Retail's New Reality

Learn what it takes to survive in today's challenging market.

Imagine you’ve been cast to star in a new deal-making reality TV show. The objective is to outwit the competition, overcome obstacles out of your control, and complete as many deals as possible — or risk elimination from the show. It isn’t as easy as it might seem: In this contest, capitalization rates don’t matter, replacement costs aren’t considered, and comparable sales don’t exist. The market’s parameters change constantly and you must quickly adapt your strategies to stay viable. Are you up to the challenge?

While this scenario sounds like the premise for an entertaining TV series, it’s not too far from reality in today’s retail market. A recent Southern California transaction illustrates just how extreme conditions have become: “A 300,000-square-foot multitenant home furnishings center that sold for $100 million in 2007 with an $84 million loan went into receivership,” says Joseph DeCarlo, CCIM, CPM, CRE, managing partner of JD Property Management in Costa Mesa, Calif. “It lost several tenants including Wickes Furniture and was down to 34 percent occupancy. It recently sold for about $35 million, which reflects the actual and projected cash flow as determined by the buyer. The price has no relation to comps, cap rates, or replacement costs.”  

While this transaction resulted from a confluence of many factors, CCIMs across the country concur that the retail market’s fundamentals are likely to worsen before they improve. But how much further can they drop? Retail investment dollar volume was down approximately 70 percent through most of last year, and the number of transactions in 2008 sank nearly 50 percent, according to Marcus & Millichap.

Despite these discouraging figures, CCIMs have faith that the market will return in earnest — it’s simply a matter of when, not if. “The timeline is indeterminate,” says Paul G. Fetscher, CCIM, president of Great American Brokerage in Long Beach, N.Y. “But I haven’t met anyone who doesn’t expect a return to full prosperity be it in a year or two or three.”

In many ways, today’s market is a competition where brokers must think strategically about each short-term decision to ensure a positive impact on their long-term viability. To avoid losing, CCIMs must sharpen their skills to effectively manage more-complex transactions, adapt their deal-making approaches to the market’s changing dynamics, and effectively prepare for the sector’s inevitable return.

De-Stressing Distressed Deals

Though retail transaction flow has been reduced to a trickle, increasing numbers of store closures and foreclosures are creating a niche buyer’s market. “Value-added distressed property acquisitions and asset management opportunities will be a way for CCIMs to profit in 2009,” says Silvia G. Gangel, CCIM, president of SiGa International in San Antonio.

“Lender-owned assets will be the most promising retail investment and acquisition opportunities,” agrees Sandy G. Shindleman, CCIM, SIOR, president of Shindico Realty in Winnipeg, Manitoba. He also recommends keeping an eye on assets that are overleveraged or poorly managed, which may present prime buying opportunities.

As the economic crisis deepens, several of yesterday’s powerhouse retail hubs, including Phoenix and Las Vegas, now rank as top distressed markets to watch, according to Madison Marquette research. The company’s market study of vacancy rates, velocity of vacancy rate deterioration, absorption of new inventory, preleasing activity, and retail space under construction uncovered 35 U.S. markets that are “fertile ground for distressed retail assets.” (See table, “Top 10 Metros for Distressed Retail.”)

While these struggling properties may represent investment opportunities, CCIMs recommend using a pragmatic approach when purchasing distressed assets. The first step is to assess exactly “what went wrong” with a weak property, says Kathleen Rose, CCIM, president of Rose & Associates Southeast in Davidson, N.C. “The property is distressed because the owners either overestimated the market or location, or it’s poorly managed.” It’s critical to “figure out why it failed” to make accurate assumptions going forward, Rose adds.

Market Analysis Must-Dos

In-depth research provides the foundation for scrutinizing distressed deals. “Investors and brokers alike must understand trade areas and the underlying economic drivers that generate retailer sales,” says Allen C. McDonald, CCIM, principal of Baker Storey McDonald Properties in Nashville, Tenn. In addition, real estate professionals also “must know how to underwrite company risk, model proper vacancy and credit loss, and thoroughly understand the capital stack that will drive a minimum internal rate of return or cash-on-cash return demanded by equity.”

Demographic analysis is more important now than in the past when considering distressed investments. “Get a good sense of the population’s buying habits,” says Michael Broadfoot, CCIM, principal of Urban Realty Advisors in Chicago. “Will they return sooner — or later — to shop? Some locations have a conservative population that will wait a long time to return. Others will return the moment good news is reported,” he says.

Some properties may require more-sophisticated demographic studies to uncover the asset’s best and highest use in the current market. “If mass vacancy exists, re-evaluate the center in the market, including the stratification of household income. Down-cycling [the property] one or two classes makes sense, even if the bricks and mortar suggest a higher class center,” Broadfoot continues. For instance, if a struggling property originally was developed as a class A center but research shows that the market is oversupplied with that format or the population’s buying habits don’t support class A product, formulate a tenanting plan for the center that caters to the market’s actual buying-consumer niche. “Clear your perception regarding the bricks and mortar,” Broadfoot says.  

Understanding a struggling property’s fundamentals also is essential in this market. “Be realistic as to why [the property] is distressed,” Broadfoot advises. “If being overleveraged, a single vacancy, and rising cap rates caused the center to go under water, there would appear to be more opportunity than a center that moved progressively to 50 percent vacant.” A slow crawl to vacancy may represent “systemic issues” in an asset that could take much longer to recover, he says.

Calculate Carefully

Conservative underwriting is another aspect of distressed asset purchases, says Nicholas L. Miner, CCIM, associate broker with Eagle Commercial Realty Services in Phoenix. Use realistic numbers when calculating pro forma and projecting returns: “If submarket vacancy is 10 percent, use 15 percent. If tenant improvements cost $5 per square foot, use $10 psf,” he advises.

In addition, “make sure that you have enough cash in reserve to handle deferred maintenance and repairs,” says Joshua S. Peck, CCIM, vice president of The Peck Co. in Midlothian, Va. “Talk to second-generation retailers during due diligence to gauge their interest in filling up your vacant anchor spaces. Their insight into your property may save you a lot of pain down the road and should test the assumptions of your pro forma,” he says.

Understanding capital costs is especially important when junior or anchor boxes are vacated, McDonald says. “It may trigger co-tenancy clauses contained in other leases and then a domino effect can occur,” he says. Reconfiguring vacant blocks of space to attract smaller tenants’ is a potential solution. However, owners and landlords “must understand the capital costs to renovate these spaces into smaller footprints and the construction costs to achieve the smaller footprints.”

Aside from solid market demographics and strong underlying fundamentals, potential is a key factor to look for when considering distressed asset purchases. Ultimately, “buy the best assets for which you can create a viable business plan,” Shindleman advises.

Adapting to New Market Dynamics

To successfully engage in today’s retail transaction market, commercial real estate professionals must adapt to a new deal-making paradigm. “For the past several years, value could be determined from a rearview mirror approach and use of a cap rate on the first year’s net operating income,” McDonald says. Such methods may be “easy enough” in fast-paced markets where plenty of sales create a benchmark for pricing. But now, “it’s all about forecasting and projecting into the future,” he says.

Industry pros must understand discounted cash flow analysis but also how to underwrite individual retailer credit risk, construction, and redevelopment costs, McDonald says. “You must comprehend replacement retailer sizes and rent structures. Additionally, you have to understand leverage principles, the cost of attracting debt and equity to projects, and the local market drivers. In short, be able to apply all of the academic concepts to real-life situations.”

Another shift in today’s deal-making paradigm involves more thoroughly educating sellers about the market and managing their expectations, Peck says. “Potential sellers need the proper tools to establish fair-market values for their assets,” he adds. “Properties for sale in 2009 may have been purchased at the top of the market in 2006. Prepare sellers for higher cap rates due to less leverage and uncertain creditworthiness of former retail industry titans.”

Leasing and Tenanting Tips

For landlords and owners, a center’s overall health may depend on how flexible they are with existing tenants. Thomas F. Campenni, CCIM, of Thomas F. Campenni Co. in Stuart, Fla., recommends doing “everything possible to retain good tenants.”

For instance, Shindleman recently negotiated and re-leased a 34,000-sf former Linens ’n Things where the landlord acquired the fixtures and furnishings as part of the lease agreement. “Taking that extra step helped to complete the deal,” he says. “Urge building owners not just to think of the prospective tenant, but to think beyond the tenant to the prospective customer.”

Many CCIMs recommend proactively renegotiating and rewriting leases to reflect current market conditions — whether or not tenants have asked for help. “Study the specific retail business and understand its business model, profit margin, and rent-to-gross revenue percentage,” says Samuel S. Fung, CCIM, principal of Oregon Commercial in Medford, Ore. “Work backward to arrive at the maximum rent the tenant can afford to pay. If the tenant’s sales are not doing well, put in a percentage rent clause with a formula to convert the percentage rent back to base rent when the economy improves.”

While it may be time-consuming, closely monitoring each tenant’s performance has advantages, McDonald says. “Most national retailers are examining each individual store’s performance and looking at gross sales to occupancy. If occupancy costs are running at a high ratio, that location soon may appear on a closed store list.” By monitoring each tenant, owners are in a position to anticipate or offer rent reductions to get occupancy ratios more in line with the retailer’s ratios as a whole. “A lower rent is far less expensive than a vacant space or having to re-lease and pay tenant improvement and commission dollars,” McDonald says.

Peck even suggests customizing solutions that meet individual tenants’ needs. “Meet with your most reliable tenants and determine how to help them through the next 12 months without reducing your net operating income,” he says. For instance, “Give them abated rent for eight months and add an unabated period on at the end of their term. Insist on receiving monthly financial statements in exchange.”

Evaluating tenant mixes and re-tenanting strategies is essential in these market conditions, particularly when national retailers vacate. “We are completely shifting our retail leasing efforts to local tenant leasing,” says Tom Rohde, CCIM, vice president of Rohde Ottmers Siegel in San Antonio. “Most national retailers have halted store expansions for the next two years.”

Kelley Kathryn Glenn, CCIM, broker of Coldwell Banker Commercial Atlantic International in Charleston, S.C., agrees. “A positive side to the economy is that the lower rents and available space are creating opportunities for local businesses that were pushed out before,” she says. “Typically national tenants come into a market with good credit and landlords will work with them over an independent retailer. Now the premium space is available at lower rents for smaller retailers and entrepreneurs. Landlords are willing to take whatever they can get.”

Retail Survivors

Even with the challenges retail’s new reality brings, grocery stores, drugstores, discount and value chains, convenience and gas chains, and quick-service and fast-food restaurants are winning in the current market. “Despite a downturn, I haven’t found anyone who has given up eating,” Fetscher jokes.

And industry analysts remain upbeat about the sector’s eventual rebound, noting retail’s resiliency in the face of hardship. “Retail will continue to reinvent itself,” according to U.S. Retail: Race to the Bottom, a January 2009 Cushman & Wakefield market forecast. Citing the downturn as an opportunity for retailers to lease rather than build and for owners to concentrate on enhancing their properties and portfolios, the trend should help to moderate vacancy due to store closures. “This chain of events will ultimately place many owners in a more stable, competitive position.”

CCIMs also see potential in the retail market, particularly for commercial real estate professionals who adapt their strategies to today’s new deal-making paradigm and plan now to take action when the economy improves. And though a new reality TV series chronicling the retail sector may not rank high on networks’ fall lineups, the market certainly is providing plenty of drama for industry watchers.

Retail Snapshot
Year-end 2008 performance metrics for all property types vs. year-end 2007
Vacancy: 6.7%, ­50 basis points
Asking rent: $17.69 psf, ­1.7%
New construction: 135.5 million sf delivered, ¯10%
Construction pipeline: 87 million sf, ¯28%
Net absorption: 68.9 million sf, ¯52%

Source: CoStar Group

Top 10 Metros for
Distressed Retail
Ranking based on speed of vacancy rate deterioration, current vacancy rate, net absorption of new inventory, new construction in the pipeline, and level of pre-leasing.
1. Phoenix
2. Las Vegas
3. Kansas City, Mo.
4. Atlanta
5. Birmingham, Ala.
6. Indianapolis
7. Memphis, Tenn.
8. Detroit
9. Sacramento, Calif.
10. Providence, R.I.
Source: Madison Marquette

Re-pricing Retail Risk
Capitalization rate trends by market type

Vacancy Highs and Lows
3Q07 to 3Q08
Top 5
Retail Markets
rate (%)    YOY
in bps      
New York
Austin, Texas
bottom 5
Retail Markets
Sacramento, Calif.
Petersburg, Fla.
Salt Lake City
Tucson, Ariz.
Jacksonville, Fla.
Source: Marcus & Millichap

Retail Investment Trends
Sales volumes by price, in millions


Jennifer Norbut

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