An Appetite for Risk

Over the years, grocery-anchored centers built a reputation as the most rock-solid type of retail real estate investment that throws off steady returns in good or bad times. It was necessity retail — not fad-driven fashion merchandising. After all, everybody has to eat.

Well, Americans are still eating but they no longer buy all their Mallomars at the little center down the road. After a decade of relentless, price-driven competition, Wal-Mart and other “supercenter” grocers have seized nearly 17% of the national shopping cart, and the supermarket chains that anchor most neighborhood centers have lost their guaranteed drawing power. Over the past decade, 30 chains have fallen. Safeway Stores recently announced it would close 26 stores in Texas; Winn-Dixie Stores is in Chapter 11 bankruptcy and Albertson's has put itself up for sale — the latest casualties in a war of attrition.

“If you had any strong national or regional grocer in your center, investors assumed there wouldn't be much risk,” says Jim Garvey, director of acquisitions for Chicago-based LaSalle Investment Management, a real estate investment manager that oversees $26.4 billion in assets. “Now, there's a lot of risk.”

Yet investors continue to pour money into grocery-anchored centers. Demand has been so strong in fact that buyers have bid up prices and hammered capitalization rates down 90 basis points to 7% for the year ending Sept. 30, 2005, according to the New York-based Real Capital Analytics, a commercial real estate research and consulting firm. Meanwhile, shopping center REITs averaged a total return of 7.1% in the first nine months of 2005, which was nearly two percentage points better than free-standing retail property REITS, but half that of regional mall REITs, according to the National Association of Real Estate Investment Trusts, a REIT trade group.

Even Winn Dixie's decision to close more than one-third of its roughly 910 stores has failed to diminish interest in the properties. Indeed, in some cases, owners are filling the troubled chain's abandoned shells with tenants who are paying higher rents (see sidebar). Through three quarters this year, investors have acquired 427 grocery-anchored properties for an average of $153 per sq. ft., the most transactions in the first nine months of any year except for 2004, when 556 grocery-anchored centers traded hands for an average of $134 per sq. ft., according to Real Capital Analytics.

Institutions continue to boost their portfolio allocations toward real estate, which is creating more demand for all property types, Garvey says. Plus, debt and equity markets are eager to provide REITs with capital. In the first nine months of the year, a handful of grocery-anchored center REITs have raised at least $575 million in unsecured debt and about $382 million in equity through preferred and common stock issues.

But retail property experts continue to warn that investors are paying too much for assets that now have a higher risk profile. “I think a lot of investors have just resigned themselves to the way pricing is,” says Bernard Haddigan, managing director of the National Retail Group for Encino, Calif.-based Marcus & Millichap. “They're the ones who were sitting on the sidelines a couple of years ago, and now they've become buyers at these crazy prices.”

Case in point: In July, Jacksonville, Fla.-based Regency Centers Corp., which owns nearly 390 properties in 26 states, sold a Winn Dixie-anchored property in Orlando for an undisclosed price, but at a cap rate of 8.5%. During the company's second-quarter conference call discussing the disposition, Regency Centers CEO Martin “Hap” Stein remarked that five years ago the company couldn't find a buyer for that property, even at a higher cap rate.

In fact, adds Glenn Rufrano, CEO of New York-based New Plan Excel Realty Trust, aggressive capital providers who are financing deals at ever-lower cap rates are ignoring risks. That has virtually eliminated the margin for error — such as losing tenants and taking a hit to NOI — and in some cases will lead to lower returns or even foreclosures. “The capital today has beaten down the risk premium to zero, and that's a danger,” says Rufrano, whose company owns and manages 450 neighborhood and community centers.

Seasoned players are taking defensive action to pool risks and broaden revenue bases. New Plan, for example, keeps a database of its grocery-anchored centers ,and rates its tenant grocers according to their exposure to existing Wal-Mart Supercenters or the likelihood that one will appear. “If you find yourself with the No. 3, 4 or 5 grocer in the market and losing market share to Wal-Mart,” Rufrano says, “then you'd better be prepared to remerchandise that space.”

New Plan, Regency Centers and other REITs also are acquiring properties through joint ventures, and then managing the assets. Meanwhile, North Miami Beach-based Equity One Inc., which focuses on grocery-anchored centers and owns 187 properties in the South and in the Boston area, plans to add residential and other commercial uses to new and existing retail projects.

No ‘meaningful’ recovery

The health of grocery-anchored centers continues to depend on how supermarkets fare. On that score, Wall Street is mixed. CIBC World Markets' Perry Caicco, for example, upgraded the top three conventional grocery chains — Kroger, Albertson's and Safeway — to outperform in a September research report. Caicco notes that Kroger and Safeway are remodeling stores and introducing new formats, and suggests that Albertson's break-up value is worth more than its operations.

On the other hand, Edward Kelly at Credit Suisse First Boston (CSFB) initiated coverage of supermarkets in September by predicting continued turmoil. Conventional grocers simply have too many structural problems, such as high unionized labor costs, that prevent them from competing effectively with non-conventional rivals. “Each company is taking steps to drive top-line growth and raise profitability,” he says of the top three chains, adding the initiatives will not be enough.

Meanwhile Wal-Mart continues to spook the industry with its Supercenters and Neighborhood Markets. The discounter's share of total U.S. consumer food sales increased to nearly 14% in 2004 from 9.3% in 2000, according to CSFB, and Supercenters have a commanding lead as the No. 1 grocery chain. In 2004, 1,712 Supercenters sold $115 billion of groceries while Kroger, with 3,323 stores, had sales of about $57 billion, according to the 2005 Directory of Supermarket, Grocery & Convenience Store Chains.

Other discounters, wholesale clubs and specialty stores such as Whole Foods are heaping the misery on conventional grocers, too. In all, non-conventional competitors have snatched nearly 600 basis points of food retailing market share since 2000, while the top three supermarket chains have lost almost 200 points over the same period, CFSB says.

Hasta la vista

Wal-Mart's impact on grocers has been particularly evident in Texas, which was used as a grocery test market about 15 years ago. Conventional supermarkets were shocked by the discounter's rise to dominance. In the Dallas-Fort Worth area, for example, Wal-Mart now operates 51 Supercenters, 19 Neighborhood Markets and 19 Sam's Clubs. Largely because of that intrusion, Safeway in mid-October announced that it would close 26 of its roughly 140 stores in the state by the year's end — nine of its Tom Thumbs in Dallas and Fort Worth, 16 Randalls in Houston, and a Randalls in Austin. In 2003, Winn-Dixie abandoned its 40 stores in the Dallas-Fort Worth area.

While other supermarket chains have filled some of the empty Winn-Dixie slots, very few, if any, of the nine Tom Thumbs will backfill with grocers, predicts Robert Ginsburg, vice president of Dallas-Fort Worth retail advisors for CB Richard Ellis.

“There's no one standing in line to take those spots,” he says. Indeed, Wal-Mart's dominant presence in Texas has made the state particularly risky for owners of grocery-anchored properties. Paul Morgan, a REIT analyst with Friedman Billings Ramsey, cites Regency Centers' Dallas-Fort Worth and Houston portfolios as risky. The REIT will suffer two Randalls closings in its Houston portfolio, which totals 11 properties. “Wal-Mart's intense pricing pressure and rapid market-share growth are likely to lead to significant market dislocation over the next several years, thus creating a greater risk of store closings and dark anchors,” Morgan wrote in a recent analysis.

Some grocery-anchored owners are picking up stakes. Equity One, for example, has put its entire Texas portfolio on the block, and the REIT has received interest from at least 50 potential buyers. The company plans to redeploy sale proceeds into Northeast properties, says Howard Sipzner, Equity One's CFO.

For now, grocery-anchored centers in Texas continue to fetch competitive prices. Cap rates hover around 8%, similar to initial rates of return in more densely populated markets. That, says Sipzner, confirms the wisdom of Equity One's move out of the region and into the densely populated markets where the company can invest in its mixed-use strategy.

One place where Equity One's new strategy is taking shape is in Florida, where the growing population provides an opportunity to squeeze more profits out of properties by adding residential components. In May, the company paid $22 million for the Publix-anchored Young Circle shopping center in Hollywood located in a redevelopment district zoned for additional commercial and residential space. Preliminary plans to put high-rise residential atop the retail center are under way, and the company hired Hollywood's director of downtown community redevelopment to oversee the project.

Equity One also is not putting all its chips on mixed-use. It is still buying land where new rooftops are still two or three years away — where there's a greater risk of running into competitors such as Wal-Mart. Currently, the company has nine parcels encompassing 130 acres in Florida, Georgia and Alabama. “You really need to make a lot of other assessments as to what all the other potential parcels are going to end up as, so it's a more complicated decision,” Sipzner acknowledges. “We're only going to do those kinds of developments in markets that we know really well.”

Ambitious developer

Regency Centers is pursuing a somewhat different acquisition and development strategy. It's focusing on neighborhood locations where household incomes are above average and where shoppers prefer more variety, convenience and service than Wal-Marts provide, says Stein. The REIT is particularly focused on high- population growth markets in Florida, California and the Northeast.

Regency is spending $502 million to develop 26 new centers and expand two properties, and Stein expects the projects to generate annual NOI yields of 10%. On a broader scale, Regency has 53 additional projects valued at $850 million in what the company calls its “high probability” development pipeline, also projected to yield about 10%.

“In spite of the challenges in the supermarket industry, we're continuing to grow our development program,” Stein says. With a wary eye on Wal-Mart and Costco, he says, “Anything that we feel is susceptible, we sell.”

Indeed, Regency anticipates selling $275 million in properties this year, compared with dispositions of $240 million last year. Over the last five years, Regency has reduced the number of Winn-Dixie shopping centers to four from 20.

Regency is also generating fees from property management and other transactions related to its joint venture-owned properties. This year, for example, Regency expects those fees to total about $28 million — or about 10% of adjusted funds from operations.

Regency completed its most recent joint venture-acquisition in June, when the company partnered with Macquarie CountryWide Trust of Australia to buy 12.8 million sq. ft. from the California Public Employees' Retirement System (CalPERS) and Bethesda, Md.-based First Washington Realty for $2.68 billion. The portfolio included 100 shopping centers in 19 states and Washington, D.C.

So easy to sell

Such deals are getting harder and harder to pull off, however, given the premium that grocery-anchored centers are fetching today. In earnings conference calls, several retail REIT executives have complained that little price differential exists between Class A and B shopping centers.

Naturally, executives and other real estate experts are hunting for a sign that commercial real estate prices have topped out. Most have predicted for years that some stimulus would eventually drive money out of real estate — rising interest rates, a broad stock market rally, or some type of significant event such as a rash of loan defaults. None of those have come to pass thus far, and so investors in grocery-anchored centers are stuck in an odd position: Capital providers continue to throw money their way, but prices keep rising even on inferior assets.

That's a sure indication that some investors are indeed overpaying for properties and a shakeout is likely, says LaSalle Investment Management's Garvey. Exactly when it will occur remains the question. “There will be winners and losers,” he says. “There's a lot of money flowing into grocery-anchored centers, and they're very easy to sell. But what has long been viewed as an inherently safe format won't, by itself, allow you to be successful anymore.”

Joe Gose is a writer based in Kansas City.


Discounters continue to gain market share at a steady pace.

2001 2002 2003 2004
Discounters 13.8% 15.1% 16.0% 16.7%
Wal-Mart 10.5% 11.9% 13.1% 14.0%
Target 1.3% 1.5% 1.7% 1.8%
Kmart 2.1% 1.7% 1.2% 0.9%
Warehouse Clubs 7.3% 7.7% 7.8% 8.2%
Costco 3.6% 3.9% 4.0% 4.3%
BJ Warehouse 0.5% 0.5% 0.6% 0.6%
Sam's Club 3.2% 3.3% 3.2% 3.3%
Traditional Grocers 21.1% 20.1% 20.0% 20.0%
Kroger 8.8% 8.7% 8.7% 8.6%
Alberton's 6.4% 6.0% 5.7% 6.1%
Safeway 6.0% 5.9% 5.8% 5.4%
Source: Credit Suisse First Boston


Based on sales figures, there has been a dramatic shift in the rankings of the top U.S. supermarket and grocery chains over the past decade. Wal-Mart Supercenters now leads the pack, holding a 2-to-1 margin over its closest competitor.

1993 Ranking Sales
1. The Kroger Co. $22.1 billion
2. Safeway Inc. $15.1 billion
3. American Stores Co. $14.5 billion
4. Winn-Dixie Stores Inc. $10.8 billion
5. The Great Atlantic & Pacific Tea Co. $10.5 billion
2004 Ranking Sales
1. Wal-Mart Supercenters $115 billion
2. The Kroger Co. $56.9 billion
3. Albertson's $38.4 billion
4. Safeway Inc. $35 billion
5. Costco Wholesale Group $28.3 billion
Source: Directory of Supermarket, Grocery & Convenience Store Chains

Seeing Ray of Light on the Dark Side

The competitive pressures that have forced Winn-Dixie Stores into bankruptcy and Safeway to close Texas stores promise to shutter more supermarkets and put the squeeze on grocery-anchored center owners. Dark anchors generally lessen the lease burden on smaller tenants, who depend on supermarket traffic: Immediately, a small store's fixed rent may revert to a percentage of sales, and often small shops can vacate properties without penalty if, over time, another anchor fails to materialize.

But grocery-anchored center owners consider empty supermarkets as a way to get paid twice — first by vacating grocers who often pay lump sums to terminate leases, and by new tenants who pay higher rents. New York-based New Plan Excel Realty Trust, for example, strives to replace vacating anchors that typically pay $5 per sq. ft. with users who pay $8 to $12 per sq. ft. And tenants run the gamut, including fitness centers, hardware stores, craft shops and medical offices.

Last year, the company expanded a former Winn-Dixie store by 12,000 sq. ft. to accommodate a Hobby Lobby in Snellville, Ga. Although New Plan officials declined to discuss rents, the REIT anticipated a 10% return on cost. “There has generally been some pretty good room to improve on rent if the property's in a good location,” says Glenn Rufrano, CEO of New Plan.

Indeed, some investors welcome the opportunity to fill dark grocery stores. Woolbright Development Inc., a neighborhood center investor based in Boca Raton, Fla., acquired Marketplace at Dr. Phillips in Orlando with an empty Winn-Dixie for some $56 million in late 2004. The company divided the 50,000 sq. ft. former grocery, and HomeGoods moved into one space in early October.

Re-fitting supermarkets isn't cheap, however. It costs about $35 to $40 a sq. ft. to turn a grocery into two shells, for example, up from about $20 a sq. ft. five years ago, says Michael Fimiani, vice president of leasing for Woolbright.

Tenant improvements are an additional $10 to $20 per sq. ft. Signing up a new user doesn't guarantee success, either. Big Lots, a frequent supermarket back-filler, in early October announced it was closing 85 stores in the Midwest.

Despite the challenges, Woolbright officials plan to spend $4 billion over the next four years to acquire community centers and develop a handful of projects. The goal: to expand the portfolio to 80 properties from 20. “We look at acquisitions from the standpoint of what we can do with the properties down the road,” Fimiani says. “We're not so concerned with buying something for the in-place cash flow.”
— Joe Gose

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