Market Changes, Turbulence Create Opportunity for Savvy Retail Investors

By Faris Lee’s Nick Coo

Q: What are some of the challenges you see with dispositions today, and how are they being addressed?
A: Today one of our main challenges is “identifying the investor profile” prior to going to market, and proving up the “Real Estate Fundamentals” to the prospective investor and the capital providers given the changing and somewhat turbulent retail market. The buyer pool has changed somewhat with the absence of yesteryear’s TIC investors and a slowing 1031 Exchange buyer pool. 

On the underwriting side, tenant brands and their balance sheets were largely underwritten as one of the main influencing factors determining value or the necessary yield. Although tenant credit matters, I think we have, collectively as a marketplace, been overemphasizing credit over location and fundamentals. Now, sustainable rents and tenant health ratios are equally, if not more important. We are currently dealing with situations where a major grocer with terrific credit is performing below average at a particular location while paying below market rent, and it raises the question for whom the asset is best suited. Is it a triple net investor due to the credit tenancy, or a value add buyer due to the below market rent? It simply boils down to the fact that we have to do more homework on each assignment because the income stream is scrutinized more now than in previous cycles. Questions that must be asked now include: What are the alternative uses? Are they viable? Who will be the lender to finance a given property given the buyer type and the asset? Proving the real estate fundamentals requires firms with deep retail expertise to create a business plan for the asset in order to drive value, whereas, in past market cycles, underwriting and pricing worked in a much more efficient manner where the market took the lead. We now have to provide this leadership where the path looks uncertain.

Q: What interesting value add plays have you seen lately and how have they differed from before?
A: One asset we recently closed consisted of an underutilized site located in downtown Palm Springs, CA at the intersections of Palm Canyon, Ramon and Indian Canyon Dr. The the center’s total GLA was 39,730, which included a vacant former Saks Fifth Avenue building consisting of 15,345 with additional mezzanine space. The Saks portion had been vacant for over 15 years, and the marketplace had deemed the building unusable. We analyzed the asset and valued the components separately, uncovering opportunity based on the seller’s target disposition price. We created a business plan to sell the stabilized parcels and proposed repurposing the Saks with office or gym uses, while recruiting local leasing professionals to confirm our findings. To date, we have sold the asset and executed a portion of the business plan for the new owner and have estimated that their $7,350,000 acquisition is now worth over $12,000,000 with minimal capital expenditure and within a one-year hold period. Without a clear business plan, the opportunity would have been overlooked and the seller would have continued to own an under-performing asset. It’s a good example of how our advisory and brokerage services have expanded into heavy front end consulting work prior to going to market.

Q: How are structured deals coming together in this market, and how do retail and mixed-use deals differ from other product types?
A: With a shortage of well-located, true value add opportunities, capital is abundant and ready. However, the deal structures are requiring more certainty than in the past. Entitlement risk and projected leasing are two areas that have been pushed back on by capital providers. Identifying tenants and having a clear path to entitlements is vital despite the demand for capital providers to place money in new deals. In previous markets, projected leasing and entitlement risk were tolerable realities. With the number of failed projects post 2007, capital structures are placing a premium on certainty. We are currently working on a 140,000-square-foot mixed-use asset in Orange County, CA, which features an “A” quality location, but has its challenges with a mixed use tenancy and perceived “C” quality site plan. Instead of rushing to market for a capital partner, we are advising the client to take some extra time and shore up measurable pre-leasing with LOI’s and actual Leases, in addition to clarifying the development team of architects, contractors, and sponsorship. By identifying reliable income via leasing efforts, in addition to costs through construction bids, the capital availability will be enhanced in addition to enhancing the deal structure.

Another challenge specific to retail and mixed-use assets is communicating the value in creating a desirable real estate venue and tenant mix to capital providers. As mentioned earlier, the capital markets are still rewarding those developers who are focused on traditional grocery-anchored centers, and have not yet fully evolved to understand the value in new consumer driven retail concepts within the food and service space that have emerged in the last five years. Retail and mixed-use today is largely about experience and creative space planning, both push into areas that don’t yet conform with yesterday’s underwriting standards. Great examples of the changing environment are gathering spaces within projects, which would be deemed “dead space” in previous years. Additionally, small chain service or food-related tenants may lack traditional credit, but bring a huge value through consumer draw due to their unique offerings.

For comments, questions or concerns, please contact Dennis Kaiser