Pre-selling Retail Centers
Pre-selling centers is a new trend for investors looking to buy and secure properties in today's thriving market.
Richard Walter

It's no secret in today's flourishing real estate market that quality retail properties are hard to find. With retail known as the darling of the real estate industry, there is a significant lack of inventory available, resulting in increased competition and investors racing to find quality retail properties to purchase.

The lack of high-quality retail inventory for investors to acquire has spurred a new trend in the industry: pre-selling retail centers before development is complete.

The Benefits

Pre-selling shopping centers before development is complete can be a win-win situation for both the investor and the developer.

The Number 1 benefit for investors with the agility to conduct a pre-sale transaction, is securing a high quality property before it goes to market. In today's marketplace it is much more difficult for buyers to gain access to superior retail properties, because once the properties hit the market there is an increased buyer pool resulting in increased competition. With a pre-sale, buyers get the benefit of acquiring and owning a premier property without facing increased buyer competition resulting in a possible bidding war or being pushed out of the race.

On the other hand, developers can also enjoy benefits of a pre-sale transaction. With a pre-sale, developers can lock in a buyer at a fairly close cap rate to the current market. This is a significant benefit for a developer due to potential risks in the marketplace including the possibility of cap rates moving up by the time construction is complete. Developers with an equity partner also benefit by being able to strike an immediate price for the property, ensuring a definite rate of return and perfecting their “sweat” position. Developers can also typically negotiate better construction financing where there is a solid take out or sale. This may enable a developer to save the equity slice that may have gone to a financial partner.

The Risks

While there is great benefit to both the investor and developer involved in a pre-sale, there is also a certain amount of risk. On the investor's end, the risk lies in the hand of the developer being able to complete construction and deliver the product. Another risk for the investor includes the tenant leases. Even if tenant leases are signed, there is a possibility that the tenant might not fulfill its lease obligation, causing it to back out of the transaction. There is a certain amount of interest rate risk involved as well. However, that can be mitigated depending on how far in advance the pre-sale occurs, and by ensuring that the investor negotiates some type of interest rate pre-commitment and interest rate lock. If a pre-sale is conducted properly and within a certain timeframe, a loan can be arranged and the yield can be secured, no differently than financing arranged on a property already developed. The only difference is that in a pre-sale, the sale may not technically close until such time that the property is actually delivered to the tenant.

On the developer's side, there are a few potential risks with a pre-sale. (1) The developer must be able to complete and deliver the product to the market within the timeframe. (2) If the cap rates are better at the time of completion than at the time the pre-sale was negotiated, then the pre-sale was not necessarily the right bet. 3) The pre-sale price is set so the developer must be concise on the development costs as not to have cost overruns, which would dilute the profits.

The Process

The trend of pre-selling a retail center is more common in today's environment based on the thriving market and because certain investors are aggressively looking for ways to buy and obtain better product. There are typically two types of investors involved in the pre-sale trend, including cash buyers and 1031 exchange buyers.

The pre-sale process can be very complex and intensive. For a cash buyer, the process is less risky because the buyer doesn't require financing. For a 1031 exchange investor, the process is more complex. If a 1031 exchange buyer owns a property that isn't currently on the market and prefers to secure an up leg investment in advance, the 1031 buyer can locate a pre-sale opportunity and secure it with a pre-commitment. At the appropriate time, the 1031 investor can place the current property (down leg) on the market and conduct an exchange for the new investment property, or utilize a reverse exchange by closing on the up leg first. However, this process requires 1031 exchange buyers that are flexible as to when they sell their current property.

For pre-sales that involve obtaining a loan for the investor, it requires very complex structuring and negotiation in order to be successful. In the case of a buyer seeking a financing structure for a pre-sale, the loan should be secured up front even if it results in the investor paying slightly more in terms of fees or a potential slight differential in an interest rate. An interest rate can be identified depending on how far in advance the pre-sale takes place prior to the completion of the development. The benefit to arranging the financing up front is when the property closes, depending on where the property is in the process, the rate is already secured and the only risk the investor takes is if the property is not ready to be delivered to the lender. Though, the risk of the property not being ready for delivery can be negotiated into the developer's agreement to further protect the investor.

The Timing

Pre-sales can actually be secured up to 18 months before construction is complete depending on the buyer. In some cases, the developer might not have even broken ground on the project. Nevertheless, in most cases the timing for a pre-sale is dictated by where the developer is relative to leases.

In most cases, the major tenants are already signed before a pre-sale occurs. Once the major tenants are signed, it makes it easier to determine a cap rate for the transaction. Credit tenants also make the pre-sale process run more smoothly because the investor is more confident in taking a risk that the tenant will sign their lease, move in and will have an obligation to fulfill their lease obligation and perform. Once the leases are signed, the Number 1 issue for a developer in a pre-sale is delivering the final product.

Success Stories

At Faris Lee, we have closed a number of pre-sales on retail projects that demonstrate the benefits of this trend. Two examples include:

•LA Fitness — Hillsboro, Oregon

Los Angeles-based Majestic Hillsboro Partners, LLC was developing a 45,000-square-foot LA Fitness and wanted to secure a buyer as soon as possible during the construction process and close the deal. We directed LA Fitness's pre-sale, procuring a non-refundable commitment from a 1031 exchange buyer as well as forward-basis financing prior to the building being completed. The property had not finished construction when it went under contract and resulted in a $9.6 million sale meeting both the developer's and the investor's needs.

•Winchester Springs — Murrieta, California

Winchester Springs, a 108,000-square-foot retail center in Murrieta, California, was in the planning stages by a San Diego-based developer. Before construction on the retail center began, the developer hired Faris Lee to conduct a pre-sale in order to lock in the deal. We secured a 1031 exchange buyer who placed a significant deposit on the property and closed upon completion of the project for $16 million.

While there is a certain amount of risk involved in a pre-sale of a retail center and the negotiation process can be complex, there is great reward for developers and investors in today's market. As the real estate market continues to thrive, buyers are racing to find quality retail products. Pre-sales open up opportunities for buyers to get into the investment game and purchase a superior product without facing increased buyer competition when a property hits the market.

Richard Walter is president of Faris Lee Investments, a retail investment advisory and brokerage firm in Irvine, California.