From the street, the brand-new Point Berkeley in Duluth, Ga., a suburb north of Atlanta, looks like any other neighborhood shopping center. The 217,000 sq. ft. complex is anchored by an Asian supermarket, with a flurry of conventional retailers and restaurants filling out adjacent spaces. There are cellular telephone shops and insurance company storefronts and all manner of mom-and-pop merchants.

From appearances, this certainly seems to be a harmonious mix of tenants. And yet the residents of Point Berkeley aren't tenants. No, the shopping center has been split into 111 pieces and has 111 owners. The developer, NorthPoint Group Inc. of Alpharetta, Ga., is a condominium specialist, building office, warehouse, service and even hotel condos over the past decade. The firm's latest interest is in retail condos, which are popping up along the East and West Coasts as well as in places like Chicago.

In major cities such as New York and Washington, D.C., high-rise apartment and condo residences are being built in downtown city neighborhoods with retail shops on the first floor, which are for sale.

In suburbs like Duluth, enterprising developers are building strip centers and neighborhood shopping complexes and shunning more conventional leasing income streams in favor of instant sales of individual spaces to tenants.

“Retail condos are not a major nationwide phenomenon yet, but the sales in this sector are growing at an impressive rate,” says Dan Fasulo, managing director with Real Capital Analytics in New York. Real Capital didn't even track retail condo sales until 2003, when it recorded all of $44.9 million in sales transactions. By last year, the total had ballooned to more than $862 million (See chart, p. 60). “Investors are noticing this sector and now the demand for these kinds of assets is obvious.”

Driving forces

The condo trend has been driven by a combination of low interest rates, rapidly rising property values and the emergence of merchant developers eager to flip their assets. At some developments, small spaces are sold off piecemeal to end users, while at others entire floors are aggregated and sold off to investors, who then lease the spaces themselves.

David Ervin, president and chief executive of Ervin Development Corp. in Winchester, Va., helped pioneer retail condos around Washington, D.C. as early as 2001. “With interest rates low, retailers suddenly realized they could buy their own spaces as cheaply as rent them, and then take advantage of the appreciation in property values while building equity,” Ervin says.

In New York, the epicenter of retail condos, the economics of retail condo deals have dazzled investors. Jon Epstein, senior director with brokerage Cushman & Wakefield based in Manhattan, says that many new residential condo towers are selling upper-floor space for $1,000 to $1,500 per sq. ft. But the ground-floor retail spaces in the best-located buildings along Madison and Lexington avenues are selling for $3,000 per sq. ft. and more.

“By selling off their ground-floor retail along with the condos above, developers are maximizing their returns,” Epstein says. “Today, many sponsors of new construction are not interested in holding onto leased real estate assets as a long-term investment.”

One of a kind

The New York market, however, appears to be in danger of overheating. More than a year ago Vornado Realty Trust paid $113 million for 17,000 sq. ft. of retail space on Madison Avenue, with the jeweler Cartier as its major tenant. The price amounted to $6,647 per sq. ft., a record for retail space in the U.S.

A foolhardy investment? Maybe not. Rents have rocketed to $1,000 per sq. ft. for retail space in some top-notch Manhattan locations. Average asking rents, however, rose from $56.23 per sq. ft. at the end of the third quarter last year to $59.88 at the end of the third quarter this year, a 6.5% increase. A developer content with an initial 5% capitalization rate could conceivably pay as much as $20,000 per sq. ft. for that space and generate a tolerable return, brokers say.

The law of supply and demand is driving rents and condo prices higher, says Robin Abrams, executive vice president at Lansco Corp. in New York, a leasing and brokerage firm. For all the publicity some high-profile sales have gotten, he figures currently there are only 50 buildings in Manhattan with retail condos. “For anything that comes up for sale and is available, we have multiple investors standing ready with bids,” Abrams says. “There is a lot of money waiting to buy retail condo assets.”

Retail-residential formula

Metropolis Development Co. based in Washington, D.C., is erecting a 90-unit residential condo building at 1515 15th Street Northwest spread over seven stories, with completion due in the fall of 2008. The units, which are 60% sold, are priced above $700 per sq. ft. On the ground floor is nearly 32,000 sq. ft. of retail, with a local health club, Vida Gym, signed on for 22,000 sq. ft. already. The retail spaces, though not yet priced, are all for sale.

R. Scott Pannick, president and CEO of Metropolis, says that most of his sales are to small entrepreneurs taking between 1,000 and 10,000 sq. ft. and paying $500,000 to $5 million. In the past, budget-minded investors who wanted to get into real estate were relegated to buying two-flat and four-flat apartments, with the requisite maintenance headaches. Now these same investors can buy into commercial condos — where maintenance is usually provided by a condo association — in small-bite portions.

“Retail condos here are particularly popular as instruments in 1031 tax-deferred exchanges,” says Pannick. “A guy who owns a restaurant or a gas station and wants to get rid of it, but who doesn't want to pay taxes, can take the proceeds from a sale and put it into a $1 million retail condo. Exchanges like that often work beautifully,” adds Pannick.

They work great for the developer, too. Pannick says that in his mixed-use condo buildings, sales of the residential space on upper floors pay off all his construction loans. His profit? It's in the retail.

“That's the leftover piece that drives our business,” he explains. Pannick reveals that in some of his Washington buildings a prime corner retail condo can attract rents of $75 per sq. ft. and more. If that space goes condo and the investor is content to purchase at a 5.75% cap rate, then the selling price comes to $1,300 per sq. ft. Meanwhile, the residential spaces on upper floors are selling for $700 per sq. ft.

With hard and soft costs included, his residential space costs him $400 to $500 per sq. ft. to build and generates an average sale of $700. The retail spaces, with far less build-out, cost him less than $300 per sq. ft. and command prices higher than residential spaces.

The tenant mix can be important, too. David Sobelman, vice president with Calkain Cos. in Reston, Va., is hired by retail condo developers to qualify prospective tenants. Occasionally retail condos are sold without tenants, but that's rare. Most investors want to see occupancy of a space first.

“On one hand you want quality tenants who are going to be around a long time,” says Sobelman. “But on the other hand, a condo tower needs mom-and-pop businesses like dry cleaners and shoe repair shops that are not always the best credit tenants. It's a balancing act to come up with the right mix.”

Early returns

As urban markets get saturated with retail condos, the next frontier is almost certainly suburbs and small towns. In Winchester, a suburb of Washington, D.C., Ervin Development Corp. has been building retail condos since 2001, though the pace of construction has picked up substantially of late. David Ervin, president and CEO, sees his market changing all the time.

“When we started, 80% of our retail buyers were users,” Ervin says. “By 2006, some 80% of our buyers were independent investors. Now we're back to a ratio of 60% of our buyers being users.” The latter have re-emerged as retail condo bidders, he theorizes, because local retail leases are widely forecast to rise 10% in the next year. “They'd rather buy now and avoid the inflation.”

Ervin just finished a 25,000 sq. ft. shopping center in Winchester that he divided into 18 units and sold for an average $200 per sq. ft. His total costs amounted to $175 per sq. ft. Over a two-year period he received a 12.6% return. But his cash-on-cash return was far better, for Ervin pre-sells his retail condos, demanding generous deposits, and using the proceeds to obtain construction loans. That allows him to proceed on projects with very little of his own money invested.

In St. Charles, Ill., a suburb of Chicago, Stoneleaf Properties recently put up a 17,000 sq. ft. retail condo center called Westgate Commons. Brian Buoy, president of Stoneleaf, says that his cost of development was $2.7 million. He realized $3.1 million in condo sales.

Buoy could sell for more, but opts to sell at a discount early in the development cycle in order to raise funds for his next project. “If you're building in volume, you give up some return to move on to the next development,” he says.

And what happens if demand for retail condos begins to wane? “We can switch our signs from ‘For Sale’ to ‘For Lease’ on our new properties at any time,” says Ronald Onorato, president and CEO of Atlanta-based NorthPoint Group Inc. “But so far investor demand is strong, and we don't see any reason to lose faith in condo development.”
— H. Lee Murphy is a Chicago writer.

Institutional investors embrace retail condo concept

At the start of the 21st century, most retail condo investors were small entrepreneurs. But the mom-and-pop nature of condo investing has steadily evolved as the projects have gotten bigger and more valuable. With deals for packaged retail condo spaces now exceeding $25 million in some cases, institutions are diving into the marketplace.

A diversified REIT with over 140 owned or managed shopping centers totaling more than 28 million sq. ft., Vornado Realty Trust has become one of the most aggressive bidders on retail condo spaces in New York in the past 18 months. Pension funds and even hedge funds are jumping into the market, too.

Madison Capital in New York, which holds a portfolio of $1 billion in investments for private and institutional partners, entered the retail condo market five years ago when it bought 20,000 sq. ft. of retail space at 1223 Second Avenue in a building featuring luxury residential condos on upper floors.

Richard Wagman, managing director of Madison Capital, says that his group paid $700 per sq. ft. for the retail space, or $14 million. That retail space has more than doubled in value, Wagman says, to $1,500 per sq. ft, or $30 million.

“We've earned some very nice returns on that asset,” Wagman says. Madison has continued to invest. It's now part owner of 85,000 sq. ft. in the lower floors of a residential condo building now under construction, replacing the old Mayflower Hotel at 15 Central Park West. Madison and its partners, which include Fortress Investment Group of New York, are paying a dizzying $1,500 per sq. ft. for the retail space, located at 1880 Broadway. The total investment comes close to $130 million.

That scale has been enough to rouse the interest of investors, including Goldman Sachs and other big names. “Institutions typically like to invest $50 million or more at a time,” Wagman notes. “Some will go down to $25 million. A few years ago it was private investors who started buying up retail condos, but as prices have risen the institutions have become attracted to this asset class.”
— H. Lee Murphy

What's the downside to retail condominiums?

Though retail condos are growing in popularity, experts caution that they aren't for everyone. Most franchisees, for example, are stretched financially to cover their franchise fees and finance their equipment. That's why they are seldom buyers of retail condos.

The independent-minded retail condo buyers, meanwhile, need to realize that they are likely to be part of a condo association and have a limited voice on special assessments for the repair of leaky roofs and parking lots filled with potholes. And if a retailer buys instead of leasing, there is an inherent risk: The retailer may find it more difficult to switch locations down the road, if the business grows or shrinks and needs a different footprint.

There is also the issue of tenant mix. “A typical shopping center has one owner who controls the destiny of the center. The company knows it's important to attract the right tenants,” says Lee J. Shapiro, managing director of Charles Dunn Co., a retail consultant and brokerage in Los Angeles. “In a retail condo complex, you have lots of different owners. It can be hard to make communal decisions about the colors of your façade, and the joint advertising in a local newspaper.”

There's another aspect to this loss of central ownership. “If you lease space in a shopping center and your roof leaks, you call up the landlord and ask him to fix it,” says Janis B. Schiff, a retail condo expert with the D.C. law firm Holland & Knight LLP. “If you are a retail condo owner and you have a leaky roof or a messy entrance lobby, who do you complain to?

Often there is no direct remedy for such problems,” adds Schiff. In retail condo situations, determining who is supposed to pay for insurance and who owns the common areas can pose a challenge.

Yet the concept is growing. Business Condos USA, a development firm based in Jacksonville, Fla., has completed 18 retail condo projects in the past five years and is now taking its business model national. It's sold nine licenses to developers in other cities and is schooling each on the advantages of condo construction.

“Owning real estate is an advantage for the small businessman going to the Small Business Administration for a loan,” points out Larry Walshaw, president of Business Condos. “A banker takes an approving look at real estate holdings when somebody is seeking a loan.”

Some skeptics believe that if interest rates move higher and retail vacancies mount — leaving tenants with plenty of discounted leasing options — the interest in retail condo investing could decline. Others point out that the growing ranks of ethnic retailers, particularly Asians, prefer to own their stores and will fuel more retail condo construction in the future.
— H. Lee Murphy