(More) Thoughts On The Market
Shopping Center Business partnered with Holliday Fenoglio Fowler’s Investment Sales Group to bring together a group of esteemed institutional investors to get their thoughts on the market.
Roundtable moderated by Randall Shearin and Lynn DeMarco

In the last issue of Shopping Center Business, we provided the first installment of a meeting between a group of institutional investors brought together by Shopping Center Business and Holliday Fenoglio Fowler’s Investment Sales at The Harvard Club in New York City. In this issue, we bring you the second installment. Lynn DeMarco, managing director of HFF’s New York office, chaired the roundtable along with SCB Editor Randall Shearin. Participants of the roundtable were: Barry Argalas, senior vice president and head of transactions with Regency Centers; George Fryer, principal of AEW Capital Management; Lauren Holden, vice president of portfolio management for Equity One; Adam Ifshin, president of DLC Management; David Jacobstein, senior advisor to Deloitte LLP; Michael O’Hanlon, president and CEO of Inland Western Retail Real Estate Trust; Elizabeth Owens, senior vice president with BPG Properties; Edward Senenman, vice president of acquisitions for Kimco Realty Corp.; and James Stolpestad II, managing director of GE Real Estate.

DeMarco

[Continued] DeMarco: What should equilibrium look like? If that can be answered.

Fryer: It is hard to say what is normal equilibrium because few of us have a historical context to relate to; the pendulum has never stayed in the middle very long. Before we feel equilibrium, there has to be a narrowing in the bid-ask spread. We need to have a financing environment where maturities as high as 75 percent LTVs can be refinanced. And I always go back to the fundamentals. We need to be demonstrating some rent growth within one point of the inflation rate and it is going to be a couple or three years before we can should expect that.

Senenman: Required returns continue to increase in all categories, core, value add. Real estate returns should be a higher than they have been given the inherent risk in both declining  rent levels and leasing  up large boxes with no new concepts on the horizon. I don’t think equilibrium is going to come back until the debt markets come back. There has to be liquidity and cheaper capital otherwise it is going to be real tough.

Ifshin: Clearly there has been an unprecedented closure in the structured finance market in the world, not just this country.

Fryer: We are at 0 percent real borrowing rates. So if you look at cap rates today we are at historic spreads over the real treasury. So pricing, in pure theory, should not have to adjust further.

Argalas

Argalas: I actually went and looked at that because I was curious to see the data from 2001 to current. I’m not going to flood you with numbers, but you start out at about 485 basis points as a spread between treasuries and cap rates in 2001. And then here’s how it went sequentially down from there: 475, 456, and then here’s the big jump from ’03-’04 down to 366, and then 309, 227, 217, and then year to date now, we are up to 327. There was about a 46 percent jump in transactions from 2003 to 2004, and you can probably tell me if it was caused by a new leverage system that made full term, high leverage IO prominent in the market. I have been at Regency for 12 years, 6 or 7 or 8 of those years selling properties, and in the early part of those we were not transacting on many sales because there just was not that much demand but it did significantly pick up around that ‘03-‘04 time period. If we are at a treasury / cap rate spread of 327 today, something around the 400 mark, translates to a cap rate range that is probably close to normal so there is probably a little bit more to go, but the curve started to come back up.

Fryer: No one has mentioned the REITs as being able to inject some equity into the market and restore some transaction volume.

Senenman: We just raised $350 million.

Fryer: Then perhaps the REITs will be the bright shiny object that attracts a little of the trillion dollars sitting in money market accounts.

Holden: As we have been selling properties this year, we have used the proceeds to buy back our debt and decrease our leverage. So that has been our strategy.

Argalas: We have not bought back stock yet. We are still primarily a development company and even with a smaller development pipeline today and compressed development yields, development returns compared to a 100 percent acquisition return are still more attractive. The exception would be if I have an investment partner and can leverage my equity up to a return that is higher than the development. But as we have talked about, that money is difficult to find right now.

SCB: How would you say retail fits in with the other sectors of real estate? Some of you I know are involved with sectors other than just retail. Maybe we’re not as bad as multifamily product in South Florida, but where are we in the scheme of things with other property types?

Fryer: Our research tells us that senior housing is the only property type right now that is favorably priced. Competition for the capital that would usually consider traditional shopping center investments really comes from alternative investment instruments, such as distressed CMBS securities and “B Notes.” There’s less focus on product type. We’re buying B Notes with capital originally intended for straightforward property acquisitions. We’re also originating B Notes in alliances with life companies that want to take the primary position. These programs are far less focused on what the product type is. Let’s just say the competition comes from from generalized opportunity.

Holden: I’m working on a couple of financings, and the lenders are certainly more cautious today. They’re nervous about retailers; we’ve had a number of bankruptcies to date and believe there are more to come. Loan to value is less, no more 70 to 75 percent, 60 to 65 percent appear to be the max. Lenders are being very selective on which assets to bid on and only valuing the asset on in-place income. You get zero value for vacant spaces, and they’re getting more conservative with including some capital reserves.

Senenman

Senenman: I think backfilling the boxes is a big issue too. There’s not a lot of new retail concepts out there to backfill the boxes as they are vacating with increase in bankruptcies occurring. It is not a question of replacing the existing rents that the tenants were paying, but it’s finding the user for the vacant box.

Ifshin: If you have the user, you’ve got to be prepared to make that deal.

Fryer: We’re still considering power centers, but we underwrite the rents to the what the specific likely end user is accustomed to paying, rather than some notion of a market level.

Ifshin: We’re underwriting a lot of deals where there are boxes vacant. It starts to look a little bit like an office deal. “We have other options in the market. We have other landlords who will buy us into their other empty box,” so it’s like, “yeah we have an option, if it’s favorable to us, we’ll take it.” Best case, you’re going to have flat rent. It’s flat or declining in a lot of the big boxes, particularly when you’re looking at guys like Circuit who bought up the TI package with above market rent.

Jacobstein: There is leasing taking place but it’s hard to find the third and fourth generation tenants for big boxes. Go around and look at centers with big box vacancies, and you’ll say to yourself, who is going to fill these spaces? There’s not a lot of capital available to tenants, so there aren’t a lot of new concepts out there.

Fryer: I used to believe in the “marketing theory of two,” that when an industry matures, there will be two players. For big-box retailing, it looks as though we’re headed for just one in many of the categories.

Jacobstein: When I was in the retail real estate business, we always looked at it like Noah’s Ark. There were two players in every big box category. Now there aren’t. In many cases, there’s one, and if there are two, the second is teetering.

Ifshin: Some of that has to do with the nature of not great management teams not executing well and getting bailed out by the private equity market. Now that market is gone. I think what you’ll see, ultimately, is new concepts again.

Senenman: Retail is also driven by Wall Street, and many retailers took locations because they had to show growth. I think a lot of locations have not been  successful for the retailer given the rent that they were paying. Obviously, landlords subsidizing a big chunk of that rent, the TI allowances made it a lot more attractive to them. Kimco has always been careful about giving T.I. allowances to weaker credits.

O’Hanlon

O’Hanlon: A lot of retailers were destroyed by private equity funds due to financial engineering. We’re telling tenants that there’s such little development going on going forward that in 2011, whatever year it is, instead of 100 stores, they’re going to have 40 locations or 60. I look at our portfolio in Linen’s, and I view that as future inventory. We’ll get some of it to lease pretty quick — about half of them done in 12 months.

Fryer: Half of the goods and services that we’ll be buying 15 years from now don’t even exist yet.

Ifshin: For the last 10 years, almost all of the creative minds in retail have focused on either building street retail or lifestyle centers. There is going to be a return to open air centers because the consumer is constrained and needs the cheapest source of retail goods possible. This means the real estate will need to be simpler and more utilitarian. I don’t perceive there are going to be a lot of new lifestyle centers that succeed any time soon. That talent pool will ultimately migrate to where the opportunity is.

SCB: We touched on the consumer a little bit before. What are you hearing from the tenants in terms of what’s going on with the consumer? What are they spending money on? Are they refocusing on home, on basic needs, or are they still splurging and having a night out every now and then?

Stolpestad

Stolpestad: Consumers are not going to Europe on vacation. They are not buying that new car. They’re not eating out as much. If they eat out, they step it down a bit. They are saving money now. People are adjusting their spending patterns. They are adjusting where they shop. Wal-Mart is doing well, TJ Maxx is doing well, Bed Bath & Beyond is doing well. True value retailers are doing much better than discretionary and luxury retailers.

Ifshin: Wal-Mart is back. They’ve retooled the chain; they’ve redone a huge number of stores. Right now, the American consumer needs an extreme value proposition, and that’s what they’re offering. TJ Maxx, Ross, Dollar Tree; they’re all opening stores. They’re all calling and saying, I’m not going to get in this new development because it’s not going to get built. Is the deal tough? Yeah, the deal’s tough. Do they want more TI? Yeah, they want more TI. When they open, they’re also bringing customers, which is the quintessential trade off of why you take that deal in the first place. What you’re not seeing right now is as much of the follow on retailers who say, oh, you have them? I want to be there. Those guys are not necessarily in great shape. Certain tenants, and it’s the ones with great management teams who execute well, have unbelievable cost discipline at every aspect of their business. If you’re a retailer and you can’t get it done on the cost side in a world-class way, you have a problem.

Senenman: The stronger retailers also see opportunities to take boxes with vacancies that they couldn’t have gotten before because they didn’t pay the highest rent. Good credit is going to mean more going forward.

O’Hanlon: Wal-Mart is coming out with their new Marketside concept, which is a smaller grocery store. If they put their mind to it, they’ll have 100 or 1,000 of those stores in a couple of years, and that’s going to have a dramatic impact.

Senenman: Costco is a phenomenal retailer. Everyone is looking for value. They are now the second or third largest electronics store in the United States — Wal-Mart, Costco, Target and then Best Buy. They could go across the street from a Sam’s and beat them.

Fryer: I’m going to wax philosophical for a moment. When we try to identify the nascent psychographic movement that will lead to the next big thing, I think the loss of confidence in the stock market, housing impacts, loss of net worth, jobs, etc., present the final wake up call to baby boomers. They need to save. Simultaneously, we’re seeing movements toward social and personal responsibility. You’ve seen these themes everywhere, especially in the political campaigns underway — the greening of America, charitable responsibility, service to your community and responsibility to your family. Profligate consumption is no more. College tuition is looming, retirement is fast approaching, so focus needs to be on value and practicality in whatever purchases are made. Image means nothing anymore in terms of material goods. Maybe some of those new concepts yet to be developed will be tied to green products, social responsibility and personal service to one’s community. Sarah Palin certainly tapped into a fledgling movement that should have been recognized earlier as inevitable.

O’Hanlon: The Fresh Market is half the size of Whole Foods and has done better.

Ifshin: Has anybody else seen a lot of mainstream grocers shrinking their footprint to get into markets? Guys who, for years, drove at, ‘I want to be 55, I want to be 65, I want to be 75.’ They’re coming back and going, ‘Can you find me 35,000 square feet?’ They’re coming the other way because of construction costs, energy, some of the sustainability things come into it. The other thing is, you sit down and you talk to a grocer, and he says, “I’m selling 28 types of one item, and I’m not selling enough of any of them, so why don’t I just carry 12, and get on with it.” A lot of the grocers have come back and said they’d rather be in a really dense location with 35,000 square feet then be at the edge of growth with four competitors at the same intersection at 100,000 feet.

SCB: We’ve seen that in the urban markets. In Chicago, Jewel is doing that, and in Atlanta, Publix is doing that too.

Jacobstein: I think the exception may be Wegman’s. Wegman’s is family owned. They don’t have the pressure of quarterly earnings growth. They only open about two stores per year. Wegman’s is appealing to a very high-end demographic.

Ifshin: I think a lot of the grocers are doing really well right now. Wal-Mart has made the ones who are left a lot sharper on tough discipline and operation, and they’re getting a big benefit. They’re selling the same number of SKUs, and volume is up because of pricing. They’re making roughly the same gross margin and net margin across a higher number.

Jacobstein: Wal-Mart has made Kroger and Safeway better companies.

SCB: Are there some tenants who are diamonds in the rough? Super H Mart, a Korean-oriented grocery store, has more than 30 stores, and Trader Joe’s takes secondary space. Are there things like that you’re seeing out there, not just in the grocery business but also in electronics and other industries?

Argalas: We actually had some opportunity with H Mart. A year ago, we bought three Mervyns stores in the pacific northwest and immediately re-tenanted them, one with a JC Penney, one we split and did a Best Buy/Sports Authority and in the third we did an H Mart. H Mart is going to open up in November, and we’re taking that to market now. All three former Mervyns locations were all very successful deals for us. H Mart was a tenant that wasn’t on my radar at the time. I know one recently traded in Atlanta, and it seems to be well received by the investment community.

Fryer: We did the first H Mart in Southern California, and we sold that very successfully at core-like numbers.

Owens

Owens: H Mart does very well. The one in Atlanta that I saw was unbelievably crowded. Local Hispanic stores, I think they’re going to grow. Do you see any of the big grocers buying them as they get more successful and do well in the market?

Fryer: Publix tried one of their first Sabor concept stores in one of our centers. It was a conversion of an existing store. It increased their sales significantly, but not to the extent they hoped.

Ifshin: Management means being in the aisle. Remember, a lot of them don’t have to do the volumes that some of the big corporate places need. I went to a store that had been not a good ethnic market in Elgin, Illinois, that has now been completely redone. It’s spectacular. We were not exactly the prototypical customers, and the manager came over, and we started talking. He said he has two stores, and he’d like to have four. I’m now looking at half of the corporate G&A of a company (one guy). It was extremely well done inside; finishes at another level from most local grocers. H Mart is doing the same thing. Finishes are moving up. It’s not just going in the old Winn-Dixie with the same exact stuff and opening up. That’s moving, but very cleverly done — not wedded to some fancy design. Very, very hands on and very promotionally priced. They’re making a bigger gross margin and net margin than Publix or Kroger, but they’re also substantially cheaper, so they’re maintaining their extreme value proposition for their customers.

Fryer: We recapitalized a $235 million Hispanic-oriented portfolio with Weingarten back in March. It’s 18 shopping centers, most anchored by Hispanic grocers. Those grocers are owned either by families who are not Hispanic or by the wholesalers. The wholesalers continue to operate under the original brand, but that’s where some of the consolidation you were wondering about has begun. In our portfolio, the grocer sales are off the charts, as are the margins.

Argalas: I think they’re best left to operate as they are. If you look at Miami, where Publix has a 53 percent market share and they’re operating where Sedano’s has a strong foothold. Do they ask themselves, do I really need to go spend the capital and time and resources to capture that little additional market share that’s out there remaining or should I focus on my core customer? It’s hard to come in and be successful in the ethnic grocer market if you are not an original, local operator.

Owens: I don’t disagree with you. My problem is how sell a center with an anchor that is a local operator who has 10 stores and most likely will not have the credit that most landlords want for an anchor.

SCB: Who could underwrite that deal? I mean who are the institutional investors who will be willing to take that on?

Fryer: If there is a repositioning story where you can remerchandise the rest of the small shops to be consistent with the grocer’s profile and move the rents up, the potential value-added returns should attract institutional capital. This was the premise for the large deal with Weingarten.

Ifshin: That is just going to get better over time, right? But the other thing is you may have to provide an attractive deal to a buyer, but you may find a buyer that doesn’t concern himself so much with exit cap rates. Right? There is a whole universe of buyers, us included, who in certain of our programs, if we like the real estate and it can cash-flow at a certain level, with normalized debt underwriting, we will hold the asset forever. I would rather hold a local grocer doing $800 a foot than a Safeway-run Dominick’s doing $250.

Fryer: I think the HMart trades are perfect examples. They traded at core-type numbers with leases that are not well-collateralized. In a couple cases, the leases are not even backed by the full faith and credit of whatever parent company there may be.

Ifshin: You’re right. The ones that were traded are in pretty special locations. I think that is a big component of it. And they traded to special buyers.

SCB: Is anybody developing these days? Can you get money for development?

Ifshin: We are building a center right now. But we got control of the land at $10 million less than the retail value of the land and we bought the land for cash and we fought our way through the process. Home Depot, Wal-Mart SuperCenter, Ross, Famous Footwear, Dollar Tree, again, all value, and we financed it ourselves. That was the only way to do it. That is what you have to do now, otherwise it’s very difficult.

Senenman: We have actually discontinued our development business. I do however believe there will be some opportunities on “broken” development projects that lenders have or are going to take back. The lenders will need someone like Kimco who has wonderful tenant relationships to put these deals back together. We may look at some selective development projects with our cadre of local partners but it only be on “back to basics”   grocery anchored developments with substantial pre-leasing and 10 percent free and clear return on costs using very conservative small store rent assumptions.

O’Hanlon: We are building out what we had in our pipeline but to duplicate the deal that we did a year or 18 months ago is impossible. One you would have a hard time getting tenants, two you would have to give away 50 percent recourse on the construction loan, and it is almost undoable.

Argalas: We are set up a little bit different just because most of our developments are done in-house and not with development partners. But I echo what Ed says — strong focus on pre-leasing and strong focus on the amount of shop space we are developing. We have scaled back the size of projects and are looking at phasing projects rather than building everything at once. I think as the market heated up and we expanded our focus, we learned some valuable lessons. We went back and looked at some of the deals and said, “we developed to the site and not to the market.” If the site can hold 300,000 square feet, then we may have 300,000 square feet on it when the market may not be able to sustain that amount of GLA. So those are lessons learned. But if you look at our pipeline now, it is re-trenched, it is infill and our shadow pipeline or in-process pipeline has 80,000 average populations in 3 miles. We are not going out to the next corner and waiting. It is smarter development, but it is slower.

Fryer: We are breaking ground on a neighborhood center in about two weeks, after we spent the summer demolishing an old paper mill to create the site. Somehow or another, we have a construction loan commitment.

Shearin

SCB: Are there trends that are going to go away? How is the mixed-use looking to you? We talked about that about a year ago that attracted some of you and now not so much so or maybe more so?

Argalas: Our lessons have been tough. I think just like we talked about some of the retailers sticking with what they do best, we have determined that we are a better neighborhood/community shopping center developer and to get into a large mixed use project is more problematic.

Ifshin: We were never a fan of either mixed-use or lifestyle, I don’t think it is a positive thing, but I think our view was validated. It feels as though it is going to be much harder to work out those deals than single product-type deals, and I think that is a big component of it. There is a whole generation of development deals now that didn’t work that are going to need to be worked out, and the longer they sit around, the more of a negative they place on the market, and the more complicated they got with the condo interest and the three different developers and the air rights and who is going to pay for the other guys share of the parking deck. All of that stuff is going to make those deals a lot harder to work out and I think that is the concern now. There is no question that pipeline is shut down.

Senenman: We were never big fans of lifestyle centers due to large T.I. allowances, short term leases, kickout clauses and co-tenancies if they some tenants vacate. We really didn’t develop any. We did develop some mixed-use and we are struggling, but we will get through it.

O’Hanlon: We have about 8 percent of our portfolio is lifestyle and it is 9 or 10 properties, and all but one, we are extremely satisfied. If you are in a high-demographic area with good population you will be fine. If you are out there on the prairie waiting on housing development you have a problem.

Jacobstein: My former company has sort of the same philosophy. We set certain percentage targets as to where we thought lifestyle ought to be, and lifestyle does not have to mean mixed-use. Lifestyle is not a well defined concept. What Poag & McEwen thinks of lifestyle is not the same as what Simon may think. But I would agree with Michael [O’Hanlon]. The thought was always that lifestyle centers are a good product but had to be done on a limited basis. It is not a mass product such as neighborhood and community centers. You need exactly the right location and the right demographics. I believe that it is difficult to receive appropriate risk adjusted returns on complex, multi-level mixed-use projects — not impossible, just difficult. You see some award-winning projects, which are beautiful and very useful to the community, but a public company would have a very difficult time developing such projects because of unacceptably low returns.

Owens: You make a good point. Our development division is working on a lifestyle center. It has been a long process but the retailers are still interested. because it is an  infill location. If they are in the right location, it works.

Fryer: We have done four of them, but they were earlier in the generation of lifestyle centers. Two of those would be considered mixed-use projects, but again they were done early in the cycle when there was good demand for all three of the different product types planned for the projects. We sort of shut down that program well before the whole condo crisis came about, recognizing that your timing has to be very, very acute.

DeMarco: Maybe everyone wants to share one positive thing.

O’Hanlon: We are in the real estate business. If you are not an optimist you are in the wrong business. It is a highly cyclical business. We fuel ourselves on debt. So all the things we have talked about have to stabilize. I think you made the comment about equilibrium. There is never a perfect equilibrium that we have seen in 20 years or more of this business. It changes. So you have to believe that you have good product. If you have good assets in well-located areas, you will survive, even if you have vacancies. We talked about good concepts. I mean we all know the new concepts, some are in their infancy, but they are coming. Starbucks closing 600 stores and then replacing all of them with Dunkin’ Donuts, I would have never thought that a year ago, 6 months ago. I have been in this business. I have seen good times and bad. I think a lot of us have. I believe in this country and I believe in this business and we will get through it. The lack of inventory is what will ultimately help us.

Holden

Holden: I think the opportunities are coming. Property owners who cannot refinance or have partners who want out will be forced to sell. Small local developers who are financially stretched, who cannot secure debt or need help with leasing have been reaching out to us for help either through a joint venture or sale. There are currently some distressed debt or mezzanine financing opportunities in the market which we are exploring. There is still a wide bid-ask difference between Buyers and Sellers, but I think the gap will narrow over time and transactions will begin to occur.

Senenman: I think the banking crisis, while it is a horrible thing, I think it flushes the system out, and it leaves the people around this table as the survivors. The people who will have liquidity have the opportunity to step in and buy those opportunistic plays, the broken development deal, the center that has two or three boxes that are vacant who has cash and can move quickly.

Jacobstein: For companies that have outstanding development, I think there will be opportunities. I am not sure that we are quite there yet, and the bid/ask spread is still too wide in many cases, but there will be opportunities for the DDRs and the Regencys of the world to take on properties that are in the pre-development stage and cannot get the financing or projects that have already started and they cannot get permanent financing. The other opportunity in the REIT world, down the road, is an increased number of IPOs as private equity exit strategies are implemented.

Owens: I think there is going to be a lot of opportunities to acquire properties once  the market becomes a bit more stable. In the last few years it has been very hard for us to purchase properties because the pricing was overly aggressive. I think this market will offer us  an opportunity to grow our retail portfolio.

Ifshin: I think it is the best time in the 20 years that I have been in the business to actually recruit and bring really smart young people into a business that was cut off from the talent pool for so long. The caliber of the young people who want to come work for us and that we want to train is as good as I have ever seen.

Senenman:  In our business before the economic crisis we are always competing with the investment banking firms and the big bonuses they paid to attract good, young talent. Quite frankly it was difficult to retain talent once they figured out they could make more money working for those firms. Now with economic crisis we will have the ability to select the “best and the brightest” of the group that is our there with the relative “stability” of a company like Kimco. I now have concern however that college students may shy away from the real estate business given the negativity that has arisen particularly on the retail side.

Jacobstein

Jacobstein: I think part of the talent pool over the last 4 or 5 years was taken by investment bankers, because it was an easy way to make a lot of money, while real estate, working for a REIT, the stock goes up you do well, but I think now there will be a bigger pool of potential talent. I think people are going to be looking more for stability than for the quick opportunity to make a couple of bucks.

Owens: I think you are right and  this is the best time for real estate professionals that have not been in the business that long  to learn.

Holden: I agree with you. Over the last few years, when I interviewed junior people they always wanted to work in development or acquisitions and they never wanted to work in asset management. Now that the development and acquisition teams are cutting back and retail asset management is so crucial there have been an influx of interested young candidates. Leasing is probably one of the most important departments in a down economy, and we hope that now will be the time to find and attract some talented leasing agents to join our platform.

Fryer: In our shop, we attracted frighteningly talented people over the last couple of years. Whether they are motivated to hang in there with us will depend upon our investment pace getting back to or near to where it was.

Argalas: I don’t view it necessarily as a generation turnover or talent pool issue. I feel as though on the development side and construction side of the business, while the pace was so frantic, people were getting hired at numbers that were probably too much for the skill set that they were bringing. And now there is the opportunity to kind of retrench and maybe get twice the bang for the buck with a more experienced person.


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