As owners continue to pay incredibly high prices for retail properties, asset managers are under more pressure than ever to boost cash flow.
Huge demand for retail — and commercial real estate properties in general — has compressed cap rates. Average cap rates on retail property sale transactions fell to 7.1% during the fourth quarter of 2005, a drop of 120 basis points compared with two years ago, according to New York-based Real Capital Analytics.
So, how are asset managers squeezing more profits out of their assets? Property renovation, expansion and re-tenanting are the obvious choices to jump-start rents. Taking such steps to generate higher rents and increase returns certainly helps justify the hefty prices owners are paying for retail properties.
Yet even if sale prices level off, as many experts anticipate will happen, that will not relieve the pressure on asset managers. In fact, slower property appreciation will place even more emphasis on elevating returns elsewhere — namely net operating income.
“Owners are clearly looking to make more revenue,” says Ron Pastore, a principal at Boston-based AEW Capital Management. Mall ownership, for example, is dominated by publicly owned companies that “live and die” by funds from operations (FFO), and earnings that miss expectations by even pennies per share can spur significant drops in stock prices, Pastore adds.
“Everyone is trying to maximize values regardless of what marketplace you're in,” says John Delatour, managing director of operations at Jacksonville, Fla.-based Regency Centers. Although asset managers certainly search for ways to cut costs and make properties run more efficiently on the operations side, the primary focus for asset managers is finding ways to push rents higher. “Most of our internal growth comes through rental growth,” Delatour adds.
There's another reason for asset mangers' sense of urgency. Existing properties will continue to face new competition as development activity accelerates. Among community and neighborhood centers alone, data provider Reis says that the shopping center industry will add 37.7 million sq. ft. in 2006. At the same time, Reis estimates absorption for the year at 31.1 million sq. ft. The net effect is that the national vacancy rate is projected to rise 20 basis points to 7% by year's end.
Creating a dominant center
Owners can certainly coast along and introduce rent bumps that coincide with overall market rate increases. A solid performance within the retail sector in recent years has resulted in steady rate hikes. Vacancies among community and neighborhood centers, for example, which reached 6.8% at the end of 2005, have hovered between 6.3% and 7.3% since 2000, according to New York-based Reis Inc. Net effective rental rates rose 3.2% in 2005 to $16.77, and effective rents are expected to rise an additional 3.1% in 2006, according to Reis.
But who wants to be average? Owners such as Ramco-Gershenson Properties Trust, which owns more than 75 shopping centers in the Midwest, Mid-Atlantic and Southeast, believe that hands-on asset management is crucial to boosting returns and maximizing property values. “Owners who build shopping centers, lease them to 95% to 100%, and then turn their focus elsewhere, are missing incredible opportunities,” says Dennis Gershenson, president and CEO of Ramco-Gershenson, a REIT based in Farmington Hills, Mich.
In order for a shopping center to become — and remain — the central focus of its trade area, owners must maintain a constant vigil over the asset, Gershenson emphasizes. Asset managers need to continually assess how current tenants are performing to determine possible expansion or contraction needs, as well as keep an eye out for new retail concepts that would make a good fit for a particular center.
“Even when we do a re-tenanting or expansion, it doesn't mean we take our eye off the ball,” Gershenson says. In fact, some of Ramco-Gershenson's properties have undergone multiple expansions and renovations over the years. For example, Ramco-Gershenson built the Tel-Twelve shopping center in Southfield, Mich. in 1968. The original mall totaled about 550,000 sq. ft., and was first anchored by Kmart and Montgomery Ward.
Over the years, Tel-Twelve has undergone several major changes, including replacing the two original anchors, and converting the enclosed mall to a 700,000 sq. ft. power center that is anchored by tenants such as Lowe's Home Improvement, Petsmart, Pier One and Michaels. The current center is 100% occupied, and it is the primary retail destination in its trade area, Gershenson notes.
It's no secret that spending money on property renovations and improvements can help drive rents higher, as well as ensure that properties remain viable competitors. “We try to pick out two to three projects in our portfolio every year that are top quality, and we plan improvements to make sure they continue to look the best they can,” says Delatour of Regency Centers.
Regency expects to spend nearly $2 million on major improvements at two of its centers in 2006 — Preston Park Village in Plano, Texas and Westlake Plaza and Center in Thousand Oaks, Calif. Specifically, Regency has budgeted $1.2 million for improvements at the 190,655 sq. ft. Westlake Plaza. The center is anchored by a Longs Drugs, and also includes some upscale regional tenants.
Plans call for the addition of new lighting, redesigning sidewalks to create outdoor seating, redesigning the parking entrances to improve traffic flow and repainting existing buildings. “We want to create a real people place in the middle of the center,” Delatour says. As a result of the improvements, Regency expects rents to increase about 20%.
Yet deciding to embark on a major capital improvement project isn't taken lightly. “Whenever owners have capital expenditures, they want their money to show a return on investment,” says Todd Caruso, senior managing director of CB Richard Ellis Retail Services in Chicago.
“We have to be able to provide that rationale in advance of our client making that investment.” CB Richard Ellis manages more than 60 million sq. ft. of retail space, and Caruso estimates that about 10% of those properties have some type of renovation work or repositioning efforts under way.
For its part, Ramco-Gershenson has four to seven major value-add projects under way at any given time with expenditures on renovation or expansion averaging about $25 million per year. That strategy is effective with rent increases averaging between 5% and 8% per year.
Even when improvements don't have a direct impact on boosting rents, upgrades can be an important defensive move in protecting existing values. And spending dollars on a current project, such as expanding an anchor, may pay off in a year or more down the road, because a stronger anchor will allow the landlord to push rents higher on smaller shop space, Gershenson adds.
Asset managers are tackling renovation and repositioning projects in both existing properties and new acquisitions. In fact, pricey retail acquisitions are prompting some investors to focus on buying properties where there is an opportunity to pump up values through property repositioning, renovation or redevelopment.
In 2005, Principal Real Estate Investors spent about $300 million — 75% of its total retail investment dollars — on buying “broken” shopping centers that have lost a key anchor or are in need of improvements. The Des Moines-based institutional and real estate advisory firm expects that strategy to play a significant role in 2006.
“That is driven by the fact that our clients are looking for higher returns than core properties are providing,” says Rod Vogel, managing director of acquisitions and asset management for Principal Real Estate Investors.
The unleveraged internal rate of return (IRR) annually on core or Class-A properties today ranges between 7% and 8% compared with returns of 8.5% to 11% on properties that are repositioned, Vogel notes.
Principal partnered with Boca Raton, Fla.-based Woolbright Development Inc. in a joint venture to purchase The Marketplace at Dr. Phillips in Orlando last summer. Principal purchased the 320,081 sq. ft. center with the intent of re-tenanting and repositioning the asset, as well as building about 25,000 sq. ft. of small shop space.
The center is anchored by Albertsons and Stein Mart, and additional renovations include painting, sealing and striping the parking lot, installing a lake fountain, landscaping renovations, lighting upgrades and new signage. “The demographics of the area have improved such that we can push rents and push for higher-scale tenants to add value,” Vogel says.
Myopia sets in
Maximizing cash flow is paramount among retail owners, yet one pitfall that asset managers face is being so caught up in boosting returns that they lose sight of the big picture — the long-term viability of the asset. Asset managers that are too focused on maximizing cash flow, and don't put dollars back into properties, are likely to see properties develop problems down the road, Pastore notes.
A good asset manager works to maximize cash flow, while still understanding the importance of maintaining a strong retail offering to customers, Pastore says. “We want to make sure our customers come back and shop time after time,” he says.
As a result, asset managers need to continually make tough tenant decisions, weighing the advantages of collecting higher rents today vs. perhaps signing a less lucrative lease that will boost property values in the future.
Signing a P.F. Chang or Cheesecake Factory may not bring in the highest rents compared to other restaurant deals, but they are a huge draw for both shoppers and other retailers, Pastore notes. “Most asset managers have figured out that you do need to make those kinds of investments because they pay off down the road,” Pastore says.
For example, AEW Capital Management has introduced three large tenants to the Shoppes at Georgetown Park shopping center over a three-year period — H&M, Anthropologie and Washington Sports Clubs. It was a tricky project because the center had to be reconfigured to accommodate the new tenants, and the existing space included both a historic building and new building located in an urban, street retail setting.
AEW could have saved itself the work by leasing the space to several smaller tenants — at a higher base rate. “The reality was that we knew that these large tenants would resonate with the customer base, and all of the tenants have done extremely well,” Pastore says. Since the three tenants opened, sales at the center have tripled.
Battling market changes
Ultimately, asset managers need to stay focused on maximizing retail values in a very dynamic retail environment. Industry experts are wary of a possible slowdown in retail as high energy prices and a slowdown in home refinancing drag down consumer spending.
“We do see some clouds on the horizon in the retail marketplace,” says Principal's Vogel. Retail has been the strongest performing property type in the past decade — fueled by strong consumer spending. Consumers have taken advantage of rising home values by pulling equity out of their homes to spend as discretionary income. Yet as interest rates rise and home values begin to level off, consumers won't be able to access as much money.
So far, such concerns have yet to materialize. Personal spending actually rose 0.9% in January — the biggest advance in six months, according to the U.S. Department of Commerce.
Another challenge for shopping center owners is that most retailers, particularly the large anchor stores, are locked into 15- to 20-year leases. Because those rents are fixed, there will not be an opportunity to raise rates to coincide with rising interest rates.
In addition, shopping centers continue to face competitive pressure from various versions of the lifestyle center — those properties that combine upscale mall tenants with outdoor ambience along with a mix of restaurants and entertainment. Retailers also are continuing to change store formats, including both supersizing and shrinking store footprints.
“Although we have seen consumers' expenditures expand in recent years, they are making choices that require retailers to be quick on their feet,” Gershenson says. In turn, shopping center owners, developers and asset managers need to be equally quick on their feet to adapt to those changes.
Beth Mattson-Teig is based in Minneapolis