Ask industry analysts for a synopsis of the current retail landscape, and they are likely to sing the same song they have been singing during the last several years. Except for fortress malls, the mall sector is struggling, they will say. Power centers are overbuilt and falling victim to e-commerce. Play it safe and stick with grocery-anchored strip centers, they will advise.

The retail industry in 2001 definitely has its weaknesses. However, some of the trends that investors might think of as bad, such as the closing of several prominent chain stores, could help the industry in the long run, say some analysts. Nevertheless, the retail sector contains many pitfalls for investors.

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In their recent analysis entitled "Emerging Trends in Real Estate 2001," New York-based PricewaterhouseCoopers and Atlanta-based Lend Lease Real Estate Investments describe fortress malls as retail’s best bet. However, "pickings are extremely slim among the top centers, because owners don’t want to sell," the report says. "They realize the value of these cash-machine core investments. Value gains in fortress malls also fit the core equation — slow but steady, without much downside risk."

Predicted value gains for fortress malls stand at 0.3% over one year, 8.6% over five years and 16.6% over 10 years, according to the report.

"Emerging Trends" also gives some kudos to the grocery-anchored shopping center, which has predicted value gains of 1.9% over one year, 11.2% over five years and 20.4% over 10 years.

On the other hand, "Emerging Trends" urges owners to sell their power centers. Electronic retail continues to see increased music, books and computer sales, which form the merchandising heart of the overbuilt power center sector. Also, B and C malls, laden with under-performing tenants and empty movie theaters, offer "opportunistic investments" and "land plays," respectively, says the report.

Out on the horizon, the authors of "Emerging Trends" note the growth of so-called lifestyle centers that offer fashion stores, home accessory shops, restaurants, large format bookstores and new stadium-seating theaters in an architecturally fresh town center. However, new and unproven formats also offer risk, especially in a nation that, as the report notes, already provides 20 sq. ft. of retail space per person, compared to 2 sq. ft. across Europe.

In its final retail summary, Emerging Trends gives this outlook for 2001: "Too much space, the Internet, casual-dress codes, less time to shop, boring formats — all add up to trouble for investors in retail real estate. A sideways economy would only exacerbate the pain. Exceptions: Neighborhood centers will be OK as holds and fortress malls — well, pretty impregnable."

Beyond the status quo

In the midst of all of this, where can investors find new retail plays?

"Retail is a different kind of real estate business than office, multifamily, and industrial," said Bill Kent, executive director with Insignia/ESG Capital Advisors in Washington, D.C. "In these categories, investors can look at broad market statistics like absorption rates and vacancy rates. But in retail, investors must analyze each property, understand the trade area, and evaluate competitive properties. Then you can make some sense of vacancy rate and rental rate data."

Consider, for example, the recent bankruptcies of Chicago-based Montgomery Ward, which closed all 250 of its stores and a Braintree, Mass.-based Bradlees Inc., which shuttered all 105 of its stores. To some, such a massive exodus of stores from the retail landscape bespeaks trouble in the retail economy. However, some industry veterans embrace these events as opportunities.

"Target, Kohl’s, and Sears have already picked up a lot of Montgomery Ward and Bradlees locations," said Kent. "They picked them up right away."

When Montgomery Ward closed its doors, Chicago-based HSA Commercial Inc. was in the midst of de-malling Chicago’s Orland Park mall, where Ward served as an anchor. Without missing a beat, HSA bought the Ward’s parcel and continued the redevelopment.

"We’re a value-added company," said Doug Reichl, executive vice president of HSA. "We look for properties to redevelop and reposition. I think the Ward’s closing is a positive development that will benefit shopping centers in general." The closings allow owners to replace an under-performing anchor with an expanding overachiever such as Target, added Reichl.

Indeed, many view the apparent bad news of recent months as beneficial to the broader retail industry. "Absolutely," said Michael Wesley, managing principal with Oak Brook, Ill.-based Edgemark Commercial Real Estate Services LLC. "Montgomery Ward was a good company years ago. But it lost its focus. A lot of people view these empty stores as opportunities. In Chicago, Target and Kohl’s are fighting for Ward’s locations in Chicago. I think that’s true nationally."

Wesley has seen this phenomenon before. The closing of Builder’s Square a few years ago appeared to forecast a business downturn, he pointed out. Quite the opposite took place, though, as better tenants such as Home Depot moved into empty Builder’s Square locations with popular Home Expo stores.

But that was in the mid-1990s. Today, the economy is slowing. Right? "We’re really tired of hearing that," Wesley said. "January was a little slow, but business has picked up to where we expected. In fact, we’re ahead of plan in terms of numbers of leases, and we didn’t project a bad year to begin with."

Every industry evolves, but retail evolves more than most, said Michael J. O’Hanlon, executive director for the Dallas office of New York-based Insignia/ESG. "Retail rises and falls at the whim of the consumer," he said. "Look how the grocery store business has changed over the years. These stores are dramatically different today than they were 10 years ago. Ten years from now, we’ll wonder how we got along with today’s style of grocery store.

"Malls are the same way," he added. "Unless they constantly work their tenant mix, track how each retailer is doing and analyze the consumers who shop the mall, they can fall behind the curve."

O’Hanlon cited the Prestonwood Mall in north Dallas as an example. Opened in 1975 with anchors Lord & Taylor and Neiman Marcus, Prestonwood closed in 1995 in the midst of the recovery that followed the 1991 recession.

The tenant-mix in the mall had failed to keep up with changing demographics. People in the trading area grew wealthier as the suburban communities north of Dallas flourished during the economic expansion. "People were shopping at Neiman Marcus and nowhere else," O’Hanlon said. "You simply have to maintain a tenant mix fitted to your customers. Are the tenants creative? Are they leading the trend in retailing or falling behind? When the tenants fall behind, the mall property falls just as fast."

Take off those rose-colored glasses

Not everyone believes the recent developments in the retail industry portend positive change. "I think the news is more bad than good," said C. Bradley Mendelson, executive managing director of Insignia/ESG in New York City. "We are over-retailed in many markets, over-retailed with stores carrying merchandise so similar that you can’t tell the difference. This has been true for years. But the economy has been so good and consumers have had so much money to spend that it hasn’t mattered.

"Now that money is getting tighter, people will get more conservative about spending, and I think we’re going to see a period of survival of the fittest in retail," he added.

In other words, the Montgomery Ward and Bradlees bankruptcies may simply be the first casualties of an industry-wide shakeout.

And retailers have been struggling for months. For example, February 2001 brought a string of announcements about declining same-store sales. Stores owned by St. Louis-based May Department Stores posted a collective decline of 1.1% in same store sales. Cincinnati-based Federated Department Stores, Inc. reported a 1.6% same store decline. Meanwhile, Chicago-based Sears’ same-store sales fell 2%.

Among specialty stores, San Francisco-based Gap Inc. saw sales decrease by 11%; Columbus, Ohio-based Intimate Brands’ sales dropped 5%; and The Limited, Inc., also based in Columbus, finished February with flat sales.

Recent retail stars have found the current environment harsh as well. King of Prussia, Pa.-based Zany Brainy, which sells educational products for children, has been struggling with a default on a $115 million credit line with its lender.

There is also the matter of the continuing carnage in the movie business. Industry observers estimate that an additional 1,500 theaters will go dark in the second quarter of this year.

What’s an Investor to do?

Although retail has its woes, capital remains accessible, according to industry observers. "Despite the problems retail tenants are having and despite concerns about the impact of the economic slowdown on retail sales, there is a surprising amount of capital in the market today for shopping centers," said George Good, senior vice-president of the CB Richard Ellis Institutional Group, Chicago. "The explanation for this is that pension funds and other institutional investors have found themselves under-allocated in retail. Consequently, a lot of capital is targeting retail real estate."

Private capital, recently withdrawn from the stock market, also has begun to view real estate as one of the year’s safer investments, Good added. "On the other hand, all this capital may not result in additional transaction activity," he said. "Most of it is targeting the same types of property: grocery-anchored strip centers with market dominant grocery operators in better demographic areas. Everyone believes these kinds of centers are safe havens, but not many are on the market."

With available capital outpacing the supply of retail real estate, prices have held steady. According to Kent, Insignia/ESG’s Capital Advisors Group closed several transactions for grocery-anchored strips in late 2000. Those deals carried capitalization rates under 8.5 on first year income. "That’s as strong has this market has ever been," Kent says. "We’re at or near record levels."

Cautious lenders

While the prices that buyers are willing to pay continue to hold up, lenders tend to view the retail market with caution, said Mark McGovern, director of L.J. Melody, the mortgage banking division of Los Angeles-based CB Richard Ellis. According to McGovern, lenders, sensitive to the slowing economy, are underwriting loans with great care and calculating conservative loan-to-cost values and debt-service-coverage ratios.

"While these figures are all over the board, the averages fall in the range of 70% loan-to-cost and 135% debt service coverage," McGovern said. "We are also looking carefully at the percentage of debt service covered by credit tenants. As this number goes down, interest rates may rise."

When a theater is part of the deal, lenders will discount its income by as much as 50% when calculating debt-service coverage, according to McGovern. Lenders also evaluate the type of building the theater is in. Will another business fit the building if the theater goes bankrupt? How much will it cost to retrofit?

When it comes to malls, lenders want a minimum of three anchors. "Two anchor centers can be financed," McGovern said. "But they certainly won’t get the best pricing."

Then again, even cautious lenders attribute little significance to the demise of Montgomery Ward. "That may be a good thing," McGovern said. "Operators will put another, more vibrant retailer into those spaces. One of our borrowers, for example, is trying to gain control of a freestanding Montgomery Ward location across the street from their mall. They want to put in a retailer such as Target or Home Depot, a retailer that will increase traffic to the area and so to the mall."

Betting on the right retail horses

The greatest fear of a retail real estate investor lies in buying a percentage of a property that underwrites well and then loses an anchor to bankruptcy or a better location. "That can be devastating," said Terrence Tallen, president of the Los Angeles-based Retail Enterprise Group. "You must bet on the right retail horses.

"For example, Best Buy recently issued a very favorable earnings report that exceeded both their own and analysts projections," Tallen added. "The company’s stock has gone up accordingly. In addition, Best Buy is a great retailer."

According to Tallen, Best Buy bears watching as it continues a measured expansion into power centers and larger hybrid centers, which have added a drug and grocery component to the typical power center offering. But power centers have fallen into disfavor. Is Best Buy a strong enough retailer to alter the character of the power centers it moves into?

"Yes," Tallen said. "For two reasons. First, Best Buy will underwrite very well. Second, it will bring other quality tenants to a center’s mix and in doing so help draw customers to the center. Wal-Mart and Target have the same ability to attract good tenants and draw customers. Suppose a developer brought in a Best Buy and added Bed & Bath and T.J. Maxx. This kind of tenant mix has the makings of a successful power center."

The same is true for grocery-anchored strip centers: The quality of the grocery anchor will make or break the center. Tallen lists a number of grocers to follow, including Kroger, Publix, Ralph’s and Safeway.

In the end, many factors go into a successful retail center: location, credit tenants, solid center and store design, plus strong leasing and management operations. But even when all those factors come together, a retail real estate investment will ultimately win or lose on the back of its retail horses.

Michael Fickes is a Cockeysville, Md.-based writer.