COVER STORY, MARCH 2007

SPICY SOUTHWEST RETAIL
Growth in population, jobs and roads paves way for retail appeal in Arizona and New Mexico.
Ned O’Hearn

For retail industry observers and analysts who prefer that all market indicators be neatly aligned, these could be frustrating times. The sunny Southwest, a happy haven for retail developers in recent years, is feeling the pang of a serious housing slowdown and the more stinging, localized effects of the even more precipitous demise of the residential condominium construction and conversion craze.

But the expected carryover into the retail development and leasing areas remains statistically unrecorded and largely unobserved. Although homebuilders are scrambling to downgrade construction projections, and as large land takedowns for sprawling new subdivisions get put on hold, retail developers and leasing brokers haven’t missed a step. They seem to regard the slowdown more as a housing market catching its collective breath and readying itself for yet another surge.

And with good reason. Last year, Arizona finally wrenched bragging rights from Nevada to make the claim of being the fastest growing state in the nation, expanding by a robust 3.6 percent. Neighboring New Mexico registered a hefty 1.5 percent increase — statistics not unnoticed by local and national retail developers honing in on new consumers.  

Outward Bound

According to numbers published by CB Richard Ellis (CBRE), retail space in the greater Phoenix market (exclusive of regional malls) grew by 4.51 million square feet in 2006, with almost 30 percent of that increase occurring in the burgeoning southwest sector that includes Avondale, Buckeye and Goodyear. That level of growth, strong by any standard, actually fell short of the lofty benchmarks set in 2004 and 2005 when developers fed soaring demand by adding 5.64 million square feet and 6.52 million square feet of retail space, respectively, to the greater Phoenix market.

Despite rising costs, development won’t be slowing down anytime soon. At year-end 2006, CBRE calculated that almost 8.49 million square feet of new non-mall retail product was under construction, with almost 30 percent of that space soon to appear along the newly opened Loop 202 Santan Freeway Corridor southeast of Phoenix in the cities of Mesa, Chandler and Gilbert.

To underscore just how bullish developers are about the greater Phoenix retail market, more than 32 million square feet of additional space is currently on the drawing boards, and that figure climbs to 36.5 million if regional mall space is included.

In Albuquerque, a little more than 1.3 million square feet of retail space was added to the market in 2006, representing a 100 percent increase over completions recorded in 2005. According to Grubb & Ellis/New Mexico, much of this growth was propelled by the entry of new retailers to the market, including Kohl’s, Trader Joe’s and The Pottery Barn, amongst a host of others. 

Tenants Abound

Much to the delight of these optimistic developers, historic demand trends have justified the soaring supply. Tenants aren’t necessarily hovering over soon-to-be-completed space, but space seems to fill almost as quickly as it comes on line.

“Last year could not have been any better,” reports Michael Mugel, CEO of Red Mountain Retail Group, a California-headquartered company with 25 shopping centers in greater Phoenix and one in Albuquerque. “It seemed like every time you had space available you could count on getting a lease signed.”

The numbers back him up. CBRE reports that the Phoenix market absorbed almost 5.19 million square feet of non-mall space in 2006 — more space than was added to the market through new construction. Statistically, 2006 was an “off year” in terms of absorption compared with 2005 (6.87 million square feet) and 2004 (6.61 million square feet). On average, in the past 3 years, the greater Phoenix retail market has annually absorbed more space (6.22 million square feet) than was reported to be vacant (5.84 million square feet), indicating less than a 1-year supply was available at any given time.

Elsewhere in the Southwest, the lively Albuquerque retail market absorbed 1.32 million square feet of space in 2006, according to figures released by Grubb & Ellis. During that same time period, 1.34 million square feet of new space was added to the market. In 2005, absorption actually outpaced new supply by more than 350,000 square feet.

Rental Rate Ratcheting

Although landlords are largely able to keep shop space filled, tenants are beginning to feel the pinch of steadily rising rental rates. As reported by CBRE, peak per-square-foot rental rates at neighborhood centers in the greater Phoenix market at the end of 2006 ranged from a low of $28 in Apache Junction, Scottsdale and Northwest Phoenix to $40 at the newer centers in East Phoenix and along the Loop 202 Corridor in Mesa, Chandler and Gilbert. The newer- and better-located power centers were also commanding lofty per-square-foot rental rates for prime spaces, ranging from $26 to $40, depending on the submarket.

“Rental rates continue to rise,” confirms Judi Butterworth, a principal at Phoenix-based De Rito Partners, which has developed 18 retail properties and boasts a leasing portfolio of 137 Arizona shopping centers. “The high cost of land, city impact fees, construction cost increases and vacancy rates below 5 percent are all pushing rental rates higher.”

“Rental rates for prime retail space will continue to increase until the cost of land stabilizes,” adds Scott Boardman, a broker with Grubb & Ellis/BRE Commercial in Phoenix. “It’s been challenging for most retailers — local “mom and pops,” and even the regional and national chains — to justify rents as high as $45 per square foot NNN. And some of the major anchors are looking for pass-through deals, putting even more pressure on rates paid by the smaller shops.”

ABQ Uptown in Albuquerque

The pinch is also being felt in Albuquerque where the maximum rent now ranges from $16.50 per square foot in unanchored strip centers to $45 NNN in the more glamorous lifestyle centers, including Hunt Development Group’s new ABQ Uptown. Top rents achieved per square foot at neighborhood, community and power centers were pegged by Grubb & Ellis at $27.50, $29.40 and $34 per square foot, respectively.

Rising Anchors

Strong anchors definitely have the muscle to have their way with developers. “Wal-Mart Supercenters and Super Target stores continue to serve as the Phoenix area’s most dominant anchors,” says Grubb & Ellis’ Boardman. “Other competing grocers such as Safeway, Fry’s and Bashas aren’t anchoring as many centers as they did 5 years ago.”

Specialty grocers have a more troubled history of anchoring centers, according to Boardman, who cites the example of Henry’s Marketplace closing all of its stores in Phoenix, leaving some centers high and dry without an anchor.

The Henry’s pullout and the 2006 closing of several Albertson’s food stores didn’t cripple many centers, however, as other retailers stepped in. “Most of the empty boxes were re-leased,” observes De Rito’s Butterworth, who sees the oversupply of big boxes decreasing steadily, especially as new retailers enter the market. “Chains like American Home Furnishings, Ranch Market, Dollar Tree, D.D.’s Discount Stores and Ace Hardware have jumped on some of these opportunities.”

As Butterworth claims, Phoenix continues to be a magnet for out-of-state retailers and even some out-of-the-country retailers. She points to Tesco, which operates 1,900 stores in Great Britain and Asia, as poised to flood the Phoenix metropolitan area with as many as 50 neighborhood markets. “Typical store size will be 15,000 square feet,” she says, “and they will go under the name ‘Fresh & Easy.’ Twenty stores or more could open this year.”

Market Makers

The robust growth of the Southwest retail market can largely be attributed to basic demographics — new residents pouring into the Phoenix and Albuquerque metro areas in astounding numbers. But that’s just part of the story. Another major factor — virtually non-existent in most of the older, more mature markets outside the Southwest — is road building. In the past 6 years, upwards of 62 miles of new freeways have been built in the greater Phoenix area. For developers, that spells opportunity.

“Nothing spurs retail development like new freeways,” asserts David Larcher, founding principal and executive vice president of Vestar Development Company in Phoenix. The 2006 edition of Vestar’s Phoenix Area Map instantly underscores Larcher’s point. The map is crowded with blue, three-dimensional “Vs” indicating the locations of the company’s existing, under construction and planned retail projects. Many of the V’s are at the far edges of the map, alongside new roads and sprawling housing developments.

While acknowledging the inherent validity of the time-worn adage that “retail follows rooftops,” Larcher insists that creative retail can influence not only where homes are built, but the quality of the housing stock as well. “We’re typically working on sites well ahead of the houses,” he says. “Many times it’s a 5- to 7-year process.”

Getting in ahead of the homeowners also makes the entitlement process — a bane to some developers — much less stressful. Larcher cites Vestar’s Queen Creek Marketplace as an example. “We actually worked side-by-side with Queen Creek in developing the town’s general plan. That was 5 years ago, and the 1 million-square-foot regional power and entertainment center is now under construction. More than 250,000 additional people are projected for the trade area.”

“Retailers are committing to corners well ahead of some of the freeways,” agrees De Rito’s Butterworth. “Power centers are gobbling up space at the choice off-ramps, anchored by The Home Depot, Lowe’s Home Improvement Warehouse, Mervyn’s, Kohl’s and JC Penney’s, among others.”

Rooftops and roads are the main market makers in Albuquerque as well. “The Paseo del Norte Corridor (east of Interstate 25) has been quite strong for the past 2 years,” observes Steve Maestas, co-founder and managing partner of Maestas & Ward Commercial Real Estate. “But I believe that Rio Rancho will capture most of the activity in 2007, followed by the Southwest Mesa and South Valley submarkets.” Maestas points out that all of these areas experienced strong residential growth in the past few years, and that Rio Rancho and, more notably, the southwest submarket remain underserved from a retail perspective.

Besides adding more houses and highways, the growing Hispanic consumer segment is having a significant influence on retail in Albuquerque, Phoenix and throughout the Southwest. In Albuquerque, Pro’s Ranch Markets are geared primarily toward Hispanic consumers. “Pro’s Ranch is considered to be the Whole Foods of Hispanic grocers,” observes Tom Jones, vice president of retail at Grubb & Ellis/New Mexico. “They do a fantastic job and their sales volumes are absolutely staggering. They’ll soon be occupying the former Wal-Mart space at Atrisco Plaza, adding a much-needed retail component to the underserved South Valley market.”

Phoenix’s West Side Story

It wasn’t very long ago when the valley west of Phoenix was dominated by farms and cotton fields. Not any longer. The West Valley is a bubbling cauldron of development activity, spurred by the opening of the Agua Fria portion of the Loop 101 Freeway and a portion of the Loop 303 Freeway between US 60 and Interstate 10.

Westgate City Center in Glendale, Arizona

The retail centerpiece of this West Valley renaissance is Westgate City Center, a mixed-use urban center occupying a 223-acre site at Loop 101 and Glendale Avenue. Adjacent to Jobbing.com Arena — home of the Phoenix Coyotes and Arizona Sting sports franchises — the uniquely designed center features a dazzling array of gigantic lighted outdoor ads and a 60,000 gallon dancing fountain.

“Our Arizona deco design infuses a touch of South Beach, our billboards incorporate Times Square and our water feature was inspired by the Bellagio in Las Vegas,” explains Steve Ellman, president and CEO of Phoenix-based The Ellman Companies that is developing Westgate. “Westgate has shifted the pendulum for sports and entertainment from the East to the West Valley.”

Kierland Commons in northeast Phoenix

The unique design hasn’t gone unnoticed, as, like Kierland Commons, Westgate has emerged as a “must-see” stop for itinerant developers looking for cutting-edge ideas. “Glory Park in Dallas and LA Live in Los Angeles are now borrowing our design concept,” says Ellman, who cautions that other metro areas may not be able to duplicate the explosive growth being realized in Phoenix’s West Valley. Ellman projects that the complex will draw more than 26 million visitors annually at build-out within 5 to 7 years.

Two’s Company

Freeway interchanges always attract a developer crowd, but things get even more interesting when the rare opportunity arises to claim a spot where two new freeways intersect. Such is the case where the Loop 101 Pima Freeway in the East Valley bisects the Loop 202 Red Mountain Freeway.

Two signature retail projects are now under construction at this high-profile location where rival cities Tempe and Mesa meet. On the Mesa side, De Rito Partners is building Mesa Riverview, a mega-project that will include auto dealerships, The Home Depot, Wal-Mart Supercenter and Cinemark Theatres. But the main attraction will be Arizona’s first Bass Pro Shops Outdoor World, one of only three planned for the entire Southwest.

Tempe is counterpunching with Tempe Marketplace, a 1.3 million-square-foot regional power, lifestyle and entertainment center. Developed by Vestar, the project — the largest brownfield cleanup in Arizona history — will include, among other nationally known store names, Target, Sam’s Club, Best Buy, and Barnes & Noble. It was the tenants that ultimately made the project work.

“They stepped up,” Larcher confirms. “Land costs are already high, but when you pencil in $28 million in environmental costs, something has to give to have the deal make sense. Our tenants saw the strength of the location — where two freeways meet and more than 360,000 people already live within a 10-minute drive — and worked with us to make it happen.”  

Three’s A Crowd

If any location is to earn the title of “ground zero” for retail development in the Southwest, that place will almost certainly be a one-mile stretch on the Loop 101 Pima Freeway where north Phoenix meets north Scottsdale. Along this short arc of road, three heavyweight developers and two competing cities are gearing up for a Southwest retail roundup like none ever seen.

With CityNorth, Chicago-based developer Thomas J. Klutznick Company claims to literally be building a city on a 144-acre site that actually spans the freeway. The list of uses would seem to validate the claim — retail, restaurants, residential, hotel, office, cultural, civic, entertainment and fitness. Popular Councilwoman Peggy Neely, who’s Phoenix District 2 includes the site, agrees. “It’s more than a development,” she beams, “it’s a city in the making.”

With its enormous size and head start, Klutznick’s city-within-a-city is well-prepared to take on the Valley’s undisputed retail mall kingpin, Westcor, in competing for top-name tenants. The Chicago developer has already turned some heads — probably spun some around — when it announced on August 29, 2006 that Nordstrom had signed on with CityNorth. Conventional wisdom had it that the Seattle-based fashion retailer would align itself once again with Westcor, since that Macerich subsidiary owns the two Phoenix area malls where Nordstrom is currently a tenant.

Despite its towering stature in the Phoenix retail landscape, Westcor is the decided underdog as the tenant tussles take place. Westcor doesn’t yet have control over the land on which it hopes to build Palisene, another multi-use, open-air center promoting itself as the “Standard for luxury shopping in the Southwest.” Although Westcor has been huddling for more than 10 years with the City of Phoenix and the Arizona State Land Department, which will auction the land, no bidding date has been set.

One Scottsdale in Scottsdale, Arizona

The third entrant in the “ground zero” retail sweepstakes is DMB, which privately owns 120 acres of prime turf in Scottsdale on the east side of Scottsdale Road, the dividing line between that city and Phoenix. Dubbed One Scottsdale, the project also promises to deliver “a unique luxury retail and lifestyle community” for sophisticated buyers, including 400,000 square feet of “world-class” retail shops and 10 to 15 posh restaurants.           

As 2007 slips into its third month, the colossal clashes expected among such mighty retail combatants for the toniest tenants seem to have dwindled down to a more peaceable sorting process. “We’re certainly aware of what’s happening with our neighbors,” acknowledges Robert Mayhew, who oversees the development, marketing and management of DMB’s commercial properties, “but our niche is more focused. We have a lot less retail space in our unanchored project, and perhaps only 20 to 30 percent of the tenants we’re interested in will overlap with them. They can start by filling spaces with secondary, lower-profile tenants. We can’t do that. It’s a different product.”

All three developers obviously feel that there’s ample room to grow the luxury or fashion component of the Phoenix retail market. And all three face a similar challenge — not just competing with each other, but convincing the highest of the high-end retailers that the time has come to make their mark in this increasingly sophisticated and blossoming desert community. “We have to convince them that the market has matured to the point where they can achieve success here,” says Mayhew.

The Wellspring

Last month, REBusiness Online released the results of a survey probing the question, “Is there a surplus of lifestyle centers?” More than half, 53.6 percent of the respondents, didn’t think so, but an additional 19.8 percent warned that the product type was in danger of being overbuilt. A little more than a quarter of the respondents — 26.6 percent — had seen enough of the much-ballyhooed concept.

In Phoenix and the Southwest, the mountaintop — the place where developers go to soak in the ethereal essence of lifestyle centerism — is Kierland Commons. In the Southwest, and perhaps elsewhere, the notion that shoppers might prefer a conveniently approached and easily surveyed open-air environment in a leafy pedestrian-friendly atmosphere is known as “The Kierland Concept.” Interestingly, the people who built Kierland Commons in northeast Phoenix weren’t even trying to set a new trend.

“We didn’t create a new model,” insists Daniel “Buzz” Gosnell, president of Woodbine Southwest. “We simply resurrected an old model, one that evoked nostalgia among consumers. Our goal was to bring back Main Street America and all it represented.”

The retail component of the project that created all the hubbub comprises 70 specialty retailers, including Crate & Barrel and Coldwater Creek. It was the layout, not the tenant mix, that changed the way retail is presented in the Southwest. And it was smashingly successful, although even Gosnell can’t grasp the full measure of it. “We didn’t have an economic baseline to start with,” he maintains, “since it was a new type of concept. I will say, however, that we probably doubled our expectations.”

As far as the next generation of lifestyle centers, Gosnell doesn’t anticipate any radical change. “The next step will likely involve adding more elements to the model by combining — vertically as opposed to horizontally — uses that function well together. You’ll see more stacking on top.”

Cap Rate Compression

If tenants aren’t quite hovering to pounce on available retail space, that image unquestionably does apply to retail investors in the Southwest. At year-end 2006, the vacancy rate for all types of shopping centers in Phoenix, exclusive of regional malls, was just 4.77 percent, down from 5.23 percent at year-end 2005, according to data compiled by CBRE. As expected in tight markets, rental rates are on the upswing. This combination, coupled with the soaring cost of buying land and building new centers, has lured every type of buyer to the retail investment table including REITs, family trusts and tenant-in-common (TIC) buyers.

Owners who might be sellers are quite aware of the leverage they have, and this is strikingly reflected in the going prices and cap rates for retail product. The worsening imbalance between strong demand and limited supply has pushed prices up and driven cap rates down.

However, some buyers weren’t biting. “Cap rates went crazy last year,” bemoans Red Mountain’s Michael Mugel. “Many assets were placed on the market and just sat there.” Mugel anticipates some improvement as 2007 wears on. “The investment market slowed down the last 4 months of 2006, but it has picked up quite a bit already in 2007. That said, I don’t think cap rates will fluctuate any more than 0.25 to 0.5 percent.”

In spite of taking a more cautious approach to cap rates in underwriting transactions, Mugel has Red Mountain Retail Group positioned as an active player this year. “We are currently negotiating to buy a several asset portfolio in the Phoenix area,” he says. “Our plan is to dispose of some of our Class B and C assets and continue to upgrade our portfolio.”

Nor are savvy investors ignoring Albuquerque. “With a population reaching more than 850,000, the greater Albuquerque area now offers the critical mass national retailers need to take this market seriously,” explains Michael Kelly, president of Q10 Realty Mortgage & Investment Company. He adds that it hasn’t hurt either that Forbes magazine anointed Albuquerque as the nation’s No. 1 “Best Place for Business and Careers” in 2006.

“I would describe the current retail investment market in Albuquerque as strong,” asserts Kelly. “Developers are acquiring locations and designing the type of product that national retailers are seeking. This trend has attracted a lot of investor attention.”

Maestas & Ward’s Steve Maestas agrees, stating, “The overall economic picture is healthy in the Albuquerque area.” But Maestas also feels that this degree of healthiness does have a downside, especially for second-tier retailers. “As long as demand outweighs supply, second-tier retailers will have a difficult time securing the few Class A locations that are not developed,” he explains. He also notes that secondary sites are becoming scarcer as competition increases. “Even the larger retailers have limited choices and alternatives, unless they decide to seek farther out locations.”

Ned O’Hearn is a principal with Scottsdale-based Boulders Realty Advisors.

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