FEATURE ARTICLE, SEPTEMBER 2005

OUTSIDERS SET SIGHTS ON ARIZONA RETAIL
California investors see golden opportunities in the Valley of the Sun.
Frank Demeter and Ned O’Hearn

It’s no secret when a shopping center is sold in Phoenix that the buyer is probably from out of state — most likely from California.

While many industry insiders in Phoenix continue to raise eyebrows over prices paid for retail product there, Californians oftentimes don’t bat an eyelash. “You can’t shop Phoenix for bargains, but the market is robust and less congested with buyers, and the prices, though high, still make sense,” says Andrew Van Tuyle of Los Angeles-based SCI Real Estate Investments.

SCI, which specializes in tenant-in-common (TIC) deals, recently bought the 130,100-square-foot Casa Paloma neighborhood center in Chandler, Arizona, for $43.6 million. As Californians scouring the Arizona landscape for deals, the firm is not alone. Of a survey population of 40 neighborhood and power center sales in the past 2 years, 72.5 percent were sold to out-of-state buyers. Close to half the sales (47.5 percent) involved buyers from California. All-Arizona deals involving an in-state buyer and seller represented only 12.5 percent of the transactions completed.

California buyers expressed concern about declining inventory in Arizona and especially in their home state, more than rising prices. Peter Kleis, a San Francisco-area private investor, has been driven into markets like Phoenix by the lack of inventory in his own backyard. “There’s simply no room to build, so those who own existing centers are sitting on a goldmine,” he says. “What’s the motivation to sell?”

Overall, today’s retail buyers don’t appear to be overly focused on factors that might demand more attention in a less competitive market. A 2-year look at the top 20 percent of sales as measured by dollars paid per square foot reveals little in terms of critical trends or correlations, other than buyer origins. The retail centers that captured the highest price per square foot all featured out-of-state buyers, more than a third of which swooped in from the neighboring Golden State.

Municipal preference was not a factor. The top deals were spread quite evenly across the Valley, with only Phoenix and Chandler (two each) hosting more than one of the top sales. Avondale, Chandler, Fountain Hills, Glendale and Scottsdale also made the list.

Size didn’t matter. Three transactions produced per-square-foot sales exceeding $300. The top deal involved a 130,000-square-foot center in Chandler. The third-ranked sale involved a 34,000-square-foot center. Age was a factor, somewhat. The centers bringing in the most dollars per square generally were under four years old, although one in the top group was built in 1985.

Occupancy was a factor. Of the top sales, only 25 percent featured occupancy levels below 90 percent, and none of them registered below 85 percent. Of the total centers that sold during the review period, fully two-thirds were 95 percent leased or better, and four out of five exceeded 90 percent. A scant 11 percent sold with occupancy levels below 85 percent.

Quality of tenancy is always important, though difficult to quantify. A reasonable proxy for quality of tenancy is the overall condition of a center, since high quality tenants gravitate to or tend to stay with attractive, well-maintained centers. Anyone hooked on the popular public television program Antiques Roadshow will tell you that condition is always important by itself, and retail shopping center buyers clearly subscribe to the same philosophy. Of the 40 sales analyzed, 27.5 percent were rated as “excellent” in terms of condition. Tellingly, 62.5 percent of the top deals warranted this highest rating.

Buyers don’t seem biased towards certain types of anchors as analysis revealed negligible correspondence. Slightly more than half (57 percent) of the centers sold involved a food anchor (or shadow anchor), whereas the remaining 43 percent featured a merchandise anchor. No appreciable difference in cap rates between food-anchored and merchandise-anchored centers with “high investor appeal” (defined as 90-percent-plus occupancy and an “excellent” or “good” condition rating) was observed. The most appealing food centers sold at an average 7.44 percent cap rate while the merchandise centers sold at an average of 7.48 percent.

Less than a quarter (23 percent) of the total sales examined were straight cash deals. Only 10 percent were 90 percent or more leveraged. The average loan was for 75.3 percent of the sales price.

“Days-on-market” information was available on about a third of the total sales. Correlations between time on the market and three factors — year built, condition and percent occupied — were analyzed. Quite predictably, the quicker sales involved highly occupied newer centers in top condition, with occupancy arguably the most critical factor.

Time-critical exchange deals are most certainly influencing sales activity. Among the buyers interviewed, more than half noted that their purchase was part of a 1031 exchange. More than half also described their minimal “comfort zone” on retail investment returns at 6 to 7 percent, the low end of the choices presented.

Outside buyers with voracious appetites for Phoenix-area projects are not, however, oblivious to what’s going on. They just don’t see major problems looming ahead. When asked if the much-ballyhooed bubble was real and whether it might burst or simply deflate, not one California buyer forecasted a dangerous scenario precipitated by a bursting bubble. The majority anticipated a slow deflation, and some expressed bold confidence that the bubble talk is greatly overstated.

“It’s not a matter of straying from fundamentals,” contends Kleis. “Some retail centers are deserving of low cap rates, others are not. A Bashas’ Supermarket-anchored center in Apache Junction should be selling for 150 basis points higher than a Bashas’ Supermarket center on Scottsdale Road, but that isn’t always the case.”

Investors like Kleis aren’t bothered by all the buzz about bubbles. “The industry is not as broken as it was 10 to 15 years ago,” he says. “Having bidders line up when a good center hits the market is not a phenomenon — it’s the norm. The buyers will always be there.”

Van Tuyle agrees: “There’s an underlying demand for stability in our industry,” he contends, insisting that real estate isn’t poised for a plunge reminiscent of the technology stock fiasco a few years ago. “I don’t foresee waking up to a 10-cap world anytime soon.”

And what will happen to the industry when interest rates rise or the sizzling housing market cools? “What you’ll see then is the return of the all-cash buyers, REITs, and foreign buyers who are willing to pay more because of the deflated dollar,” says Van Tuyle.

More for the right deal, that is. Even optimists like Kleis see Phoenix as a somewhat risky market. “Phoenix has lots of land and the market is constantly growing, and that means that tenants will always be tempted to jump,” he warns. “There are two sides to growth.” Though openly bullish on Phoenix, Van Tuyle sees interesting opportunities unfolding in some of the less-contested markets like Albuquerque.

What all this indicates is that although fundamentals are important, and will remain important, deals of all types and shapes are making it to market and finding willing buyers. Or, perhaps better stated, buyers are finding them. Phoenix continues to be a retail investor’s haven, and, more than ever, the money pouring in is money that couldn’t find a deal to chase at home in California.

Frank Demeter and Ned O’Hearn  are principals with Scottsdale, Arizona-based Boulders Realty Advisors.

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