Grocery-Anchored Centers Help Keep the Retail Sector in Business.
The 2001 holiday retail season was "the last gasp of the overly indulgent U. S. consumer. We cannot count on the U.S. consumer to carry the United States and the global economy on his back any longer," pronounced Stephen S. Roach, chief economist at Morgan Stanley, during the World Economic Forum held in New York in February.
Such words can chill the spines of retail real estate professionals as visions of empty big boxes morph into darkened mall spaces, shuttered outparcels, and miles of empty parking lots.
But surprisingly, brokers and investment specialists nationwide are calm, reporting stability in local retail markets. In south Florida, the retail market is still quite active, says Christian J. Johannsen, CCIM, managing director of the Aztec Group in Miami. "Buyers are plentiful, but there isn`t a lot of product available." He fingers low interest rates as the culprit. "Sellers aren`t selling because either they can get similar proceeds from refinancing or they don`t have replacement alternatives available that provide the same security return."
Washington, D.C.`s overall retail market is stable, says Prakash R. Kamath, CCIM, whose firm, Insignia/ESG Capital Advisors Group, specializes in shopping centers. "Retail vacancy remains low, and Washington remains one of the most desirable markets for retail investment activity." Discounters are benefiting from the current downturn, he says. "Economic uncertainty has increased value consciousness, driving necessity and the leading discount retailers to high sales and creating a sharp decline in high-end retailing."
The economy in Tennessee is relatively secure reports Allen C. McDonald, CCIM, co-owner of Baker, Storey, McDonald Properties in Brentwood, Tenn., a suburb of Nashville. The state`s strong automotive and health-care industries have helped stabilize retail sales in central Tennessee. Oklahoma continues to enjoy a steady, strong growth, barely affected by the fallout of the dot-com industry. "Our market is extraordinarily busy," says Judy J. Hatfield, CCIM, president of Equity Realty in Norman, Okla. "We were not as negatively impacted by the high-tech slowdown."
However, a number of retailers in the Chicago area have slowed or curtailed expansion plans, which has narrowed the field of prospective tenants for vacant spaces, says Todd Caruso, managing director of retail services for CB Richard Ellis, based in Bannockburn, Ill. Vacancies are high because of second-generation space coming back on the market either due to store closings or relocations to newer centers, he reports.
"The downturn in the dot-com industry really has hurt the Northwest, causing major layoffs ... We have yet to feel the full effect," says Thomas P. Hoban, CCIM, president of Coast Commercial Properties in Everett, Wash. Hoban says that it is likely that retail development activity will be limited to premium locations and renovations of existing projects in the best locations, such as areas with strong demographics and higher-income households.
Brian Opert, president of Sterling Partners Capital in Fairfield, Conn., believes that the performance of the retail sector will be very region specific in the future. "On the West Coast, in pockets where ... lots of dot-coms have failed and housing prices have dropped, a lot of retail will go out of business," he says.
"Some markets will be harder hit than others," concurs Mary O`Rourke, an analyst for Fitch, a financial rating firm in Chicago. "All property types will be affected to some degree by destabilizing factors."
No Real Surprise
As an industry sector, retail has been on the watch list for some time. Reports of an "overstored" America started appearing in the mid-1990s as the first wave of big boxes went dark.
But retailers responded to the influx of stores by opening even more stores. Between 1997 and 1999, 92,000 new stores opened, almost twice the level of new supply during the 1992-94 retail expansion, according to Therese Byrne, a retail columnist for Reis.com and founder of Pantheon Capital Management, a retail investment company in New York.
Many of the new stores marked retailers` expansion into multiple formats as they tried to diversify to cover more customer bases. For example, Toys "R" Us gave birth to Kids "R" Us and Babies "R" Us and the Gap spawned Old Navy and Banana Republic. Category killers such as Home Depot, Sports Authority, and Wal-Mart charged full speed ahead into new markets.
So in some respects, retail specialists have been primed for a market slowdown for some time. Now, it`s just a matter of how slow it will go. Byrne predicts net store expansion as low as 1.2 percent in 2002 and the possibility of 13,000 units closing. She targets as many as 40 chains that must downsize to live to see 2003.
National retail vacancies will rise from 11.9 percent to 12.5 percent at midyear, and then drop back to 12 percent by year-end, according to Salomon Smith Barney`s 2002 retail outlook. These forecasts are predicated on an improving economy, increased consumer confidence, and retail sales growth.
But recent closing announcements send ominous signals. Kmart`s bankruptcy will result in 284 empty stores. Service Merchandise is going out of business, selling its 70 fee-owned properties and 150 unexpired leaseholds. Toys "R" Us announced a restructuring that will close 64 stores. Convenience chain 7-Eleven will close between 115 and 120 underperformers this year; Gateway will shutter 19 of its 296 stores, mostly on the West Coast; Eddie Bauer, owned by the Spiegel Group, will close 45 underperforming stores after posting a 15 percent drop in sales last year; and the list continues to grow.
Even the aggressive drugstore chains are not immune: CVS is closing 200 of its 4,174 stores this year. "I am not surprised by the CVS closings," says David C. Mayo, CCIM, a principal of Vector Realty Advisors in Louisville, Ky. "They are due in part to the past CVS sins of an aggressive, expensive, poorly planned [expansion] executed primarily by a desire to satisfy Wall Street growth projections, rather than a sound economic model."
A number of retailers have pared back expansion plans in light of the economy. "Now there are more realistic projections for store openings," says Cynthia Shelton, CCIM, vice president of business development for Commercial Net Lease Realty Services in Orlando, Fla. The Gap is projecting 5 percent store growth rate in 2002 after posting 17 percent last year and 31 percent in 2000. Women`s clothing retailer Ann Taylor slashed its expansion plans in half to 8 percent for this year.
The reduced expansion plans correspond with a slowdown in new mall development, according to the International Council of Shopping Centers research. Only nine new malls are scheduled to open this year, compared with 11 last year.
The Bright Spot
While the overall retail constellation has dimmed somewhat, grocery-anchored shopping centers still shine like a bright star in many markets. In Florida, they provide the greatest return with the least risk, according to Johannsen. Even in slow economic environments, shoppers generally continue spending on the basics, he notes.
"When you`re a grocery-anchored shopping center with a strong grocer that has a good term left on the lease, good sales, and some small shops attached to it, it`s just a very risk-free investment," says Harrison Perrine, chairman and chief executive officer of Perrine & Wheeler, a real estate investment firm based in Norfolk, Va.
But location remains a key factor. "The demand for grocery-anchored centers in in-fill locations is extremely high across most investor types. We are seeing very aggressive pricing levels for this type of product," Kamath says.
"There is a shortage of supermarket locations in my area," says broker Richard Brunelli of R.J. Brunelli & Co., based in Old Bridge, N.J. "The location has to be so strong that the center will not be out-positioned by a bigger supermarket down the street."
A lot of the smaller grocery-anchored centers locate in the middle of neighborhoods, says Linda Warfield, who is in charge of property management for Grubb & Ellis in central Florida. She notes that shoppers don`t want to spend money on gas and will go to the centers that are closest to them and most convenient.
Many supermarkets now insist on a "no compete" clause, which limits the type of stores that can locate in the same shopping center as them, according to Edward T. Byrd, president of Edward T. Byrd & Co., an Orlando-based life insurance company that invests in grocery-anchored shopping centers. The square footage available around a 45,000-sf to 55,000-sf supermarket has dropped from 35,000 sf to between 12,000 sf and 15,000 sf, he says. "Lenders are very sensitive to how much [space] a center has without the no compete provisions," he adds.
As grocery stores expand their in-store services and amenities, limitations on the number of non-competing tenants that can locate in the same center will increase. For example, sandwich shops and photo stores now compete with in-store deli counters and photo drops.
But many other possible tenants exist. Pizza parlors, Chinese restaurants, video stores, dry cleaners, liquor stores, beauty salons, and banks with drive-up windows are all tenants that could locate in these centers, Brunelli says.
Competition from discounters also affects the success of centers in the Northwest, Hoban says. "There may be a lot of in-line store space vacancy for secondary center locations unless the rent is super cheap. The development of Costco and FredMeyer continues to compete with retailers who used to make up 30 to 40 percent occupancy of these centers. Now service tenants are what makes these centers viable, but one neighborhood can only benefit from so many dry cleaners, video stores, espresso shops, and deli-type outlets," he says.
In addition to finding the right mix of tenants, landlords also must cut better deals on leases due to the weakening economy.
"Because shopping center owners are apt to experience more vacancies, it is a real simple problem of supply and demand," McDonald says. "The power has shifted toward the user from the landlord, so tenants will be restructuring their leases at rollover and, in some instances, before."
Tenants are far more aggressive now as they negotiate lower lease rates, Mayo says. They also are negotiating lower additional charges such as insurance, taxes, and exterior and interior maintenance. "Those charges can get pretty high. I have seen them up to $12 per square foot but usually they range from $1.50 to $3.50 psf," he says.
But those additional expenses may limit rent increases, McDonald says. "Insurance costs for shopping centers are expected to increase in this market 20 percent to 60 percent. This, along with additional security costs, will be passed along to tenants, limiting base rent increases from retailers," he says.
On lease terms, tenants are thinking shorter, not longer, according to Mayo. Instead of a 10-year lease, for example, they now are looking for five-year leases with four or five options. And they are asking for -- and receiving -- more basic amenities such as paint and shelving before they move in. Owners of these properties are cognizant of the slowdown and are willing to negotiate terms far more favorable than seven or eight months ago, he says.
In the future, lenders may require retailers to pick only those locations that meet the needs of their economic model. "There are very powerful [shopping center] real estate investment trusts that will dictate to potential end users," Mayo says. "Space will be leased to a retailer in two prime retail centers, but the cost of this deal is that the retailer must place a third store in a declining center."
Other Market Sectors
A brief look at other retail formats reveals mixed results. Despite the closing announ-cements, new store openings will outpace closings three to one, according to Byrne.
For example, Staples will close 30 stores but open 120 new locations worldwide; Charming Shoppes will close 77 Added Dimensions locations and 130 Fashion Bug outlets, converting 44 of them to their higher-performing Lane Bryant format. Among the discounters, Wal-Mart plans a 9 percent increase in square footage in 2002, up from 8 percent last year. Kohl`s plans to open 13 stores, mostly in the Northeast.
Another bright spot on the retail horizon is the free-standing major chain drugstores. "Their sales of bread, milk, and photos are phenomenal, and they will continue to be strong in a down market," Shelton says.
The economy is not even a bump in the road for drugstore chains like Walgreens, Mayo says. The chain plans to open 475 stores by November to add to its 3,623 outlets in 43 states.
"It would have been easy to say we`re going to put the brakes on expansion during this recession, but that would be just plain wrong," says Rick Hans, director of finance for Walgreens. "This is our opportunity to build market share, which is one reason why this is still the best time in our 100-year history to expand our store base."
Despite new ad campaigns and store placement strategies, department stores report fewer customers and declining sales. "Customer traffic at many department stores was down consistently 10 percent to 15 percent in 2001," says Britt Beemer, president of America`s Research Group, a retail consulting firm based in Charleston, S.C. "I think there will be consolidation this year in some department store chains. There is no need for as many stores if the demand is dropping so dramatically."
Yet mall developers report that an increasing number of new small specialty chains are taking the place of larger tenants. For example, a space vacated by a department store tenant could be subdivided into three smaller specialty tenants, improving the overall mix and reducing risk.
Another interesting phenomenon is luxury goods, which historically has remained untouched in recessions. Orlando`s 1.2 million-sf Mall at Millenia will open in October featuring high-end stores such as Neiman Marcus, Tiffany & Co., and Nordstrom.
"It is going to be interesting to see how they handle it if tourism is still down and the upscale retailers have to rely on local dollars," says Yun-oh Whang, marketing director at the University of Central Florida. "Those stores live on high profit margins and sales of very expensive products, which don`t typically attract a lot of locals."
Overall, the shopper base for luxury retailers has been eroded. They have lost the cachet of exclusivity and will be more at the mercy of economic downturns, according to Grubb & Ellis analysts. However, new products and a focused approach could entice shoppers back to high-end stores.
Well-performing discount retailers such as Wal-Mart, Costco, and Target have benefited from economic uneasiness. And although discount retailer Kmart has announced the biggest bankruptcy in U.S. history, not all view this as a problem.
"As a whole, Kmart will emerge leaner and meaner, as filing for bankruptcy has become a management tool rather than a preface to failure," Kamath says.
"Assuming that Kmart emerges from bankruptcy in a stronger position, those locations where Kmart affirmed their leases will benefit. In those locations where they shutter stores, it could be a positive -- if one can find replacement tenants," Johannsen says.
However, replacement tenants aren`t a problem in markets such as Houston, where the landlords and lenders will be more motivated to lease the vacated space without Kmart`s rent coming in, says Scott Shillings, CCIM, an associate at Boyd Page in Houston.
In addition, the availability of these large spaces should hold down big-box development, McDonald says. "It should provide investors with redevelopment opportunities as both Service Merchandise and Kmart have some excellent locations."
Regional malls should continue to do well, according to Salomon Smith Barney analysts who note that few mall companies have lowered 2002 forecasts.
"We recommend overweighting the regional mall REITs based upon attractive valuations and solid growth prospects," says Ross Nussbaum, an analyst for Salomon Smith Barney. "On the earnings front, we are looking for the mall REITs to grow funds from operation by 6 percent in 2002 on a weighted average basis, 190 basis points above the 4.1 percent growth rate expected for the real estate universe."
The REIT Scene
Nussbaum expects retail REITs to continue their strong showing for the rest of the year. "Retail REITs grabbed the spotlight in 2001 following several years of underperformance," he says. "Regional malls produced a 32.7 percent total return, and shopping center REITs gained 32.2 percent while the freestanding retail sector rose 38.4 percent."
"We are looking for the REITs to deliver an 8 percent to 10 percent total return in 2002, with mall companies scoring among the highest return," says Salomon Smith Barney analyst Jonathan Litt.
However, potential risks facing this outlook include a fast jump in the economy that could cause interest rates to increase. The best scenario for REITs is a moderate recovery in economic growth that will keep interest rates low, Litt says.
Retail, industrial, and office categories, which all have long-term leases, tend to be less impacted by economic slowdowns, he points out. "However, those leases that do come due during the slowdown may be subject to greater risk than the short-duration type," Litt says.
As the Economy Turns
Despite Roach`s pronouncement on the U.S. consumer, for now the fate of retail and the economy remain tightly intertwined. And currently it`s a matter of whether one sees the glass half-empty or half-full.
"There are many encouraging signs that economic activity is poised to expand once again," said Rosalind Wells, chief economist for the National Retail Federation. With lower interest rates, falling energy prices, low inflation, mortgage refinancing, and a rebound in the stock market, she expects an increase of 3.7 percent in the overall economy, compared to the 2.2 percent gain in 2001.
"Consumers` reactions and spending patterns since Sept. 11 are good clues as to what to expect in the future," she says. "While spending definitely slowed, it did not collapse. In fact, consumers were very responsive to sales incentives."
"We have yet to see what is going to happen," Kamath says. "There are big players in the market still aggressively pursing retail. Investors who had their money in the stock market are now looking to retail real estate," he says. "Pension funds are weathering the storm. They want to be able to find an asset that will bring a stable return."