An Appetite for Retail

Despite slowed consumer spending, investors are still hungry for quality properties.

By Bernard J. Haddigan

Daily, it seems, the retail industry expands and contracts: Lowe's announces plans to open 150 stores, and Casual Corner closes 350 stores. Kohl's sets its sights on 500 stores in the next five years, and Musicland closes 341 stores. Like the universe itself, the retail industry is in a constant state of flux.

But just as the U.S. economy places great faith in American consumers and their ability to shop, so too does the retail industry. Commercial real estate investors have reinforced that faith by sinking billions of dollars into retail property investments. Disillusioned by the stock market and caught up in the general real estate fervor, investors find retail to be one of their favorite investment vehicles, and developers and sellers provide a steady supply of retail product for them.

But now, six years into a sellers' bull market, investors and brokers are sensitive to how the current retail scenario will play out. Yes, the economy is growing, many major retailers are thriving, capital is going into the market, and there is significant construction. But at the same time, bankruptcies, consolidations, and store closings mount. Similar to a game of musical chairs, at some point the music stops. Investors hope to be sitting pretty by that time, but no one knows when it will happen.

What's Feeding the Economy?
Retail owners have enjoyed a relatively long run of stable market fundamentals. Early 2006 brought only mild uncertainty regarding the consumers' resilience. For the past few years, consumers' ability to monetize the value of their homes through refinancing at attractively low interest rates has bolstered consumer spending. Homeowners have cashed out approximately $690 billion of home equity since the beginning of 2001, igniting a robust performance in the retail sector. With the housing market cooling off this year and interest rates forecast to rise moderately, many economists expect consumer spending to decelerate. Throwing in the effect of higher energy costs and legislation requiring higher minimum payments on credit cards, it is easy to conclude that consumers may be under more pressure in 2006.

With the exception of automotive sales, retail sales have continued to surprise on the upside, although growth in 2006 is likely to fall short of the 6.1 percent gain posted last year. The National Retail Federation forecasts a 4.7 percent increase in retail sales overall this year, with first-quarter 2006 sales increasing 5.0 percent, compared with fourth-quarter 2005's 6.5 percent gain. Still, several specialty areas, including clothing, accessories, food and beverage, and health and personal-care retailers should see solid sales growth, according to NRF.

The effects of slower retail sales growth on property performance may not be immediately apparent. Demand for retail space is expected to remain healthy this year. And generally speaking, 2006 will equal or surpass last year in activity. Fundamentals are relatively stable. Rents continue to grow, mostly as a result of the considerable increase in construction costs. Therefore, tenants are paying higher rents to make investments work for owners. Vacancy is largely in check and most construction right now is build-to-suit and fee-development projects, not speculative properties.

Some retailers are facing difficulty, such as Blockbuster and Krispy Kreme. Others such as Winn-Dixie and Musicland Holding Corp., parent of Sam Goody and Suncoast Video stores, are in Chapter 11 for reorganization. A handful of retailers, such as Toys 'R' Us, OfficeMax, and Eddie Bauer, are selectively closing stores.

But even failing retailers have their suitors. Retail real estate investment trusts such as Kimco Realty Corp. and Vornado Realty Trust have been successful in buying up struggling retailers, mainly to control the underlying real estate. For example, Vornado along with partners purchased Toys 'R' Us last July and announced in January that they will permanently close 75 stores. Kimco bought the weakest stores in the Alberstons mega-deal portfolio, mostly for their upside potential. In most instances REITs are buying long-term space that they can re-tenant, subleasing it at higher rents, or selling the real estate at a value higher than the enterprise value.

Food Retailers Trim the Fat
While many retailers have ambitious expansion plans for 2006 and beyond, each retail sector will experience varying degrees of growth. Hardest hit could be the grocery sector, which may cause concern among grocery-anchored center investors. So many retailers are vying for the grocery dollar that it is difficult for traditional grocery retailers to compete effectively. Unless they have premium locations and are market share leaders, they are highly vulnerable.

Traditional grocery stores are expected to open fewer new locations than other food retailers. Grocery-sector expansion is occurring primarily through warehouse clubs and niche formats such as Whole Foods Markets, Wild Oats Markets, and Trader Joe's stores. Whole Foods is expected to increase sales by 20 percent this year to $5.6 billion. Wild Oats Markets has more than 110 stores in 24 states and Canada with annual sales in excess of $1 billion. The natural products niche is a $44.5 billion industry that expects 10 percent compound annual growth during the next five years, according to Natural Foods Merchandiser.

Wild Oats' niche of natural and organic food is one way grocers can break away from the pack in the marketplace, and differentiation will divide the profitable from the unprofitable, according to a recent Standard & Poor's supermarket report. The report still looks favorably on supermarket stocks: Grocery stores' real sales growth through October 2005 rose 1.8 percent, the eighth month of year-over-year improvement, compared to 0.6 percent in October 2004, according to the Food Institute. Wal-Mart's dominance over food retailing will weaken in the next five years, eventually to a 20 percent market share, S&P predicts.

Grocery-store turnaround may be based on the ability to promote local brands in local markets. Analysts give high marks to SuperValu's selective acquisition of Albertsons assets: The company bought stores and brands that were first or second in local market share, avoiding such competitive markets as Florida, Arizona, and Texas. SuperValu's chief executive officer Jeff Noddle outlined what is now the second-largest U.S. grocery chain's plan to distinguish its chains as locally tailored brands that will compete on service, produce, and other specialized areas. SuperValu also is developing the Sunflower Market organic foods brand to compete with natural food retailers.

Despite the daily roll call of closings and reorganizations, most grocery retailers are in good shape and continue to move forward with relatively aggressive expansion plans. Regarding new supply, neighborhood and community center completions are expected to rise but again will remain in line with expected demand.

Big-box discounters, too, continue to make inroads into the food retailing arena. The largest big-box discounter, Wal-Mart, plans to open 275 U.S. Super- centers this year, each with a substantial grocery section. Wal-Mart also plans to open 30 to 40 Sam's Clubs and 15 to 20 Neighborhood Markets, its grocery-only concept. At the same time, Target has added 140 SuperTarget stores to its roster of 1,300 stores. Along with milk and bread, SuperTargets also carry frozen foods, wine, and other groceries.

It will be interesting to watch as Wal-Mart and Target continue their U.S. expansion plans and at what point they begin to look at overseas markets, such as China, to fuel growth. It is clear, however, that these warehouse-type retailers will continue to eat away at traditional grocery-store chain market share, and they pose a possible threat to traditional department store concepts as well.

Other Sectors Still Appeal
Value-oriented retailers, also known as deep discounters or dollar stores, are one of the fastest-growing sectors in the retail industry. One of the large players, Family Dollar proposes to open 400 new locations in 2006, while the sector's other heavyweight, Dollar General, has its sights set on 800 new stores.

However, dollar stores, once thought to be recession proof, proved to be vulnerable last year. As middle- and low-income consumers shelled out more money for gas and food, they cut their dollar-store purchases and visits. Still, deep discounters have aggressive expansion plans, as well as new merchandise formats to attract customers. The top 10 players may operate nearly 27,000 stores by 2009, up 20,000 from 2005, according to Retail Forward, a retail consulting company.

Elsewhere, in the apparel sector, a desire to capture the expanding echo boomer market as well as the wealthy baby boomers has encouraged some familiar names to open offshoot brands, a trend that likely will pick up speed in the years ahead. Product offerings in this category include Ruehl by Abercrombie & Fitch and the Gap's Forth & Towne.

The department store concept continues to evolve. Consolidation within the sector is expected to continue as industry retailers combine resources to gain market share. Last year, Federated Department Stores purchased May Co. and Saks sold off its Northern Department Store Group to Bon-Ton Store, while Belk purchased its Southern Department Store Group.

Consolidation in the regional mall market is likely to continue as well. REITs are buying other companies, including other REITs. Over time a handful of major shopping center owners will be left with the second-tier players bought up by the larger, primary players such as Simon Property Group and Kimco.

Investors have been flocking to the drugstore sector, known for its single-tenant net-lease opportunities. Drugstores also have been edging into the food retailing market, doubling the size of their stores to around 14,000 square feet to increase their food items and offering such conveniences as drive-through prescription pickup windows and photo processing centers. Walgreens and CVS will continue with ambitious expansion plans. As another part of the Albertsons sale, CVS bought 700 Sav-on and Osco drugstores for $4 billion on top of more than 1,200 Eckerd stores purchased in 2004. Walgreens, the top drug chain by sales, plans to open 475 stores this year, aiming for 7,000 additional units by 2010. A distant third, Rite Aid must figure out how to compete effectively given its higher borrowing costs and sales difficulties.

During the past 10 years there has been steady growth in fast-food and concept restaurants and that is likely to continue this year and beyond. Quick-service restaurants such as McDonald's and Starbucks expect to earn around $142 billion in 2006, according to the National Restaurant Association, and the fast-casual segment is expected to bring in $70 billion in 2006, with more than 150 concepts in the marketplace, according to Fast Casual magazine. Americans seem to be committed to eating or buying food outside the home - the average yearly restaurant tab is $974 per person. About 44 percent of restaurants plan to add or increase their takeout service this year, as 78 percent of U.S. households purchase at least one carryout meal every month, according to 3M Communications. Takeout sales are expected to reach $126 billion by 2007, according to Technomic Research.

Investors Gobble Up Prime Deals
From a demand perspective, 2006 is turning out to be a strong year. Premium-quality properties will experience further capitalization rate compression. Climbing prices have pushed investors who once focused primarily on drugstores and fast-food restaurants to seek other types of single-tenant assets. Strong retail sales at co-branded or multibrand properties have attracted investors. In these properties, two fast-food tenants share a single roof, drive-through window, and order counter. By having two well-known brands in one structure, co-branding increases merchants' sales volume as much as $250,000 to $300,000 per year, according to Yum Brands, which includes A&W, KFC, Long John Silver's, Pizza Hut, and Taco Bell. A leader in the multibrand concept, Yum has about 15 percent of its 18,400 U.S. outlets multibranded, which it hopes to increase to 23 percent by 2007. In addition, CKE Restaurants has co-branded 230 Carl's Jr. locations with Green Burrito outlets and Wendy's has merged 30 of its stores with Tim Horton's coffee shops. Yum Brands plans to add 500 multibrand locations this year.

Private capital has poured into retail properties and is expected to continue streaming in throughout 2006 as a major part of the retail investment market. Investors remain driven by a desire for cash flow and a willingness to accept lower initial yields in return for stability. Additionally, many private capital investors are selling properties purchased in the 1990s that have appreciated considerably. The redeployment of sale proceeds into retail assets in tax-deferred exchanges is expected to keep the market humming. This will remain a strong component of the year's market. At some point, however, the exchange element in the market will slow. Currently, investors are looking for value-add land and development opportunities. Tenancy-in-common transactions are becoming a more prominent part of the market as well. Insurance companies are out of the marketplace because they can't compete.

Fundamentals Are Enticing
Cap rates for grocery-anchored multitenant properties in infill locations continue to fall, and currently range from 6.4 percent to 6.8 percent. Wal-Mart-anchored centers, meanwhile, can trade in the low 6 percent range. These properties are not without some risk though, as Wal-Mart annually closes 75 to 100 stores, usually in secondary locations.

Areas with strong demographic growth will see increased retail and investor demand. These include California, Florida, Texas, and other Sun Belt states. Retail should be fairly healthy and investors will want to be in these markets. Phoenix, Las Vegas, and California will remain strong markets.

Investor interest in single-tenant net-lease retail properties remains strong, especially from "crossover" buyers. This investor pool typically is multifamily owners who desire fewer management responsibilities. Single-tenant assets require minimal upkeep, and returns in the sector average 100 basis points more than in the apartment market. A large amount of crossover capital is coming out of some of the most heated markets, primarily in California and Florida, where apartment prices have skyrocketed in recent years. Strong demand for assets occupied by strong credit tenants has led to a significant decline in cap rates in recent years, which has led to a growing market for noninvestment-grade properties.

Opportunity also exists in older, multitenant retail properties. This product type in secondary markets tends to generate higher yields, which is what drives much of investor demand and buyer interest.

Lenders Cut Back
On the financing side, loan spreads during the year are expected to remain in a relatively tight band. The yield on the 10-year Treasury has held in the mid-4 percent range since the end of 2005 and is expected to rise only moderately to 5 percent this year. The Federal Open Market Committee continued to raise short-term rates in early 2006, even after the release of the surprisingly low reading of fourth-quarter 2005 gross domestic product growth. Most economists are not viewing the report as a true indicator of the economy's health, and the government maintains that growth is advancing at an acceptable rate. The Federal Reserve Board also is holding firm in its fight against inflation, leaving the door open to additional rate hikes as both wage and pricing pressures continue to build.

If rates rise more rapidly than currently expected, however, concerns about borrowers' exit strategies could lead to widening spreads as underwriting standards tighten. Retail properties currently are being underwritten from 100 basis points to 110 basis points over the 10-year Treasury. Spreads are increasing some on noncredit deals. Lenders are underwriting more on a cash flow basis rather than a loan-to-value ratio. This might slow down the noncredit, single-tenant business somewhat by requiring more equity in transactions.

Improving market fundamentals will help support prices as mortgage rates rise moderately. Overall transaction velocity is expected to remain in line with 2005, though some shifts in capital flows to higher-return markets are anticipated. Mortgage rates will remain at comparatively low levels, and many private and institutional investors are expected to take advantage of current conditions to reposition portfolios for the longer term. Economic and demographic factors will drive investment activity over the next few years. Real estate not only offers cash flow and appreciation potential, but is a tangible asset that remains attractive to investors, especially aging baby boomers.

Overall, 2006 should continue to be a strong year for the retail industry. Inventory and sales volumes continue to be high, and investor interest remains strong. Overall transactional velocity in the marketplace probably has increased two to three times in the past five to seven years. Investor interest has created this velocity in the retail marketplace.

Bernard J. Haddigan is managing director of Marcus & Millichap's national retail group. Contact him at (770) 393-1700 or bhaddigan@marcusmillichap.com.

National and organic food retailers such as Wild Oats Markets average 8 percent annual growth with gross margins ranging from 30 percent to 50 percent.
photo credit: Wild Oats Markets

Dallas-Fort Worth inventory tops 157 million sf yet we continue to show 90 percent occupancy. We're seeing an explosion of mixed-use projects, not just in urban locations but also in suburban markets such as Allen and McKinney. We continue to see the most demand for community centers anchored by a grocer or discounter. We're also seeing demand for Wal-Mart Supercenter peripheral retail projects.
- Eddie Liebman, CCIM, investment properties group, senior vice president, Weitzman Group, Dallas

The 25,500-sf Sand Lake Plaza was created by demolishing the restaurant adjacent to Sound Advice and adding a retail extension. The resulting property sold for $10.2 million or $401.96 psf - the highest price for a non-grocery-anchored center in the Orlando, Fla., area. Pocklington, Pocklington & Forster Retail Investment of Advantis Real Estate Services represented both the buyer and seller.
photo credit: Advantis Real Estate Services

After Trammell Crow determined the buyer could add 16,000 sf and raise rents, the Crossroads Center in Lake Buena Vista, Fla., sold for $57.1 million or $388 psf, one of the highest sale prices for a central Florida grocery-anchored center.
photo credit: Trammell Crow Co.

Pad Site Inflation
"I purchase and ground-lease pad sites for McDonald's Corp. I see a glut of out-lots piling up, particularly in high-growth areas where housing will not keep its current pace. In one Illinois growth community, a new 65,000-sf grocery store opened and nearly 20 vacant outparcels are available at this intersection. They all have inflated prices, as if the anchors, population, and patrons were there today."
- Jeff Cermak, CCIM, area real estate manager, McDonald's Corp., Warrenville, Ill.

Restaurants lead the way for growth, followed by banks, hair salons, and real estate companies. I have represented Tim Horton [coffee shops] in the placement of nine stores in the Dayton area in the past year, with 10 more by year-end.
- Robert L. Zavakos, CCIM, principal, NAI Patterson Maas Blank Zavakos, Dayton, Ohio

TIC Speed
"SCI Real Estate Investments purchased Anderson Station shopping center in Anderson, S.C., from AIG Baker in December 2005. The 243,663-sf center is anchored by HH Gregg, Hobby Lobby, Bed Bath & Beyond, Old Navy, Ross, Pier 1, and Shoe Carnival. SCI structured the purchase as a tenancy-in-common transaction and raised $32.6 million in equity in 14 days. In my 20 years of commercial real estate experience, I have never seen such a large transaction take place so quickly."
- Jane Hope, CCIM, regional director, SCI Real Estate Investments, Charlotte, N.C.

The creative extension to the Sand Lake Plaza center as well as $20 to $30 psf lease rates are evidence of the continued success of retail redevelopment in the greater Orlando, Fla., area.
photo credit: Advantis Real Estate Services

The Gap's latest brand extension, Forth & Towne, targets over-35 female shoppers searching for something to cover their midriffs -- further proof of retail's increasing market segmentation.
photo credit: Forth & Towne

Local and regional retail developers looking to cash in on historically low cap rates are eager to sell to retail real estate investment trusts and institutional investment partnerships looking to place large amounts of cash. In terms of tenants, health clubs such as L.A. Fitness and 24 Hour, electronics stores such as Best Buy, and Target, Wal-Mart, and J.C. Penney are the most active.
- Stephen E. Williamson, CCIM, senior vice president, director of retail sales, Transwestern Retail Services, Dallas