FEATURE ARTICLE, AUGUST 2006

NNN INVESTMENT REPORT: ALL HAIL RETAIL
Urban areas and retail condos are top targets in single-tenant, net-lease market in the West.
Alvin Mansour

Mansour

Higher energy costs and a slowdown in the housing market appear to be putting the brakes on consumer spending, which fuels two-thirds of the national economy. According to a recent report issued by MasterCard Advisors, year-over-year sales, excluding gas and automobile purchases, rose 5.9 percent in May, down from 8.3 percent in February.

Just as the U.S. economy rests its hopes on the power of its consumers, so do retail investors. While slower consumer spending may sound like gloomy news to some, the effect of that slowdown has not become immediately apparent in the retail investment sales market.

Optimism, in fact, was the pervasive tone set at the May 2006 convention for the International Council of Shopping Centers in Las Vegas. Bernard Haddigan, a national retail expert based in Atlanta, said that investor demand for single-tenant, net-leased retail assets has out-paced demand for for-sale product. As construction costs have deterred speculators from adding new inventory to the market, competition for properties has increased, placing upward pressure on rents.

Currently, many investors interested in single-tenant, net-leased retail properties are classified as “crossover” buyers. Typically originating from the multifamily market, these investors are interested in the minimal management associated with maintaining these assets and their higher cap rates when compared to multifamily assets.

California is a hotbed of this crossover capital, as numerous buyers express interest in securing single-tenant assets with strong credit tenants. That demand has resulted in further compression of cap rates, pushing investor interest into nearby markets with slightly higher rates, such as Phoenix, where 6.6 percent cap rates on single-tenant properties remain the average.

With the margin between cap rates and interest rates narrowing, investors in heated West Coast markets are rapidly seeking new opportunities. In terms of single-tenant, net-leased properties, some investors are moving towards retail condos, urban redevelopment and a preference for strong credit tenants that promise moderate returns.

In Southern California, there are a growing number of single-tenant retail condo transactions due to the rise in mixed-use projects nationwide. A growing trend is developers selling off the retail condos in the mixed-use projects; in some cases, one retail developer will buy the entire retail floor, put the tenants in and then flip the units.

One such example of the emergence of the retail condo trend in western markets is the 300,000-square-foot Los Angeles Fashion Center. Located in the city’s Downtown Fashion District, the asset will feature 196 condominium units that individual retailers will own.

All eyes are on the project, which is one of the largest retail condo projects in the country. Investors are set to monitor the sales pace of the retail condos, and since interest rates are still at historic lows, demand remains strong for retail condos. If the retail condos trade at attractive pricing points, the stage will be set for a rapid increase in retail condo sales throughout the western states.

A large number of retail condo transactions tend to take place with private investors. Buyers interested in satisfying a 1031 exchange are looking in emerging neighborhoods and urban revitalization zones in order to identify those properties that offer low-maintenance and significant growth potential.

High-density urban areas are well suited for these smaller retailers, especially those who provide niche products and services, including boutique shops and luxury goods. Individual retail condos typically range in size from 1,000 to 5,000 square feet, making them optimal choices for these smaller retailers. For retailers, a condo acquisition means long-term occupancy rates at a fixed expense.

There’s a great deal of activity in urban areas for all single-tenant, net-leased properties. In dense areas, there is always less risk to the buyer when it comes to re-tenanting a property.

Bobby Turner, managing partner of Canyon Capital Realty Advisors, predicts continued growth in the urban retail market. In Las Vegas, Turner advised investors to remain focused on dense, urban cores for investment opportunities. “Densely populated, diverse communities are a key target, and they’re not getting enough capital,” Turner reports. “Urban areas are not without risk, but they offer the greatest opportunities.”

Outside of this scenario, there is great potential in up-and-coming suburban neighborhoods. With job formation fueling housing development in suburban markets, a renewed interest in single-tenant properties with strong credit tenants is evident. People are willing to take a lower return for a more secure tenant. Although interest rates are increasing, there is still tremendous demand for a quality single-tenant asset.

Walgreens, Starbucks Coffee and banking tenants are at the top of the “desirable” list. As any casual review of busy street corners will testify, Walgreens and CVS/Pharmacy continue their aggressive expansion plans, and remain top choices in the single-tenant, net-leased property investor’s mind. On a national basis, the drugstore segment has expanded its market share of the food and convenience service sector, and doubled its overall store size to nearly 14,000 square feet per location.

Spurred by the expansion of mixed-use property development across the West and the increased popularity of retail condos, the outlook for single-tenant, net-leased properties remains positive for the rest of 2006.

Alvin Mansour is co-director in the San Diego office of Marcus & Millichap’s National Retail Group.

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