicago is doing three times the volume projected.

With regard to reliability, Wehr says, "You can pretty much quantify and substantiate the income stream and be comfortable it's going to be around for awhile. With urban infill, you can pick the best of the best in terms of retailers."

Although urban land is more expensive, the payoffs are proportionate. "Volumes going in are a lot higher on projection," says Wehr. "In San Francisco, we've seen very few infill projects where the tenants haven't been extremely successful."

Geographic Factors

In general, analysts see little difference from one area of the country to the other right now. According to Caputo, opportunities today are a product of highly specific conditions that can be found in any region. "We invest in approximately 35 major metropolitan areas in the United States from coast to coast. There are no areas we shy away from," he says.

Valuation International lists the top 10 retail markets as Atlanta, Minneapolis, Denver, Seattle, Orlando, Portland, Ore., Columbus, Ohio, Phoenix, San Francisco, and Washington, D.C.,based on data that includes vacancy rates, GAFO sales, years to balance and population and household growth (by both percentage and absolute change).

But as Wehr notes of the western United States, "If you take the broad-based markets in [the] West, they're all pretty healthy in overall economic terms. With retail today you still have to pick very carefully."

Steuterman says New Plan has a preference for the Northeast and Midwest, primarily because of the climate.

"We like these upper Midwest and Northeast markets better for the apparel business. In Florida, you don't need a lot of apparel. Even the money spent on groceries per capita is lower because people are more conscious of their bodies. In more northern areas, there's more spending for clothes for the different seasons," he says.

New Plan also likes the fact that the so-called Rust Belt is less susceptible to boom and bust cycles. "In more primary markets, like Atlanta currently, competition is very fierce. Parties bid higher and produce less in terms of yield. And when they cool down, they cool down dramatically," Steuterman says. "We're a little contracyclical. We like to go where people aren't necessarily looking. We may be able to make a more attractive buy."

Financing

The lending picture is as varied as the industry, according to Steuterman. "You have lenders who are not committing to Kmart loans. You have lenders who are not committing to Wal-mart. They're becoming increasingly concerned about risks and consequently act in ways that may seem unpredictable to the developer or investor. There's not a lot to depend on," he says.

Although low rates make loans exceptionally attractive, lenders are keeping a tight hold on their purse strings. However, say respondents, the general conservatism of lenders mitigates against poor investments. Financial institutions simply will not lend on anything with undue risk.

At the same time, they will lend on appropriate projects. For example, Melody reports his company made about $1 billion in retail property loans over the past three years. About 90% of that involved debt financing, and the other 10% went to equity financing. Probably two-thirds of the deals his company did involved refinancings rather than takeouts, he adds. As noted earlier, new projects are so heavily scrutinized that few get built.

The difficult part of development is for the developer to team up with a money source. "There are a lot of malls people would like to develop, but the money sources are focused exclusively on preeminent malls in primary market areas," says Melody.

According to Latella, cap rates for malls have been rising steadily for the past few years. "Cap rates have continued to rise. '95 was no exception. We expect 96 will go further. Investors have demanded a greater risk premium," he says.

He pegs cap rates for the top 25 malls, few of which ever come available, at 7 to 7.5. For the next rung, what Latella calls "Grade-A dominant malls in the top 50 markets," he sees rates of 7.5 to 8.25. Again, few are available. The remainder, he says, trade at 8 to 10. For community centers, the range is 9 to 10, with a few breaking below 9, while neighborhood centers, he says, are trading at 10 to 11.5.

Most respondents, however, indicate cap rates are not the best measure of a property's value. Certainly, they say, there is no "best" cap rate at which to buy.

"You can't come up with a standard cap rate. Each property's going to depend on the rents in place and sales in the center and where we think we can take rents in the future," says Caputo.

Steuterman discounts cap rates almost entirely, saying: "We're not a cap rate buyer. We don't evaluate based on cap rate. We do look at the initial yield for first year, but that's far down the line after looking at a lot of other things."

According to Wehr, cap rates in California rarely change. "The state seems to have a preoccupation with high-8s to lows. 9Go across the state lines, and you can start looking at 10.5 and 11. 1 don't know why we don't move, but we don't," he says.

So, is success in retail possible?

Many retail professionals agree that success in retail is possible, but it takes choosing the right property, re-inventing the center's image when necessary and creating the right atmosphere for shoppers and retailers.

There is no simple answer to being successful in retail, according to American Nevada's Perlmutter. "A developer must understand the customer and their needs. The developer must understand the needs of the retailer and retailing trends and must understand the benefits or limitations of the location."

One of the problems m retail that must be confronted is creating new images and new shopping center formats. Retail seems to have fallen into a developing routine once a working formula was created.

"Centers that were considered leading edge in the 1980s have been copied many times," says RTKL's Brotman. "Today's consumer is tired of going into homogeneous environments, however, many investors and developers remain committed to the old 'tried and true formulas.' They have little vision and have lost sight of the fact that consumers find delight and excitement in planned chaos."

But simply re-imaging a center is not enough to be successful. Retail developers must also study the property itself. It also must have a good location with strong demographics.

"Savvy developers know that they can't build another 'typical' mall and expect it to be successful," says Brotman. "It has become a matter of designing to demographics - and that often means violating heretofore established 'rules' with respect to center layout, design and imaging as well as tenant mix."

One other aspect that developers need to be concerned with is making the shoppers happy. There must be a pleasurable shopping environment to keep the retailers in business.

"The biggest challenge to everyone involved in the shopping center and retail industry is how to get the consumer to enjoy shopping again," Brotman says.

"People still want to be entertained; they want to fill their time while they're being entertained, and they still want to touch the merchandise", Greenfield of COMPASS Retail says.

In other words, yes retail can be successful once again. However, certain criteria must be met now to ensure success.

"Retail will bounce back," says Brotman, "but only if developers and retailers offer what consumers perceive to be a desirable commodity - (one) within an interactive environment that makes a bold statement and leaves a lasting impression."