New Rules for Retail

Saturated markets and deep-pocket competitors are prompting changes in this once by-the-book investment sector.

T he rules for retail are changing across America, almost as quickly as the holiday lights come down and the racks of valentines go up on Jan. 2. Wal-Mart has morphed from the feared competitor into the good neighbor that attracts a slew of national credit tenants that flourish in its demographic pull. The world’s largest retailer also is a pioneer, staking out territory in small markets and moving into inner cities. However, it reported the lowest same-store sales in 10 years last November and ended its fiscal year on Jan. 31 with the lowest annual same-store sales gain in 27 years, according to a Wall Street Journal Online report. As a result, Wal-Mart is slowing expansion plans this year, and when Wal-Mart hiccups, the rest of the retail world scrambles either to gain market share or rewrite pro forma numbers.

The Changing Game
Such dependency on the actions of a single retailer is one of retail’s revised rules. And while Wal-Mart remains every leasing manager’s favorite shopping center anchor, today’s rules question if developers and owners even care about the anchor concept. Investors aren’t too concerned: In Orlando, Fla., a top Southeast retail market, unanchored centers were last year’s most favored retail investment. “Unanchored retail centers are so popular because purchasing one is within reach of a much larger pool of investors,” says Jeffrey Pocklington, director of Investment Services for GVA Advantis and a partner in the company’s Pocklington, Pocklington, and Forster Retail Investment Group in Orlando. “However, in recent years, a few institutional investors have begun to show interest in unanchored retail, causing more competition and increasing prices.”

And that’s a problem for many of today’s smaller, private investors. While the American shopper will have no trouble finding something new to buy this year, those who buy big — in particular retail property investors — may not find the right property at the right price. Competition in hot markets such as Orlando and Fort Lauderdale, Fla., Phoenix, and California’s Orange County has driven prices up and capitalization rates down. Now that real estate investment trusts rule the mall world, institutional and large private investors are amassing portfolios of smaller shopping center properties. The influx of capital chasing core assets is tremendous; but big buyers are very particular, as competition for top-tier assets in top markets is very tight, says Joseph French, CCIM, Sperry Van Ness’ national retail director in White Plains, N.Y. However, in less-stellar markets, cap rates are rising as sellers set more realistic prices. “It’s tough in Bethlehem, Pa., to sell a Big Lots shopping center for a 7 cap rate,” French said in an interview with “It may be good credit, but it’s a second-tier center in a tertiary market and it’s not going to command the same price as it would have two years ago.”

Overall, retail sales are expected to grow 4 percent to 4.5 percent this year, still healthy but not as strong as 6 percent and 7 percent in the last two years, according to Marcus & Millichap. In reaction to a slowing housing market, national tenants are pulling back expansion plans, and retail development this year will add about 120 million square feet, approximately 10 million less than last year.

Despite a slower national outlook, retailers still are searching for new markets to enter, but they are not necessarily following traditional rules. For example, Swedish home furnishings giant IKEA opened a store in Austin, Texas, which is much smaller than its usual target market of 2 million people. Whole Foods is settling into a food-filled neighborhood in Jacksonville, Fla., in 2008, across the street from a Publix and within a half-mile of three other grocery stores — despite the fact that nationally it is facing increased competition as traditional grocers beef up their organic offerings. In what some experts see as a defensive move, Whole Foods recently bought its closest natural-foods competitor, Wild Oats, in part to keep the chain out of the hands of traditional grocers.

Such moves indicate the retail industry’s ever-evolving nature. In response, investors seeking retail real estate are looking at alternative opportunities. For example, as proof of today’s reconfigured retail landscape, once-risky projects such as shadow-anchored centers now catch large investors’ attention. A little off the beaten path, power centers are popping up in small markets, as retailers widen demographic rings and seek former competitors as neighbors. Infill projects in secondary markets are under development, as cities such as St. Paul, Minn., try to replicate the new urbanism of major metropolitan areas. And some retailers and developers are pushing into inner cities, which many experts call the next big retail frontier.

For developers, brokers, and investors, retail projects are out there. While they may be a little edgier and riskier than predictable grocery-anchored centers, not even safe bets are safe given retail’s changing rules.

Caption: With stores such as Target competing for food shoppers, grocery-anchored centers look less appetizing to investors.
Credit: Target Corp.

Shadowing the Big Boys
When it comes to leasing retail real estate, there is no bigger guarantee of usual success than Wal-Mart. “Where a Wal-Mart Supercenter goes, so goes about 20,000 sf of tag-along tenants,” says Tom Rohde, CCIM, of Rohde, Ottmers, Siegel Commercial Real Estate in San Antonio. Rohde finds the attraction even in the smallest markets, such as Hondo, Texas, population 5,000. Wal-Mart vacated a 46,000-sf space and built a new 200,000-sf Supercenter right behind it. Rohde listed the former Wal-Mart in early January and had enough leasing prospects to fill it in 30 days. In contrast, he has a listing for a vacant Albertson’s in Victoria, Texas, a town of about 50,000. But “it has sat vacant for three years with few prospects because it is not in the shadow of a major new anchor,” he says.

Investors have traded nearly $2 billion in shadow-anchored space in each of the last four years, according to Real Capital Analytics, indicating both lender and investor acceptance of this once-risky product. Cap rates have dropped to 6.8 percent on the average shadow-anchored transaction, down from an average rate of 9.8 percent five years ago. “The problem was the shadow centers located next to the older, smaller Wal-Marts,” Rohde says. For a number of years Wal-Mart abandoned smaller leased spaces in favor of building larger supercenters. Today, space in the shadows of more than 900 Wal-Mart Supercenters is pretty secure, because Wal-Mart never has relocated a Supercenter, Rohde says. “They can’t find large tracts of land [on which to build].”

But Wal-Mart’s sluggish performance late last year is curtailing its expansion plans, although it is expected to focus on the supercenter format almost exclusively, according to Marcus & Millichap. The retailer blames store remodeling for keeping shoppers away, but retail analysts say Wal-Mart’s entry into markets with stiffer competition may be more the cause for lower sales.

Last April, REIT Kimco Realty Corp. and Michigan-based Schostak Bros. paid more than $100 million for a portfolio of 28 shopping centers shadow-anchored by new Wal-Mart Supercenters. The transaction indicates the range of interest in shadow-anchored centers: Kimco owns more than 1,000 community and neighborhood centers, where as regional Schostak has a portfolio of 50 properties, according to Shopping Centers Today.

Home Depot, Lowe’s, Kohl’s, and JCPenney also are effective shadow anchors. And in Texas markets, HEB Grocery also attracts tag-along tenants, Rohde says, indicating its strength as a regional retailer.

Won’t You Be My Neighbor?
While Wal-Mart is the prime shadow anchor, some retail leasing specialists favor Target as a center anchor because “it attracts a higher-level fashion group of tenants that pay higher rents,” Rohde says. “Most of the apparel stores want to be next to [Target] because it draws women — Ross, T.J. Maxx, and even Penney’s are larger stores from 30,000 to 90,000 sf. You can build a lifestyle center around a Target.” In contrast, a Wal-Mart anchor attracts more service-oriented tenants and lower-priced apparel retailers in smaller stores. “CATO, Dots, Shoe Dept., and Dollar Tree are typical for a Wal-Mart center,” Rohde says.

Wal-Mart remains a prime magnet for new retail development in very small markets. When the retail giant landed in an industrial-zoned corridor outside of Ankeny, Iowa, — population 30,000 — retailers that Barbara K. Hokel, CCIM, had hounded for years suddenly returned her calls. “Every six months I was in touch with Target. I’d call, they’d say no, and that went on for several years.” After Wal-Mart agreed to a location across from Hokel’s property, “I called Target immediately and they said, ‘We think you have an excellent site!’ At that time, they bought enough land to build a Home Depot next to them. From there I asked Target who they liked as neighbors. They said one of them was Kohl’s, so I called Kohl’s and the rest is history.”

Hokel, who now does retail leasing with NAI Ruhl & Ruhl Commercial in West Des Moines, Iowa, was working with a local developer when the retail corridor began to develop along Interstate 35. The combination of interstate access and isolation from other retail competition was key to its success, she says. “The power center caught the attention of other big-box retailers who like to neighbor together: Pier 1, Michaels, Dress Barn, Starbucks, and PetSmart. This also sparked the development of a couple of retail strip centers that attracted more national retailers such as Tuesday Morning and Jimmy John’s.”

Making retail connections at International Council of Shopping Centers conventions also proved very beneficial. “In one trip we landed T.J.Maxx, Factory Card & Party Outlet, and Shoe Carnival,” Hokel says. “The conversion from an industrial site to retail was phenomenal and it continues to be a very successful place to shop.”

Rohde sees similar interest from retailers in small Texas markets. Since many retail chains have saturated major markets they are looking at smaller countywide trade areas. Rohde cites a project in Bastrop, Texas, a town of only 6,500. “Being a county seat with many intersecting highways, we are working on a retail project of more than 700,000 sf. The county is over 80,000 in population and the anchor tenants are looking at that countywide trade area because it has become the crossroads of central Texas.”

Caption: Retail space in secondary market urban infill projects such as Straus Building in St. Paul, Minn., faces density and parking challenges.
Credit: Sherman Associates

Small-Scale Mixed-Use
In other parts of the country, infill development and mixed-use are trickling down to secondary and tertiary markets. Retail is a component of these projects, which have had great success in larger metro areas. But it’s not as easy as it looks, says Robert A. Kost, CCIM, commercial leasing manager and project manager for Sherman Associates in Minneapolis. “You have to keep the pro forma rent low and stretch out the leasing schedule to two or three years” in smaller urban markets, he says.

Kost has two projects in downtown St. Paul’s older warehouse district bordering the city’s financial district. Sibley Park Plaza is a new residential building and the Straus Building is an adaptive reuse of a knitting factory. Each project contains about 10,000 sf of first-floor retail that Kost is leasing at $12 to $16 per square foot net.

St. Paul city officials have embraced urban development but Kost says the city lacks the urban density of larger cities and new residential neighborhoods have not reached critical mass. As a result, leasing managers need to be flexible, he says. He has leased part of the Straus Building retail space as headquarters for EQLife, a small Best Buy spin-off company. Now he’s getting more interest from local law firms that are looking for innovative spaces and is advertising the rest of Straus’ space as retail/office.

At Sibley Place Plaza, the end caps leased easily, but in-line space is harder to rent. Kost targets national credit tenants, as well as franchises, which “at least have a business process in place.” The neighborhood residents clamor for local businesses as tenants. “What they don’t understand is that if a local restaurant decides to open another location that’s a huge increase in the overhead; they can’t afford to keep going until the neighborhood picks up.”

Parking is another issue that dogs retail leasing in urban neighborhoods. While there is metered parking in front of Sibley Park Plaza, one of his in-line tenants, Wireless Toyz, complains that on weekends and evenings when the meters don’t need to be fed, residents park in the spaces instead of shoppers. Developers need to work with city planners to provide 30-minute meters or free parking in local garages to alleviate such problems.

While Kost discounts the possibility of leasing to local businesses, Regina Emberton, CCIM, director of corporate services with CB Richard Ellis in South Bend, Ind., is concentrating on them in her attempts to lease retail in a redeveloped industrial building in Benton Harbor, Mich. She also advertises the space as retail/office at a lease rate of $10 psf.

Located in the heart of Benton Harbor’s developing arts district, the building has had several showings for the retail space but no interest from national retailers, she says. “Instead, we have focused on marketing regionally to entrepreneurs and unique niche businesses and that seems to be where the primary interest has come from — arts-related groups, restaurants, caterers, photographers.” Other tenants in the area include a microbrewery, restaurants and bars, a cooperative art studio, a glass-blowing studio and gallery, and a wine-tasting room.

Situated next to twin city St. Joseph, Mich., Benton Harbor is about 90 miles east of Chicago on Lake Michigan in the center of a large tourist and second-home market. Benton Harbor “is really the only city along the lake that has not turned into a tourist community,” Emberton says. However, that is beginning to change now that Whirlpool acquired Maytag and is bringing 400 executive jobs to its Benton Harbor headquarters.

The Final Frontier
Since the 1980s urban planners have promoted inner cities as the most under-retailed U.S. neighborhoods. And it’s true. Inner-city neighborhoods represent more than $85 billion in retail spending per year and contain an average of $76 million retail dollars per square mile, compared with $8 million psm for the rest of metro areas, according to the Initiative for Competitive Inner Cities report. Yet almost 60 percent of those retail needs are unmet in some neighborhoods. In addition, 38 percent of inner-city families fall into the moderate income category with annual incomes between $20,000 and $50,000.

These statistics have caught the eye of national retailers running out of suburban markets. As major retailers have made forays into more upscale urban markets, they have become more familiar with the challenges of urban development. That experience combined with the need for expansion is convincing retailers to explore inner-city locations.

Some pioneers are already there. For its first store in the Pittsburgh market in 2002, Whole Foods settled in the declining East Liberty neighborhood right between the railroad tracks and a taxicab barn. Home Depot followed, and the next year Walgreens and Starbucks also located along the Centre Avenue corridor. This year Trader Joe’s located there. A Borders and Target are on the drawing board, along with multifamily and condominium projects.

A once-thriving neighborhood, East Liberty declined in the 1980s and 1990s after misguided urban renewal attempts cut it off from other parts of Pittsburgh. Surrounded by wealthier neighborhoods, East Liberty has shopper demographics that any suburban mall would envy, and along with national tenants, it supports shops and restaurants that are owned and operated by residents of the largely African-American neighborhood.

Milwaukee boasts a similar success story. The almost-vacant Capitol Court Shopping Center near one of Milwaukee’s poorest neighborhoods generated no interest among local developers and investors. Even when Wal-Mart came to town with the numbers in its back pocket, local lenders still weren’t too interested. But more than 200,000 people with median household incomes of $38,000 live within three miles of the shopping center. They were spending almost $1 billion annually but the nearest mall was seven miles away. Eventually Boulder Ventures LLC with partners bought the mall for $8 million in 2001, demolished it, and built a 454,000-sf open-air center. With Wal-Mart as the first major tenant, the center attracted more than 20 national tenants including Walgreens, Starbucks, and Lowe’s. Boulder sold the nearly fully leased center in 2004 to Inland Western Retail REIT for $53 million — after entertaining 13 offers for the property.

Wal-Mart continues to pursue such opportunities, opening its first Chicago store last September on the economically depressed West Side. Wal-Mart plans to roll out 50 such stores in the next two years and recently announced plans to open inner-city stores in Indianapolis, East Hills, Pa., Cleveland, Decatur, Ga., El Mirage, Ariz., Landover Hills, Md., Portsmouth, Va., and Richmond and Sanger, Calif.

Along with retailers, developers such as General Growth Properties are starting to focus on inner cities. GGP has committed to begin development of two to three $70 to $100 million retail projects annually in under-retailed city neighborhoods, according to Lyneir Richardson, GGP’s executive vice president of urban retail development. Inner-city retail is an “evolutionary process,” Richardson said at last year’s ICSC convention. “First, fast-food eateries got it, then drugstores got it, and now big-box and mass market retailers are getting it.”

As retailers chase rooftops in diverse markets, property investors continue to add retail to their investment portfolios; however, many may need to temper their investment projections. While population growth and consumer confidence continue to feed retail growth, “it will be a challenge for retail to continue to perform at the high levels and high returns that we have been seeing,” says Kenneth P. Riggs, CCIM, president of Real Estate Research Corp. in Chicago. “However, our investment-conditions rating places neighborhood/community retail above either power centers or regional malls. Community retail, where people stop in to get a haircut or grab a sandwich, or do their banking and other personal services in their neighborhoods, should continue to do well if supply does not get ahead of demand.”