Institutional Investors Ride The Wave
In an exclusive roundtable, institutional investors give a reading on the market and reveal new trends for the industry.
Roundtable moderated by Lynn DeMarco and Randall Shearin

The institutional investor roundtable was held in September in New York City.

Shopping Center Business and Staubach Retail’s East Coast Retail Investment Team recently co-moderated a roundtable of institutional investors to see what the market is buying, how the changing capital markets are affecting their behavior and what the trends are for institutional owners. The roundtable was held in September at the Westin Times Square in New York City. Attendees were Thomas Caputo, executive vice president of Kimco Realty Corp.; George Fryer, principal of AEW Capital Management; James Garofalo, director of retail asset management for TIAA-CREF Global Real Estate; Richard Coles, principal of Emmes & Co.; Adam Ifshin, president of DLC Management Corp.; Elizabeth Owens, senior vice president of BPG Properties Ltd.; Steve Vittorio, principal of Prudential Real Estate Investors; and Barry Argalas, senior vice president of acquisitions and dispositions for Regency Centers. The roundtable was moderated by Lynn DeMarco, managing director of Staubach Capital Markets, and Randall Shearin, editor of Shopping Center Business magazine.

Shearin: Let’s start by talking about the turmoil in the capital markets over the last 6 to 8 weeks. Has this impacted your acquisition and disposition plans for the rest of the year?

Ifshin: We are going to have to get used to the fact that the fundamental availability of debt capital, at least for the foreseeable future in the United States, has changed dramatically. Last year, there were about $450 billion of commercial mortgages originated in the U.S. The run rate in the first quarter of 2007 suggested that the number might reach $550 billion [for the year]. Some Wall Street conduits that, 2 years ago, were originating $400 million to $500 million of fixed-rate paper per month were originating $2 billion to $3 billion per month in early 2007. It now looks like the total market this year will be about $250 billion. It is roughly a 40 percent reduction in the availability of debt capital for refinancings and transactions. Every property in the spectrum, with the possible exception of the Class A trophy/fortress asset, has been impacted. It has also affected the buy side and the sell side. Refinancing proceeds on transactions have been cut by 15 to 20 percent. All the data points from the last 24 months assume a level of liquidity that no longer exists. Even if you are an institutional buyer or developer who is low leveraged on the front end, your expectation is that you are going to sell it on the back end to the absolute highest bidding buyer. What that buyer can pay is, in most instances, very different.

Elizabeth Owens and George Fryer.

Owens: We are a value-add moderately leveraged buyer of all property types. There has not been much availability in the permanent debt market lately but  we often obtain bank debt when we buy because our properties are normally not stabilized at acquisition. The banks are really aggressive right now in their pricing. They are trying to make up for some of the business they lost because of the residential market. We are not seeing a big problem in acquiring properties. Permanent refinancing has been harder for us right now; the lenders cannot commit to terms.

Garofalo: We are staying pretty active. We have a huge portfolio and three accounts to feed so we have to stay active in the market. What we are seeing that is different is that we are being more selective. We are holding a little firmer on pricing. We are testing the market a little bit. We’re going to wait and see how that develops. As cash buyers, we look at these choppy times and we see opportunity.

Argalas: Our mentality mirrors what Jim [Garofalo] said in that we’re being a little more selective. We’re honing our scope a little bit and not getting outside of the core major metro markets. Fortunately for us, at the time when the turmoil hit, we had closed enough at the beginning of the year that we’re able to meet our 2007 goals. On the disposition side, we were in the market with a number of properties that were impacted. I still think we will be able to transact those. We think there is opportunity out there, but that we must maintain discipline and keep our focus.

Vittorio: As Adam [Ifshin] mentioned, the Class A trophy property might not be hit quite as much. I think it may go a little deeper than that. Most Class A high-quality properties in primary markets are attractive to enough buyers that the cap rates haven’t been affected by more than 25 basis points. It is still pretty competitive for high-quality properties. Get under that, and there has been a lot of price erosion.

Randall Shearin.

Shearin: How has it been to get financing over the last 6 to 8 weeks? Has anyone noticed a change in lenders’ attitudes?

Caputo: It has been very difficult — a bit like shooting at a dartboard. We typically are in the market in our various joint venture programs looking at up to $1 billion in debt at a time. Our treasurer has always been very confident on execution — picking the right lenders and going with the folks we had done business with for a long time. Now, we have far less confidence in the conduit lenders because there is less certainty of execution. We are working extensively with the life companies, who have appropriately moved with the market and raised their spreads  significantly. We’re seeing spreads from 170 to 200 basis points over the 10-year. We had an instance last week where we had three different quotes in 3 days from the same lender on the same pool of properties. It is frustrating.

Ifshin: The lenders that we are used to dealing with are not in control of their own destiny. When someone who you have done $200 million to $300 million of business with for years says they can’t your call anymore, things are tight. At the monolithic institutions — the largest on Wall Street and the largest European lenders — is that the risk management guys are in control right now. They have a hard time understanding what their total exposure is. Moodys and S&P maybe completely wrong; but they may be holding paper that they can sell based on certain credit ratings. It is not just real estate; it is CDOs in high yield investments; RMBS, asset-backed, high yield bank debt. They can’t figure how exposed they really are. In the early years, these were giant manufacturing plants for financial derivatives. Billions of dollars originated every day; they were sliced, diced and repackaged, branded by the rating agencies and pushed out. The machine got so big, but it was executing so well. When the music stops, everyone doesn’t know what to do because they don’t know how exposed they are to every sector.

Steve Vittorio.

Vittorio: I have heard more and more from construction lenders in the past couple of weeks that they are uneasy with their participants potential reaction to deals in the syndication process. They won’t commit to firm pricing because they don’t know what other banks are going to quote. Frankly, given Prudential’s structure of providing forward commitments to our lenders, we’ve never had this problem before.

Fryer: AEW is primarily an equity buyer. Even when we do borrow, there is usually a big equity slug underneath. Nevertheless, some of our clients are taken out of the market when “interest-only” provisions are removed and they can’t stomach negative leverage. In our joint venture programs, where we are not accustomed to signing recourse on construction loans, increasing requirements for such may simply prevent us from doing the deal.

Shearin: Will there be a flight to equity?

Fryer: That is certainly what we are hoping. We just opened a new core investment fund and initially raised $450 million of equity, on the way to $1 billion or more. That fund sits ready so we can act when pricing settles out. We intentionally slowed down our acquisition pace back in February, not because of some prediction of this credit crunch, but just as a result of analyzing the fundamentals. We saw a greatly expanding development pipeline on the supply side and, as a result, tightened our underwriting assumptions and increased selectivity. However, we are continuing at that pace right through this period with no intentions of further reductions.

Shearin: Last year we discussed the difference between Class A, Class B and Class C. There seemed to be some segmentation and widening of the spreads between the three in the pricing. What do we see this year? Is it getting worse? Are the bands widening between the sectors?

Left to right: Tom Caputo, Steve Vittorio and Barry Argalas.

Argalas: We are in the market with all three property types right now. From my perspective, what happened before the debt turmoil was an across-the-board split between A, B and C. As we move through the crisis period that widened further and split among B properties in major metro markets and B properties in secondary and tertiary markets. We are getting offers right now for an A property in Florida with strong tenancy and good lease terms. The cap rate is where we expect it to be — in the low 6s.

Owens: I agree with what Steve [Vittorio] said earlier that the A properties are going to be very costly and competitive. A lot of people still want the A properties. They are going to command a good price.

Fryer: We agree that A properties remain in strong demand, but feel that cap rates have moved up more on the order of 40 basis points. Changes in cap rates for Class B assets really depend on further distinctions: whether they are located in major or secondary markets and whether they are simply maximized and risky or actually have real value-add components. Class C properties are not clearing the market at all. The gap between the expectations of buyers and sellers on Class C properties may last a long time.

Ifshin: The pricing on the lower Class B and Class C stuff was more driven by conduit financing than anywhere else. It was typically higher leverage stuff where a life company is going to go, and less likely where a bank is going to go fully on book. The widening out is going to continue.

Argalas: In early 2001, Regency had eight properties on the market. At the end of the year I also had eight properties. I couldn’t give them away at double-digit cap rates. Those were lower tier properties in secondary markets. That’s where we are likely heading for lower tier again, fewer buyers and widening cap rates.

Shearin: Several people mentioned last year that they were acquiring or looking in tertiary markets. Is there still a heated competition in those markets?

Ifshin: There is nothing in smaller towns right now. There are properties on the market, but pricing is completely disconnected. Unless the seller is also an active buyer, they just don’t understand the market. Spreads are changing daily. Availability of capital by lenders is changing daily. Four German banks, representing over $1 trillion in assets, have shut down their North American real estate lending operations. The less sophisticated the seller, the bigger the disconnect.

DeMarco: In the more frothy times, the lines were blurred between Class A properties and the B-plus to B properties. Are you seeing a redefinition of Class A that will be commanding higher prices? Are you changing your definition?

Vittorio: If you are a seller, you are calling everything an A!

Caputo: All of us at this table understand the fundamental characteristics of an institutional quality asset. We are definitely not changing our definition of a Class A asset. However, to Adam’s point earlier, there were an awful lot of unsophisticated buyers out there over the past few years that purchased lower quality assets at very high prices because there usually was a lender available to facilitate the transaction.

Richard Coles.

Coles: We have 50 centers in 17 states; we have about six properties on the market. What I have noticed is the zip codes of the people who are signing the confidentiality agreement to look at the properties. They have gone completely local. Previously, for a property in Wisconsin we would see buyers from California and New York. Now, we’re seeing them locally — and the pricing they’re offering is in our range. We’ll see whether or not they can close and whether they can finance it.

Vittorio: What market there is out there is being propped up by equity right now. It is going to be interesting to see how that equity behaves in the coming months.

Coles: In the Midwest, where we have properties for sale, the local buyer is finally competitive because they have more equity and they are using their local bank. They are buying properties the old fashioned way.

Vittorio: It will be interesting to see what the long term impact will be. In the short term, the Fed did what they felt they had to do. But they are diluting the dollar further.

Shearin: Who thinks it’s a buyer’s market versus a seller’s market or vice-versa? Is it up in the air?

Owens: The imbalance between the seller’s expectations and the buyer’s is wide. Until that gap closes, it is not going to be a balanced market. It will become more of a buyer’s market, especially on the B and C properties when sellers’ expectations become adjusted to the current market.  The Class A properties may see more of an equal market.

Fryer: It’s not yet a buyer’s market, except for properties where sellers have very short term capital structures and need to sell. We may return to conditions we saw 5 or 6 years ago where there was a wide gap in expectations that lasted a long time. That time around, the sellers ultimately won the waiting game. The buyers are going to win this time.

Vittorio: It is an interesting dynamic because it is certainly a buyer’s market. Institutional sellers are being more selective in what they sell. That may translate into higher quality assets being on the market. There is probably going to be less product on the market.

Argalas: It is a buyer’s market in non-financial terms. I am no longer dictating to others how the process and timeline are going to be. There isn’t enough competition among the buyers to swing that hammer. The buyers can’t obligate themselves to buying the center when they can’t rely on the quote from the lender, so they are caught in the middle. If you want to sell, you need realize that there is more negotiation today on non-financial terms than there was just a few months ago.

James Garofalo.

Garofalo: I don’t think it is a seller’s market anymore, but I’m not quite sure it is a buyer’s market yet either. We are somewhere in between. Top-shelf properties are still in demand. In the lesser quality assets, it is a buyer’s market.

Coles: I would agree with that. You are still seeing foreign dollars coming in to chase the trophy assets. We are low leverage debt buyers with great equity sponsorship. We recently went to buy a property and I realized in the middle of the bidding process that I shouldn’t be buying. Our lender kept moving away at 50 basis point increments. These are times when I would like to be a buyer.

Shearin: Steve [Vittorio], you raise an interesting point when you mention that sellers may be getting particular about what they sell. Since there are some sellers in the room, let’s hear their thoughts on that.

Richard Coles and Tom Caputo.

Caputo: We are in a major joint venture with Prudential on the Pan Pacific merger which closed in October 2006. We carved out about 60 properties to sell from the 138 we purchased. The “sale bucket” represents about 25 percent of the value of the portfolio. We have sold around 25 of those assets so far. The properties are on the West Coast, and there continues to be strong interest in these assets even though many of them are located in smaller markets. We are still putting deals under contract every week, in spite of the dislocation in the capital markets.

Ifshin: The market has thinned out. I think why it was hard for people to judge whether it is a buyer’s market or seller’s market is that you have deals that were in process when this [dislocation] happened, where both sides are trying to make an evaluation of what they are going to do. The buyers want to hold their original deal economics and the sellers had to give in or roll the dice with whatever the market will be going forward, or hang on to the property. Rolling the dice is not a very appetizing thought right now. If you have a buyer who knows what’s under the hood, you probably would want to try and finish the deal. Unless you have a 1031 buyer floating around, the market is very thin on the buy side right now.

Argalas: We have been selling since 2001, culling the portfolio from the bottom up. This was in step with our development platform, which is now $400 million to $500 million in starts per year. The disposition program funds our capital recycling program. We will continue to put properties on the market because that our development pipeline is still going strong.

Garofalo: On our high quality assets that we plan to move, we’re still going to bring those to market. We don’t think there’s going to be much of an impact. However, properties that may be challenged or have a story to tell, or that you have to count on market rents rising, those we think we might be better off pulling back.

Fryer: We’ve held back several non-retail dispositions temporarily, but are now looking to get them going again. In retail, we’ve only had one large disposition on the books and that one is moving forward with pricing established in late spring.

Shearin: On the buy side, are we seeing more properties come to market as portfolios or single assets, and what are you seeing out there?

Caputo: We are seeing a whole lot fewer deals than we did 2 or 3 months ago.

Argalas: I saw a lot of delayed bid deadlines, probably at the direction of sales marketing teams. There was a big portfolio on the west coast which was delayed. I think people just wanted to delay offerings, but now I’m not sure if it is sellers that are sitting on the sidelines or if they are being advised by brokers to let the market settle.

Fryer: I asked that question among the other investors at AEW and received answers that were all over the board. In the single asset category, I am seeing  a higher volume of better quality assets coming on the market. However, I think sellers have pulled back from listing portfolios, at least as compared to the torrid pace seen earlier in the year.

Garofalo: We are seeing less coming to the market. This is the time of the year when people typically put a lot of properties on the market so they can close the deals by the end of the year. It will be very interesting in the next 30 to 60 days to see if activity picks up or if it doesn’t.

Lynn DeMarco.

DeMarco: If you got an offering notice today on your desk, what would be your process for underwriting a deal?

Vittorio: Certainly, if you are using leverage you would have to factor in changes in the debt markets. Beyond that, we’re not approaching it much differently as an equity buyer. A buyer should probably pay a little more attention to the credit behind the cash flow.

DeMarco: Are you narrowing your focus in terms of markets, geography, demographics or other metrics that you may have been a little bit more liberal toward in the past?

Vittorio: We haven’t developed a new policy, but almost by default we’ve migrated towards primary markets. We’ve never been a big buyer in tertiary markets except for when it comes to big portfolios. The focus for us has been coastal primary markets.

Coles: This may sound a little off the wall, but in the latter half of 2006 and early 2007, one of the biggest threats that we were seeing was the rise of the private equity and hedge fund investor buying retailers. They have a non-retail approach to how they operate. All of a sudden, we find these retailers that were doing fine went dark. It was a foreign rationality applied to retail. It is not good to have a dark box in your center. Today, we don’t see that happening in the retail sector. Lenders want to see a vibrant retail center.

Left to right: Adam Ifshin, James Garofalo and Lynn DeMarco.

Ifshin: Deal underwriting hasn’t changed that much. The fundamentals are good. The leasing demand is good. The consumer is reasonably healthy, depending on what market you are in. We’ve been waiting for the other shoe to drop so long on the consumer that my foot hurts. The reality is that tenant demand, at least for what we do, is good. Renewal rates and same unit rental growth on lease roll is holding up to historical norms in our portfolio. What is different about this fissure in the cycle, is it is not fundamental driven. What has changed is, ‘Can you pick a spread? Can you pick an interest rate? Can you pick a loan amount to model?’ That has become exceedingly difficult. That’s where the changes are going on. We’re not marking down rents lower than we were 8 weeks ago.

Fryer: We are running a bit counter to that. We agree that fundamentals have been very strong but are not quite so optimistic looking ahead. Earlier in the year, we ratcheted down our rent growth assumptions and we’ve done it again in the past few weeks. I am paying much more attention to setting initial market rents as well. We had such rapid growth in rents over the last 5 years, but without the same underlying per tenant rise in sales volumes. Nor do we think that the market rent for a property can be determined by what Starbucks and Verizon will pay in the latest new development down the street.

Vittorio:  Are you taking that approach in your acquisitions?

Fryer: We are currently focused on two investment strategies: value-added investing, including ground-up development, as well as our traditional core property acquisitions. Our pace has been half of what we did in 2006, which was $450 million in retail, but indeed we are closing deals despite tightened underwriting. I have two development deals tied up right now that will close in the next few weeks.

DeMarco: Adam [Ifshin] made a remark that the consumer was okay. The subprime credit crunch seems to be hitting a lot of consumers on the home mortgage side. What do you think the spillover is going to be on spending? Will there be an impact on our industry in the near term or long term?

Caputo: Logically, we would have expected the consumer to falter a few years ago with rising gas prices. Now, with the combination of rising gas prices, higher interest rates and the inability to refinance adjustable rate loans, you would think that the consumer would be faltering. So far, we haven’t seen it. For the last four or five quarters, we have reported record occupancies, better spreads on renewals, and tenant demand for our vacancies. When you get to the lower level demographic, the Wal-Mart customer may be feeling it a lot. When you get to the higher demographic, the consumer seems to be hanging in there.

Garofalo: The only exceptions are the furniture and home supply categories. They have shown sales declines and they are blaming that on the housing market. The worst may be yet to come.

Shearin: Are you adjusting any metrics that you require, such as average household income?

Ifshin: Starting about 18 months ago, we began looking at the level of subprime originations by zip code. We are not in any of the top markets for that by design. You don’t realize that a lot of markets would have subprime exposure do.

Fryer: You need to understand what subprime exposure really means for an individual submarket, tenant base and project.  Technically, Nordstrom is one of the most exposed tenants to the subprime mortgage fallout because of the markets they operate in, but we are certainly not changing our outlook for them. 

Ifshin: We developed a ‘striver’s theory.’ There are two places where there are subprime mortgages. One is at the absolute bottom of the housing market — your Wal-Mart and Dollar General customer. The other is this whole striver market. These are the people who sort of think they are rich but really aren’t. They are perfectly prepared to leverage themselves to give the appearance. In Atlanta, if you draw a line from east to west across the city, you would think there would be more subprime mortgages south of that line. They’re not. They are above the line in neighborhoods with homes from $500,000 to $800,000. As soon as they got over $417,000 and they couldn’t get an insured mortgage, they needed a subprime vehicle. If you look at a house there with a subprime mortgage, there is an SUV in the driveway and a Lexus next to that. Where do strivers like to shop? They want to ditch Kohl’s and go to Nordstrom.

Shearin: What are the demographics that you go to look for when you acquire a center?

Argalas: I was just reading some research reports on the way up here this morning. Our portfolio is known for its above-average household incomes. The First Washington acquisition that we had a few years back gave us an immediate, strong presence in the Mid-Atlantic and taught us a density lesson. As we move north into the New England area, density becomes a more important metric than it did when we were only in the South, where you don’t have the density. We are trying to find the right balance between income and density. My task is to not dilute a portfolio that has an average household income of $80,000 while making sure to acquire infill centers with good density.

Garofalo: I agree with Barry. It may not be a sexy answer, but average household income and population growth are what we look for.

Fryer: We look at a combination of population density and income growth. We are not quite as concerned over where income levels are starting from, but rather are more focused on where they are going. Like Adam, we don’t want to miss those neighborhoods that are unleveraged, even if there are no Lexus SUVs in the driveways. We are, however, avoiding path-of-growth investments because it’s obvious that the housing will not be coming for awhile.

Caputo: Our average household income is about $72,000. Infill is wonderful, but infill with a little bit of growth is even better if you can find it. The Mid-Atlantic market is a terrific example of an area with strong incomes, existing density and excellent population growth. Our merger with Mid-Atlantic Realty Trust in 2003 gave us a strong foothold in the market. We own centers in Loudoun, Fairfax, Montgomery and Howard counties which are all wonderful markets. They have highly educated populations with high incomes, and they are still growing.

Shearin: Which markets do you want to be in? What’s on your radar?

Argalas: We opened an office in Boston and we’ve bought two centers there in the past 12 months. We are developing a third center. We are trying to grow in the New England area, specifically in Boston.

Caputo: We are continuing to concentrate on the East Coast all the way to Florida and the West Coast, and selectively throughout the rest of the country. We have an active urban investment program in New York City which we may expand to other cities in the future.

Garofalo: We like the Southeast, Southwest and the West Coast.

Fryer: We are primarily coastal, especially focused on the Pacific Northwest and the San Francisco Bay Area right now. We also like the Northeast, from Washington, D.C., northward. In the past, we have had good experience in going to unique and special smaller markets, but right now we are shooting more straight down the middle of the fairway. The exception would be that we remain very interested in that coastal stretch from Charleston to Jacksonville.

Vittorio: We are primarily coastal, and selectively in the Sunbelt and other primary markets.

Coles: We like the East Coast, West Coast and Southeast. Unfotunately, when we’ve bought portfolios of 25 properties, we’ve had to take those three in Detroit. Never say never, we just value it differently.

Shearin: Let’s switch gears and talk about development. A number of you have very successful development programs going. Several of you are co-investors in a lot of deals. How is development doing?

Caputo: Our development initiative is primarily focused on a merchant building program with local joint venture partners. We usually have about 30 projects underway across the country with 20+ developer-partners at any one time. Over the last 2 years we have been selectively purchasing some of these new developments and placing them into some of our existing joint ventures.

Argalas: We have expanded our development pipeline to go outside of our grocery-anchored centers. Now we develop community, power and a few lifestyle centers. The temperament from our development team is that as the spreads tighten and the smaller developers start to get squeezed out of the market, the seasoned developers will pick up more opportunities. Some major retailers are slowing their new store expansion in secondary and tertiary markets. For now, everything is fine and development yields have remained stable.

Vittorio: Over the past several years, the margins in retail development far exceeded the margins in the other property types. That has narrowed over the past 18 months.

Ifshin: How much of that was a structural shift of going to lifestyle centers?

Vittorio: There was certainly some of that, but I think it was across the board in terms of property type. Just between construction costs increases and entitlement carry costs and rents not keeping up; all those variables factored in and the spread has come down. It is still the best spread in the industry compared to other property types. You raise a whole other issue which we debate a lot. That is, is the margin for lifestyle and mixed-use worth it? Is all that trouble and the risk associated with it worth it? That’s something that everyone is debating.

Owens: We are currently developing Ellis Preserve, a 210-acre master-planned development in Newtown Square, a suburb of Philadelphia. The market has high-end income with a lack of adequate retail. We’re in the process of getting approvals. Although it is risky and expensive, we believe that the ultimate product will be worth the risk.

DeMarco: Have you thought about going vertical?

Caputo: We have a dedicated development team and a dedicated redevelopment team. The redevelopment team is combing our portfolio all the time looking for opportunities. In Washington, D.C., we own a Costco at Pentagon City. We are planning to go vertical at this site with up to 500,000 square feet of office space. We are looking across our portfolio for opportunities to add other uses and to create density. This includes some of the original centers we’ve owned for 50 years. We have a retail center in Boca Raton, Florida, which will become more of a vertical development when the existing leases burn off.

Fryer: We are doing a couple of interesting things in our mall portfolios. In one, we are considering the addition of a casino, and we are looking to add a hotel to another mall. We acquired and are redeveloping Laurel Mall in Laurel, Maryland. At the end of the day, that will be a $350 million mixed-use property with 500,000 square feet of interior retail and a few hundred thousand square feet of outdoor village retail. We partnered that with Somera Capital.

Vittorio: We have a number of vertical mixed-use developments in the pipeline. There is no question that they are challenging. We are learning lessons. There is a lot of opportunity. What is driving this trend are land prices and lifestyle preferences. Land prices have gotten to the point where, if you were looking to acquire and develop in high barrier markets, there is no way to make the numbers work without going vertical.  Changing demographics are affecting lifestyle choices. There are certainly all kinds of risks associated with these developments but they can be quite lucrative.

Fryer: It is much easier if you have a site where you can separate the uses horizontally rather than vertically.

Read more about the institutional investors’ plans to go green, what they think of the consumer’s predicament and the changing way that deals are done in the full text of the roundtable, found online at http://www.rebusinessonline.com.