The shopping center sector is stoked. The capital floodgates have finally opened up after six years of ebbing tides. This year promises to be the year of acquisitions, with a deal flow that could easily run over into 2003. The shopping center sector is entering its third phase of consolidation, with investors gunning for strip centers and B-C malls. (The first phase was the REIT boom of 1991-93, when many developers took their companies public followed by a second phase in 1995-97, when capital-fortified REITs went on a wholesale acquisition spree.) While it's too early to put a price tag on total sales volume, the fervor suggests that phase three should be the sale of the century.

However, the timing is a mixed blessing for the retail sector, where management has been less sanguine about the current economic recovery. Credits that have been struggling to turn their businesses around, such as JC Penney, PETsMART, Restoration Hardware, Musicland (owned by Best Buy) and Albertsons, have recently told investors that a full recovery will not materialize until 2005. Others less humble but equally as hobbled, such as The Gap and Sears, have calendared 2003. Who are they kidding.

Today, two-thirds of the retail sector consists of speculative-grade credits -- of which The Gap is now one -- and the other one-third consists of supermarket chains. These high-yield retailers have been paying a huge premium to stay in the game since June 2000, when the wholesale debt downgrade of the theater chains cast the sector into a severe credit crunch. The Enron debacle did not help, as alternative sources (such as off-balance-sheet financing) became even more expensive (for willing parties). Kmart has shot down the confidence of private capital investors (such as Yucaipa), with its reorg looking more and more like a liquidation than a restructuring. And more recently, Rite Aid was caught again for accounting improprieties. (These last two retailers alone represent 5,400 strip center locations.)

Accessing capital has placed weak retailers at the mercy of financial loan sharks and the rating agency mob. Consequently, borrowing costs have been exceeding returns on assets by a huge margin of 1,000+ basis points! At these spreads, retailers are operating sinkholes that lose two dollars for every one invested. (For a credit ranking of 255 retailers, contact Retail MAXIM.*)

Capital is critical to sustaining a competitive advantage. If internal cash flow coffers are depleted and unable to provide cheap funding, a fungus known as obsolescence creeps into information technology systems and store portfolios. As pointed out in "Junk Space Contagion" (Reis Insights, 5/02), over 50% of retail's gross leasable area (GLA) is noncompetitive. If you doubt these stats, check out the sagging sales-psf numbers being reported for fiscal 2001, where sales-psf declines are 10%-15% for many of the high-growth retailers of the 1990s. Restructuring strip tenants, such as Albertsons, The Great Atlantic & Pacific Tea Company, Penn Traffic, Winn-Dixie and Wild Oats Markets, have not fared much better.

The real estate capital markets have been providing some relief through sale-leasebacks and private placements. But the acquisition dollars now pouring in could benefit tenants occupying properties that have been on perpetual deferred maintenance, by making them a better destination to shop. An infusion of capital into long-neglected assets under new ownership will serve to reposition centers with better tenants, but it could also send many on a death march. These same retailers could find their leases terminated to accommodate one or more of their competitors. Or worse, the center may be razed to make way for a new shopping venue that deviates from the original function.

On the flip side, an existing anchor might find cause to pick up and move down the road, leaving the inline tenants orphaned and to fend for themselves. How many times have grocers pulled this when title changes hand? Even strong inline retailers may find it difficult to survive. At one time, Radio Shack was one of the few retailers that could be profitable in a vacant center. But with the shorting of its wireless business and intrusion of Best Buy with a better model of electronic connectivity, the Shack may have to be rewired. No matter how you divvy it up, the redistribution of capital and power can cut two ways.

But the credit problems of the retailer are not a major concern to investors in shopping centers, who have surmised that the double whammy of a national and industry recession has washed up enough Jeanies in the bottle (aka, strip center opportunities). But to get the economics to work will take a lot of rubbing or massaging of numbers. If the investor is to get his or her three wishes, they better make sure that one is a cap rate commensurate with the growing levels of risk; the second, a retailer that Wal-Mart can't trounce; and the third, an exit strategy that has a buyer waiting at the back door in two to three years' time (before the Jeanie evaporates).

To gain insight on the "high-stakes buzz" of strip center investing, MAXIM surveyed the institutional investment community while attending the International Council of Shopping Centers Las Vegas Convention this past May. This annual event is essentially a leasing forum where retailers, landlords and developers meet to commit to shopping center space some 18 months out. The convention tenor is a good proxy of tenant demand. However, at this year's meeting, investors grabbed the floor from the leasing reps. Institutional capital converged en masse not to make commitments for refi's and TI's, but hard-core acquisitions, causing this year's theme to be "everything is for sale".

The last asset feeding frenzy of this magnitude occurred in 1995. Just as it was then, today's fundamentals are weak and cap rates are aggressively low. Yet, after a seven-year hiatus, the investment cycle seems ripe for the picking. But just how much can be picked off remains to be seen. Many opportunity funds have been quietly amassing huge portfolios of this product throughout the late 1990s. For the investors holding these assets, the sell orders must be exercised in 2002 (or 2003 at the latest) to get the most bang for their buck. The bid-ask price has finally been narrowed.

By the same token, the divergence between retail fundamentals and capital values is wider than ever. If the chasm continues to widen, there's no telling how many deals will fall into a black hole of values. It's like Friedrich Nietzsche said, "If you gaze long enough into the abyss, the abyss will gaze back." Or in layman terms, don't be a dummy in today's bear retail market and overpay for assets where the downside is plentiful.

These cascading contradictions in the current market recall one of my encounters at this Bacchanalian ball of dealmakers, where a funny thing actually did happen on the way to the forum. (That forum would be the Forum Shops at Caesars.) Here "MAXIM" met up with a commercial real estate broker who represents the Dutch supermarket behemoth Ahold. Flanked by Roman gladiators (no, not Russell Crowe but the casino's 9-to-5 hired hands), he was busily adding up his anticipated winnings in what portends to be a colossal sell-off of strip centers. Who cares if the bets are still being placed, he was convinced that the house was fully in his favor.

This broker, whom I will call Mr. High-Stakes, is betting on a long run of luck that is based on cap rates for grocery-anchored shopping centers declining well into 2008. When pressed for the magnitude of gains, he was confident that current rates of 8%-9% would drop another 100-150 basis points. That would put current going-in yields below the deflationary rates of the 1960s and 1990s, when economic growth was bountiful, supermarkets were the primary food channel and Wal-Mart was competing with Kmart for market share.

At these record prices, are strip investments "in-the-money" or out? On a relative value basis, grocery-anchored strips priced at 8% are 300+ basis points over 10-year Treasuries. If new owners can get income growth of 4%-6% in a deflationary environment, then back up the truck! But there is no guarantee that the low interest rate environment of the last decade will be sustained in the current one. Isn't the latest consensus on Wall Street that the Fed will raise rates by year-end?

For those of us who are not Fed watchers and heed the drum beat of retail fundamentals, how can someone be dumb enough to pay full price for strip centers that stand to be stripped of their original function, if not value? Aside from credit risk, food and apparel retailers are experiencing aggravated channel disintermediation from other formats. This can mean only two things: 1) depressed growth and productivity, and 2) rash defensive strategies.

The supercenter is the more immediate aggressor. In reaction to this one-stop shopping gorilla, strip center anchors have been inhaling the ancillary tenants (similar to what department stores did in the early 1990s to mall inline tenants). Gone are the video stores, off-price apparel shops, drug stores, vitamin outlets, Chinese and sushi take-outs, dry cleaners, banks, travel agents. You get the picture. All the local shops that once occupied the remaining 70,000 to 150,000 square feet of spec space are being displaced and/or relocated into the supermarket or discount store. Rising vacancies, consolidation, and relocation: These trends follow the relocation of drug stores from inline to outparcels. Walgreens sees no reason to pay rent when it can own its own corner on "main and main". Not only is the occupancy cost lower on a net present value basis, but the value to the consumer is also greater access and convenience.

This implosion of inline space is the most insidious form of consolidation that is squeezing the "jam" out of these bread-and-butter assets. What will be the alternative uses under such circumstances? And of course, there's good ol' Wal-Mart. (See Reis Insights, 6/02: Wal-Mart: We Are the World, We Are Your Landlord.) The downside in today's strip centers appears as limitless as an uncovered put option. Where's the hedge? Sounds like Mr. High-Stakes just may be out-of-the money on this one. Now that's dumb investing.

When I queried Mr. High-Stakes about several of the potential risk factors, he did not see how a price discount was warranted. I would agree if the grocery anchors were the better regional chains, like H.E. Butt or Wegmans. But the anchors in his deals were the multiregional supermarkets that were under siege during the late 1990s. He argued that these commoditized chains are defensive plays because people have to eat. Obviously, he does not do the shopping or cooking in his household. Nor does he seem to be aware that there are nine food channels now competing with the conventional grocer.

At this point, he's going for broke. He even went so far as to tell me that Wal-Mart will fail. I guess this "Boomer" plans to live another 50 years because it could take that long. Either way, well before the invasion of Wal-Mart and its cadre of supercenters and neighborhood markets, there were other "monkeys" crowding the backs of supermarket chains.

Because of the growing number of food channels, many chains have been in pursuit of the optimal format. What is the right size to get better volumes, greater market penetration and greater share? What should go inside? Be removed? Specialty counters, home replacement meals, organic food, dry goods, dry cleaners, video rental, drug stores, banks, real estate offices, self checkout counters, warehouse club aisles? The ancillary tenants from the rest of the center? And what should go outside...a gas station, a drive-thru meal takeout, a convenience store? Safeway's Vons thinks all the above should be added, and they have been in its new hybrid format in Vegas (of all places). The form and function of the average neighborhood center is clearly changing. Change means more volatility in one of real estate's most volatile asset classes.

It sounds like Mr. High-Stakes is truly a betting man. The probability that strip center cap rates could fall below 8% seems such a long shot, too. I felt like telling this "punter" to hit the cash out button one finds on the slot machines. This year and next will be a jackpot for sellers and buyers who can calculate the risks. Thereafter, investors will have to take to counting cards to breakeven on the high-edge approach that Mr. High-Stakes is proposing for buying shopping centers. Gambling is a very expensive way to beat reason. It's also a good way to shed confidence along with one's net worth.

Mr. High-Stakes' proposal is not a complete crapshoot, because there is a strong rationale to buy into the strip center sector. But buying right is the trick. Opportunities abound because of 1) the level of non-competitive space (See Reis Insights, 5/02: Junk Space Contagion.) that can be converted to more productive uses, 2) voids in secondary markets that were overlooked by retailers during the 1990s, but which do not have migrating households and employers, and 3) years of poor management. A generally sustained descent of National Council of Real Estate Investment Fiduciaries (NCREIF) returns and erosion in rents over the past decade illustrate the abundance of distressed centers that can be rescued by new capital, management and retail concepts.

According to Mr. High-Stakes, the best bargains can be found in markets that missed out on the 1990s' retail expansion (which may be a lucky thing if they include the overly aggressive credits now forced to shutter stores). The short list consists of secondary cities and regions in the Northeast and Canada. MAXIM agrees, but would add Kmart to the list for those looking for urban or in-fill locations with a complete re-do of the tenant mix, especially for those investors who have a penchant for dark assets.

But buying off the radar screen of metropolis America does not eliminate risk. First, retail's unrelenting recession has curtailed the expansion of many national and regional retailers into secondary markets. This leaves the barn door wide open for the "Boys from Bentonville" to enter with their flotilla of Wal-Mart formats. (See Reis Insights, 6/02: Wal-Mart: We Are the World, We Are Your Landlord.) Secondary markets and rural-suburban turf are Wal-Mart's domain (someone who you do not want to bet against if you're not an H.E. Butt or a Meijer). Look at the demise of supermarket Winn-Dixie that has been aggravated by Wal-Mart's expansion into the Deep South. Wal-Mart's strength is not only its rural roots, but its cross-consumer appeal that both transcends class and is multicultural. Selling to immigrant populations in small-town America has developed into a new consumer market niche, as the latest U.S. Census has shown.

Second, retailers who have expanded to lower density markets have been disappointed with store productivity and have begun to retrench. Many of these include traditional mall tenants that have sought new growth in strip centers. According to the MAX-SI Spatial Index, the store expansion of strip center retailers will decline over the next two years. Driving this trend is consolidation, liquidations, illiquidity, competition and poor economic conditions.

Figure 1. Net Store Expansion: Strip Center-Based Retail

Third, no amount of geographic diversification will stem the erosion in net effective rents, not in a sector where excesses prevail. Presently, there are an estimated 40,000+ strip centers nationwide. During the late 1990s, new construction expanded existing supply by a robust 5%. The supply-demand imbalance has taken its toll on rents. In real terms, net effective rents have been sharply declining since 1998. (See Figure 2.) Of course, innovative management capable of designing strip retail around the demographic changes that are filling a void will beat the downtrend.

Perhaps Mr. High-Stakes' proposition makes a lot of sense, at least from a short-term perspective. Shopping center investments are paying the punters 100-to-1 for those who can find a buyer in the third year. This would appear to generate enough of a return to compensate for the various risk scenarios, providing that you are a seller. Under these terms, it's clear that the money to be made is in hard assets, not paper (as in stocks and bonds). It may be time to redeem the mutual funds draining our 401-Ks, and head straight to the nearest Coldwell Banker to be cut in on the deal of the century.

Even the sage of Omaha, Warren Buffet, has developed a dour outlook on the stock market. In a letter to his investors, Chairman Buffet of Berkshire Hathaway, is predicting that earnings for corporate America will grow by a mere 6%-7% over the next six years. [A more bearish (or realistic) forecast was recently published by Bridgewater Associates predicting earnings growth between 1%-3%.] If one accepts Buffet's lofty outlook, growth in the current decade will be one-third the rate of the 1990s. To achieve this growth, however, the S&P P/E ratio needs to remain at its current multiple of 42 times. Now that's a long shot. But so is six years of double-digit asset appreciation in neighborhood centers, which is what is needed to justify current cap rates.

Obviously Mr. High-Stakes is waging his bets on the bubble vision of Wall Street and not the grounded observations of value-investor Warren. The latest earnings forecasts of sell-side analysts show supermarket chains growing their bottom line by 12%-16% over the next five years, making them comparable to Wal-Mart, at 15%! To think that grocery chains, whose growth is impacted by population growth and competition, can grow at a multiple that is 15 times the expansion of the buying population -- awesome! For Wal-Mart, whose population targets are now global, double-digit growth is probable, but not for Safeway, Kroger and Albertson, whose management continues to rationalize their business (a euphemism for downsizing).

For those nervous about ptomaine poisoning (the growing food risk from Wal-Mart) and looking for an anchor replacement, there is newcomer Kohl's, which is rolling out stores every three miles in strip centers across the nation. Earnings growth for Kohl's is forecast at 24%, double the profits of department stores. But this discount department store may not be the best hedge if MAXIM is right about Wal-Mart's foray into strip center apparel. (See Reis Insights, 6/02: Wal-Mart: We Are the World, We Are Your Landlord.) Which brings me to the next issue in this wonderful zany world of asset values.

If Mr. High-Stakes is right about the strip center pricing, cap rates will be crossing over mall yields this year, just like they did in 1995. (See Figure 3.) Traditionally, grocer-anchored centers have always been riskier investments than regional malls, and are priced accordingly, at a 300-500 basis-point differential. But the latest comps say different. The last bread-and-butter grocery-anchored sale closed by a REIT had a cap of 8.2%. The last mall sale cap was 8.5%. This pricing is tight relative not only to asset class, but to risk-free investments, such as government securities, as well. What has changed to shift the risk-reward in favor of such high-yield assets? Lots.