Unison’s John DiOrio in Shopping Centers Today: “Distressed vs. Value-add: Investors dig for opportunities in difficult market”
Shopping Centers Today – September 2018
by Joe Gose, Contributor
Given the recent disruptions in the retail industry, some might assume there would be an abundance of opportunities for value-add and distressed-property buyers out to grab retail centers at discount, fix them up and then pocket the profits by operating them or selling them off. But that is not quite the way the market is playing out.
Actually, fewer assets are available now than five years ago, particularly given the dearth of construction over the past decade, and many investors are completing off-market transactions. What is more, the majority of investors choosing to stick with retail properties are already crowding into such acquisitions, sources say. Only about two in 10 investors are looking for core properties — all the rest are focused hard on these value-add or opportunistic deals, according to a Real Capital Markets survey released in May.
Moreover, at this late stage of a comparatively long real estate cycle, retail properties tend to be fully valued. Consequently, many sellers are reluctant to budge on price, even with interest rates inching up, observes P. David Bramble, a managing partner at Baltimore-based investment firm MCB Real Estate. “We see opportunities, but it is a super-challenging environment for value-add investments,” Bramble said. “Right now the big issue is a pricing dislocation between where buyers and sellers are, and there are a lot of head winds and risks in the retail space.”
Much the same can be said for distressed-property investing, says John DiOrio, vice president of investor relations at Unison Realty Partners, a Boston-based shopping center owner and operator. “While there certainly is opportunity to be had in the distressed markets, now, more than ever, [the] buyer must beware,” he cautioned. “At this point in the cycle, distress can often be a signal of a fundamental property or location issue.”
Value-add buyers look for underperforming properties in which they can increase yields, and which they can then sell off following some real estate and tenant improvements. These assets may be suffering from deferred maintenance, modest vacancy, struggling anchor tenants or underutilized parcels, points out John Riser, a principal of Indianapolis-based Riser Retail Group. In some cases, budget-constrained landlords may be charging retailers below-market rental rates, unable to charge more or to reposition the asset absent a substantial upgrade. In other cases, equity partners may simply want to trim back their retail property holdings. Typically, value-add investors target an internal rate of return in the high teens or higher.
Distressed properties can be much more risky, depending on the situation. These assets may be in foreclosure, or the owner might be upside down on a mortgage. Worse, cash flow may be deteriorating, or income may be nonexistent, according to Leslie Lundin, a managing partner with LBG Real Estate Cos., a Los Angeles–based investment management firm. Extensive redevelopments and long hold periods are more common among distressed plays than in the value-add deals, but the internal rate of return can be much higher. LBG has fetched returns in excess of 60 percent by executing such strategies, Lundin says. “In order to really harvest the value from distressed assets, you have to take a leap of faith and do some things that are not set in stone when you first buy the property,” Lundin said. “You can really knock it out of the park — or you can fail really big.”
LBG focused on grocery-anchored value-add investments early in the cycle and then plowed its profits into some big opportunistic deals. Last year the firm teamed up with Aviva Investors to acquire The Shops at Hilltop (formerly Hilltop Mall), in Richmond, Calif. This 1.1 million-square-foot regional property had been in foreclosure for several years and was about one-third vacant. But it came with entitlements for 10,000 residential units and nearly 17 million square feet of commercial space. In addition to a substantial renovation of the 42-year-old mall, the redevelopment includes the imminent addition of tenants catering to the local Asian population. New, value-based retailers, restaurants and an entertainment district are to follow there in the coming months.
In yet another distressed play, Unison Realty and Alto Real Estate Funds paid $21.1 million last year to acquire Commons at Hooper, in Toms River, N.J., in a bankruptcy auction. This 120,400-square-foot community center, with Dollar Tree, DSW and Michaels as anchors, is about 86 percent occupied. The partnership’s strategy here includes sprucing up the parking lot and the facade, recruiting new tenants and developing a pad site. “The previous owner could not pay for tenant improvements to attract national retailers,” said Scott G. Onufrey, Alto Real Estate’s president and managing partner. “We’ve already seen interest from some major national brands.”
Alto Real Estate’s value-add investments include Cranberry Square, a 195,200-square-foot community center in suburban Pittsburgh that the firm acquired this year in partnership with M&J Wilkow, for $23.5 million. This property enjoys high occupancy, and its retailers include Barnes & Noble, Best Buy and OfficeMax, but it also provides opportunity to recapture some space for re-lease at higher rates, Onufrey says. A closed Toys ‘R’ Us is one immediate candidate. “We feel very comfortable with the real estate and our basis in the deal,” he said, “even though we are aware that uncertainty surrounds some of the retailers.”
Value-add investor Pacific Retail Capital Partners is focused on buying and operating regional malls in the A-minus-to-B-range, says Steve Plenge, the investment firm’s managing principal. That particular pool comprises fewer than 300 U.S. malls currently, and the company seeks dynamic markets exhibiting growth in population, jobs and household income. Mall-owning REITs that have chosen not to invest in the bottom half of their portfolios make up the primary source of opportunities, Plenge says. “REITs are stretched, like everybody else, when it comes to manpower and capital,” Plenge said. “Some properties are operating on a shoestring budget: The lights are literally turned off, and nobody is sweeping the parking lot.”
In addition to repositioning the centers with such tenants as grocery stores, entertainment providers, and health and fitness operators, the Pacific Retail strategy includes making upgrades to the rest rooms, food courts, play areas, lighting and security, landscaping and entrances. The firm is also relying on the appeal of community events and has employed local artists to paint murals on exterior walls.
This year Pacific Retail is finishing up the second phase of a $20 million renovation to the Shops at South Town, a 966,000-square-foot mall in Sandy, Utah, that the firm acquired jointly in 2014 with Silverpeak Real Estate Partners and Goldman Sachs. The company installed a high-resolution interactive play wall and a multimedia wall featuring movies, sporting events and other content. Among the new tenants is a 50,000-square-foot Round 1 Bowling & Amusement facility, which will open this year.
Meanwhile, the Palm Beach, Fla.–based Sterling Organization, which recently raised some $495 million in its third value-add fund, is concentrated on grocery-anchored assets and street-front retail. The firm is also willing to look at riskier malls and power centers, depending on the strength of the location, the level of challenge and the amount of capital available for turning those assets around, according to Brian D. Kosoy, Sterling’s managing principal, president and CEO.
This spring Sterling acquired a vacant 10,000-square-foot, street-front retail condominium in Chicago’s Magnificent Mile district for $15.1 million. Kosoy says he sees loads of potential for turning that space into a trophy asset, given the right leasing strategy. “We believe that good real estate will always be good real estate, and that there will always be demand for it,” he said. “We don’t like to gamble and pray.”