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Buying Right

Investment sales volumes may be down, but there are still deals to be made.

The last year in retail real estate has been marked by extraordinary upheaval. Credit markets have gone from free-flowing to near lockdown, consumer confidence has swung from the heights of exuberance to the depths of despair (and rightly so) and nearly the entire community of retailers seems to be fighting for survival. Very little property is changing hands as pricing and retailer performance has become wildly unpredictable. In short, we believe it is a great time to invest.

In our view, it is all about opportunity and risk. Our current investment fund, Hutensky Capital Partners raised $100 million in cash last year for times like these. We buy under-performing retail properties and loans as well as form joint ventures with shopping center owners in need of capital. Right now we like what we see.

First, there is far less competition. Yield-driven buyers who bid up prices fueled by ever-decreasing cap rates and stoked by the free flow of even more favorable debt financing are gone. Most of these buyers were captivated by short-term flips, a new standard of lower cap rates and the downside protection of increasing NOIs. Many did not underwrite risk. Their properties will soon be coming back to special servicers.

As a result, many of those who require even modest debt will find themselves on the sidelines. Some opportunities, like deeply discounted loan purchases and properties with significant vacancy, will attract no or little debt and will be available only to all-cash buyers (or those with equity to invest). In addition, retailer failures lead to more vacancies, creating a need for asset repositioning and placing a premium on hands-on operators.

Overall, the emergence of whole groups of properties that are not appealing to passive investors and require a well-capitalized shopping center operator is a real opportunity for those who possess capital and expertise.

What about the risk and uncertainty in these turbulent times? The real question is whether things are truly more risky today. Is it really less risky to buy a high-quality supermarket-anchored center at 5 percent cap rate than it is to buy a center with low rents and high vacancy at a 13 percent rate? If we think we can lease up the vacant space over the next few years, then the high-vacancy center might be a much better deal. In the case of the 5 percent cap center, there may be limited upward movement in rent.

When Kmart was going through bankruptcy, a fund we managed contracted to buy four Kmart-anchored properties even though at the time Kmart had no clear strategy to emerge. How did we price the deal?

Our analysis concluded that three things could happen: 1) Kmart could emerge; 2) Kmart could assign the lease to another tenant; 3) Kmart could terminate the leases. We were comfortable that in the first two scenarios we would have a creditworthy anchor that was worth more than the leases in bankruptcy. In the event Kmart left, we were confident that we could re-lease the space that averaged $3.10 per square foot at close to the market rent of roughly $8 per square foot. We did not know which of three scenarios would happen, but we liked our returns in each case regardless.

In thinking of today's market conditions, one must of course believe in the long-term success of retail real estate. This entire economic upheaval will have a lot of positive effects in the long term. Most construction has stopped, so there is a healthy constraint on new supply. The retailers that survive should be better capitalized, with tighter operating models and less competition in each category. Tighter capital underwriting will also return the capital markets to equilibrium.

In the end, we are bullish on retail real estate in the long run and will seek to invest our capital today to take advantage of the opportunities we see everywhere we look.

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