After three years of a near frenzy/bubble state, the retail real estate industry is aiming for a soft landing in 2005. It hopes to avoid jolts that could burst the bubble, such as spiking interest rates and plunging consumer spending.
To keep values at lofty levels next year owners of retail properties are going to have to work hard on performance — with the economy showing only modest signs of growth and consumers showing signs of fatigue, smart management will make all the difference. REIT execs can't count on juicing their returns through big buys, though acquisitions will continue, but at a slower pace. “The key to growth will be managing assets and protecting and building net operating income,” says Craig Thomas, research director for Boston-based Torto Wheaton Research, a unit of CB Richard Ellis Inc.
That's a turn-about from 2004, when owners could automatically expect boffo returns on even the dregs of their portfolios. Instead, they will raise rents, redevelop older properties, continue to look for opportunities abroad and retenant existing centers. The emphasis will be on smart investments, not acquisitions at any price, experts say.
“Retail real estate had a great run,” says Thomas. “But, things are not going to be as easy next year. In fact, some owners remain blissfully unaware that the past few years have not been normal.”
Those owners are in peril. Others, who are aware of the realities going into the new year, anticipate about a 10 percent gain in funds from operations industrywide — even in a year of big challenges. “It will be a soft landing in 2005,” for those prepared for the altered conditions, Thomas says. “A crash landing would only occur if consumers completely pulled back on their spending rather than just spending a little bit less.”
Consumers already are getting tighter with their purse strings. The Conference Board reported that consumer confidence fell 4 percent in October — its third straight monthly drop. It was the fifth month of falling leading indicators, the Board said.
“Next year will be similar to 2003 because I see a slowdown in most parts of the economy,” says Rosalind Wells, chief economist for the National Retail Federation. For one thing, stimulation from tax cuts and the wave of home refinancings will dissipate. As a result, the NRF has forecast 3 percent growth in retail sales next year. That's half the growth expected for all of 2004.
Each sector of the retail real estate world faces a defining issue: For regional malls, the traditional department store anchors continue to lose ground to big-box retailers — a concern underscored by the merger between Sears, Roebuck and Co. and Kmart Holdings Corp. in November. Sears plans to focus its growth off-mall by converting struggling Kmarts into Sears stores. Grocery-anchored chains continue to feel the heat from Wal-Mart Stores Inc.'s success in the foods business.
Beyond the Comfort Zone
While acquisitions are expected to slow down, the results of 2004 purchases will pump up results for some REITs in the coming years. Simon Property Group, for example, expects its acquisition of Chelsea Property Group to result in 9 cents per share of additional FFO in 2005, up to $4.62 per share. The company thinks the deal will contribute an additional 18 cents per share in 2006. General Growth Properties Inc., based partly on its acquisition of The Rouse Co., is projecting 2005 FFO to jump 37 cents to $3.10 per share.
“There could be some additional consolidation in the retail REIT sector, although it's hard to say how much since we have had a lot this year,” says Dale Ann Reiss, global practice leader for Ernst & Young LLP's real estate group.
Still, few large companies (and portfolios) are available. Taubman Centers Inc. could still be a possible acquisition target, even after it successfully rebuffed Simon's hostile takeover bid. Its industry-leading sales per square foot figures and portfolio of high-end centers make it a hugely attractive target. Rochester, N.Y.-based Wilmorite, a private retail REIT, is also up for grabs.
Some of the largest owners — Simon, General Growth and Developers Diversified Realty Corp. — will likely spend most of 2005 digesting their 2004 deals. But Australia-based Westfield Group this year consolidated all of its international operations. The company's cheaper cost of capital, relative to U.S.-based firms, also gives it the ability to be an extremely aggressive bidder, even with today's overheated values. Consolidation may also come from strip center giants like Kimco Realty Corp. or New Plan Excel Realty Trust, which have both grown aggressively through acquisition in recent years.
Retail REITs hunting for growth may have to take a risk and explore opportunities outside their comfort zones, says Greg Maloney, president and chief executive of Chicago-based Jones Lang LaSalle Americas Retail group. He contends that REITs will be compelled to stray from their core businesses and continue to expand abroad, a trend that kicked into high gear in 2004. Cumulatively, REITs have now set up shop in Mexico, Canada, Spain, Italy, Latin America, Japan and Korea. In November, The Mills Corp. announced it was lead developer for a project in central Rome.
“For retail REITs to keep growing, they have to come up with new strategies,” Maloney says. “I think they are going to look for future growth in Mexico or Canada or overseas — and they will look at other types of properties. We're going to see more moves like Simon did with Chelsea.”
Through its $3.5 billion acquisition of Chelsea, Simon gained entrée into the discount arena and foreign markets simultaneously. “It gives us a future pipeline on the international front,” says Michael McCarty, president of Simon's Community Center division. “Chelsea has successful centers in Japan, opening the door to all of Asia,” he says. “Who knows where that will take us.”
Outside the Core
Simon has rapidly expanded through acquisitions. “We were focused internally five years ago, and at this point in time I think 85 percent of Simon's portfolio is brand new or has been renovated/expanded in the past five years,” McCarty says. “Now is the time for us to be more aggressive and pursue [external] opportunities.”
Like Simon, many REITs are looking to break into businesses on the periphery of their core strategy. “In the past, owners were looking for core properties with decent returns,” says Warren Fink, senior vice president and co-manager for GMAC Commercial Mortgage's National Debt/Equity Services. “Next year they'll be looking at opportunities for value creation — perhaps retenanting centers or filling up empty boxes.”
Toward that end, Fink says his firm is raising $300 million for an unnamed REIT to pursue investments in underperforming properties that could be turned around with a new management strategy. Such opportunities will enable REITs to achieve growth of up to 15 percent, more advantageous than buying a stabilized core property at a 6.5 percent cap rate.
Looking Inward
Acquisitions won't have the cachet they had in recent years, says Deutsche Bank REIT analyst Louis Taylor. “There will be selective acquisitions, but I expect REITs to really turn inward to make the most of their existing portfolios,” he says. In particular, he expects owners will focus more on redeveloping existing centers.
Take Chicago-based General Growth, for example. Its recent acquisition of Rouse has the REIT “chewing over” its growth strategies. “Our plate is pretty full,” says Bob Michaels, General Growth's COO. “We'll focus on digesting that over the next two to three years.” He expects that the REIT's growth will come from improved operations and redevelopment.”
And rents. Beachwood, Ohio-based Developer Diversified, is budgeting NOI growth for 2005 based on deal flow for new leases and renewals, chairman and chief executive Scott Wolstein says. But in seeking to grow, it's leaving no stone unturned. Developers Diversified's four-pronged approach for next year includes polishing up its core portfolio, acquiring stabilized centers, developing greenfield sites and buying troubled properties that need redevelopment.
Rents have been climbing steadily. Retail REITs upped rents as much as 30 percent in 2004, experts say. General Growth, for example, won a $9 per-square-foot boost on leases signed during the first nine months of 2004, compared with the same period a year earlier. Rising rents will be a key factor in meeting the 10 percent FFO growth targets next year.
Rich Moore, a McDonald Investments analyst, expects REITs to achieve healthy rent spreads on renewed leases — about 20 percent to 25 percent. These increases will boost funds from operations and net operating income.
Smart REITs, says Moore, will focus on driving the productivity of their centers — by aggressively pursuing early lease renewals next year. He points to Pan Pacific Retail Trust as an example; Pan Pacific had a center that was 100 percent leased. Save On, the anchor, had a lease that expired in three years. The REIT asked Save On to renew at a rental rate above current market value and below anticipated rents three years from now. “They get the early bump on their rental rates, plus they can go to the small tenants and get them to sign new leases too,” Moore says. “The smaller firms would be too skittish to renew unless there's a commitment from a big name.”
REITs will only be interested in healthy retailers, Moore says. Regency Centers Corp., for example, has only the No. 1 or No. 2 grocers in its centers. Because of that, CFO Mary Lou Fiala projects a more than 25 percent increase in NOI in 2005
Demand Dynamics
There is a caveat. Getting high rents requires strong consumer demand. According to Torto Wheaton, 25 million square feet of community center retail space will be under development in 2005, an increase of only 1 million square feet from 2004.
The firm is projecting that 30.3 million square feet of retail space for the entire industry will be absorbed in 2005, a 23.7 percent increase over 2004 absorption.
“People say, ‘Occupancy is already high. What do you do for an encore?’” Moore says. “But more demand equals either higher rents or higher quality tenants. I cannot imagine a better scenario for the retail landlords, and I think it will stay this way for years.”
In 2005, Torto Wheaton expects the availability rate for retail space in community centers to drop to 7.6 percent from 7.8 percent this year. Regional malls will see it drop to 7.4 percent, according to New York City-based research firm Reis Inc.
The ease with which space can be filled will vary among shopping venues. Since few regional malls are being built, space is at a premium. But strip centers and community centers face a different situation.
“The big story here is that supply- demand relationship is out of whack in favor of the landlord” in regional malls, McCarty says. “New space is down to a relative trickle, and growth in supply is inadequate to absorb all of the new store plans that we've heard about.”
Retailers have been encouraged by strong sales growth throughout 2004 and are compelled to expand in 2005. “They are doing much better, and if they're doing better, they're going to want to open more stores and try new formats,” Moore points out.
Not to be forgotten, of course, is the behemoth that ate the heartland: Wal-Mart. The retail giant plans to open 350 stores in 2005 through its Supercenter, Neighborhood Center and Sam's Club formats. Wal-Mart's fiercest competitor, Target Corp., also plans to open 2,010 stores by 2010. Nice symmetry.
Wal-Mart's expansion has not only hurt strip centers featuring rival discount tenants, it's gnawing away at grocery chain profits. “Most of the grocers have clearly slowed down growth plans,” Fiala says. “They're still growing, but not at the same pace.” Instead, she says that many grocers — Tom Thumb and Albertson's, in particular, are regrouping and redeploying their capital in existing stores.
Moreover, Wal-Mart, whose $250 billion in sales revenues more than triples the next largest retailer, Home Depot, and more than quadruples the combined efforts of Kmart and Sears, is now impacting just about every sector of the industry. It's the top discount retailer, the top grocer and the top toy retailer. Its influence, along with Target Inc., is also forcing department stores to rethink their strategies and impacting anchor space at regional malls.
Many department store chains are struggling, especially as the proliferation of big-box tenants erodes market share. Some have closed underperforming stores. Others, like Sears and JCPenney, are focusing their growth strategy off-mall with standalone, big-box and lifestyle center formats. Another possibility is that smaller or struggling chains, such as Dillard's or Saks, will look to merge, potentially causing more closures at malls.
“We're seeing more and more traditional mall tenants opening up outside of malls,” Wolstein says. “It's logical because there are virtually no malls being built, and the results so far for those who have made that conversion have been positive.”
Malls owners, meanwhile, have looked to fill anchor space with nontraditional tenants such as Target, campus store Steve & Barry's, Dick's Sporting Goods and others. (See CBL case study on page 20.)
New inline concepts include Columbus, Ohio-based Limited Brands' CL Bigelow, an old-fashioned “apothecary” store that is a radical departure from the company's Bath & Body Works concept. At CL Bigelow consumers can have lotions, oils, soaps, etc., mixed to their own specifications. Similarly, Abercrombie & Fitch is rolling out a new brand, Ruehl, which targets men and women in their 20s. The New Albany, Ohio-based company says it plans to open as many as 700 Ruehl stores nationwide.
“We're happy to see a company like Abercrombie & Fitch come out with another concept,” McCarty says. “For the past five years the company has been an important part of all REIT companies growth and with Ruehl we see them reloading.”
All of which bodes well for REITs. That's not to say a collapse in consumer spending or the potential for a new retail landscape following the Sears/Kmart deal couldn't prick the bubble. Overall, though, REITs are hoping for a calm landing in 2005.