PARTICIPANTS

Michael Cohen
Head of Mid-Atlantic and Southeast Origination
Citigroup CMBS and CREF

Fernando De Leon
Managing Partner
Leon Capital Group

Ted Frumkin
Senior Vice President of Business Development
Sprouts Farmers Market

Michael C. Phillips
Principal, President and Chief Executive Officer
Phillips Edison & Co.

Bill Rose
Vice President and National Director
Marcus & Millichap's National Retail Group

Rahul Sehgal
Chief Investment Officer
Inland Private Capital Corp.

MODERATOR

Ian Ritter
Retail Real Estate Reporter
Real Estate Forum

IAN RITTER: What kind of impact will the Safeway-Albertsons merger have on the industry? Do you foresee a lot of vacancies as a result? If so, can they get backfilled?

TED FRUMKIN: This is just a continuation of the consolidation we've seen in our industry. The traditional grocers have been faced with increasingly strong competition for food dollars from big box retailers like Walmart and Target, specialty grocers like Sprouts, drug stores and dollar stores. This, coupled with the continued growth of the natural/organic sector, is fundamentally changing the way consumers think about grocery shopping. It is a natural progression for retailers like Sprouts to consider backfilling any opportunities created by this consolidation. From Sprouts' perspective, it will create opportunities in markets that otherwise would be more difficult to penetrate. However, we know that there will likely be competition among retailers for any sites that come onto the market.

FERNANDO De LEON: Inevitably there will be vacancies as a result of spacing and concept similarity. They're both middle-market grocers. The specialty grocers on one end, and the value concepts on the other, are driving this consolidation. We've backfilled Albertsons boxes, and what we found is that retailers are looking for smaller footprints with more efficient prototypes, so we are having to demise spaces and build expensive landlord work letters and tenant improvements, all of which necessitate higher rents. This is in the context of fewer backfill prospects every year.

MICHAEL PHILLIPS: If there were a lot of new building going on, this would be more worrisome. Since we don't have a lot of new supply coming on in the next couple years, absorption will be significant, and most of them are good locations where landlords will get control of that space. That will mitigate a lot of dislocation.

BILL ROSE: Mike Cohen, you're financing a lot of properties. When you look at these, do you care who the grocer is?

MICHAEL COHEN: At Citi, we look for fundamentally sound real estate and are aggressive when we see an opportunity for grocery-anchored centers. We want to know the grocers in that market. Who is number one? Are they new to the market? Who are they replacing? We also want to know where the Walmart Super Centers, the SuperTargets and some of the lower-priced options are. We're definitely keyed in on knowing their sales or projected sales. We do see a lot of anchors with short lease terms remaining but with options and structure around that. When looking at smaller grocery store formats or new stores to the marketplace, we're typically looking at the remainder of the center and to see the tenant mix and traffic counts.

FRUMKIN: I agree that consumers today expect more from their food—and from their retailer. The tremendous growth in the natural/organic space is being fueled by the macro-shift in consumer behavior towards health and wellness and their gradual move away from the highly processed foods offered from the supermarkets. At Sprouts, we prioritize service and education, because there's a lot to know about natural foods, so engaging the customer is key to our success. And our Healthy Living for Less philosophy appeals to a broad segment of consumers from varying demographics and income levels—not just an affluent segment of the market.

RITTER: So can the middle-market grocer compete, or is it getting squeezed out?

ROSE: You've got a traditional grocer, Kroger, and now a Safeway-Albertsons. They represent 10% and 6% of the current marketplace, while Walmart combined is about 29% of the marketplace. The nice thing is we now have these specialty grocers that provide gourmet, fresh whole-food-type, fresh-to-market and vitamin/health-oriented products. That's really where the growth is in the business, and it's really great for landlords who want to continue to improve upon their merchandising mix in their open-air centers.

PHILLIPS: The new concepts that address the diversity in the customer base are the ones that are successful, and that's through the entire spectrum of price-to-quality to service. Retailers are looking at what the customer wants, and the customer is looking at the retailer and saying, “this does not meet our needs.” So it's a cycle that is healthy for the industry. One of the things about retail is if you don't keep up, and you're not strong with the customer and meet their needs, you probably won't be around very long, and that's what has happened in the migration toward specialty.

De LEON: The middle-market grocers need to define their identity and update their brand or risk losing market share. Trader Joe's, Whole Foods and Sprouts have cult-like followings, and it makes it hard to compete for the grocers that have commoditized the food-distribution business. People are growing concerned about the quality of food that they consume. They're not blind to obesity rates and the lifetime of health problems. The education process will take a while, but long term, I don't know how you can reverse this new consciousness.

RITTER: Coldwater Creek is liquidating. There seems to be a lot of concern about some of the mall apparel chains not doing enough to draw in customers. Is this true?

ROSE: If you're not reinventing and constantly pursuing the trends in the market, you're going to dry up. One of my favorite examples in apparel is Bonobos. This concept is directed toward men who are very busy: “Measure me, and then, when I need product, sell it to me.” It's very experiential and meets the demand curve. Most importantly, it's a multichannel delivery. It has both bricks and mortar and e-tailing, and that combination is paramount for any landlord to have in their shopping center. If the retailer doesn't have a multichannel delivery system, they'll probably go by the wayside.

PHILLIPS: The traditional retailers, particularly in men's ready to wear, are missing the blending of technology and the product at the actual site. One of the secrets for Apple, and the reason they're so successful, is that it blends social networking with bricks-and-mortar presentations. Right now a lot of the retailers are close to that. Macy's has been spending a lot of time understanding and incorporating it into the stores. It doesn't necessarily mean that you're going to cater to a younger customer. It just means that you're going to address what the customer wants and how the customer is actually shopping in the 21st century.

RAHUL SEHGAL: We're looking at things from a slightly different perspective. I spend a lot of time focusing on the retail-sales index, and clothing has done well. When you look at certain sectors like electronics, appliances stores, building materials and garden equipment, we still haven't seen a recovery. We're looking at a more permanent shift in the way consumers are spending, as there's a mesh between social media and brick and mortar. For those items that tend to be more of a commodity, there is less of a chance that they will recover with the overall economy.

ROSE: Everybody seems to be over-concerned about the impact of the Internet. It's the exact opposite. The Internet is spurring retail-sales growth. It's making it possible for us to buy a product online, and if we don't like it, return it in the store and find something better. The Internet will continue to drive retail sales and be a greater impact for more store growth. In open-air shopping centers, the greatest thing is that we're providing goods and services that predominantly can't be delivered over the Internet.

RITTER: Let's discuss cap rates. Is there an overheating in the market for class A and single-tenant assets?

FRUMKIN: Obviously too low means different things to different people, but what we're seeing is that single-tenant, grocery-anchored centers are trading at much lower cap rates. This is because the investment community sees grocery-anchored centers as a stable and low risk investment in comparison to centers occupied by more discretionary retail businesses. This is based on three key metrics. First, grocery stores attract shoppers to the center on a consistent basis, sometimes two to three times per week. Second, grocery stores are typically considered to be non-cyclical businesses. And third, grocery stores to date are not experiencing much sales leakage to the Internet. Grocery-anchored centers therefore provide a hedge to investors. The consumer needs to eat whether or not the economy is good or bad. And, so far, online grocery concepts have been difficult to implement and have not been very successful. As long as these metrics remain, cap rates for single tenant grocery stores or grocery-anchored centers will remain low.

ROSE: In New York City, we're underwriting a number of retail condos, and many of these deals are trading as though they were core, meaning a 20-year credit tenant as though the lease were in place, even though the tenant is not yet identified. When you think about price per foot, it's generated by the exceptional rent that Manhattan has always been able to drive. We're from $300 to $600 per square foot, and these are capping out in the 4% to 5% range! The single-tenant net-lease world is continuing to deliver quality product. There is an insatiable demand for single tenant net-leased investments and it's now attracting foreign capital in major markets like Florida, New York and Los Angeles.

SEHGAL: When we look at the net-lease markets, we're looking at the cap-rate compression as a result of two factors: the availability of financing and the buyer looking for product, especially for a triple-net product that minimizes any sort of management or headaches that are typically associated with owning commercial real estate.

We're also still seeing a drastic shift in the overall economy, where the alternative investments such as CDs and the other “safest” types of investments are no longer providing yields to investors. You also have 10,000 individuals every day hitting retirement age, and there will be a demand for yield. There's no question we've seen significant cap rate compression, an increase in real estate values to the point where triple-net assets in particular are trading at higher price points than they were in 2007.

COHEN: We are seeing a tremendous amount of capital chasing the deals. We haven't really seen so much rate compression that we can't support it on a loan. But I am seeing aggressive competition for the retail throughout the Mid-Atlantic and the Southeast, especially in growth markets

RITTER: Is competition for B centers heating up as well?

COHEN: I've seen a lot of those deals come across my desk, and we've been successful in financing a lot of them. If the asset has a good tenant mix, location and a strong borrower, we will find a way to make the deal happen.

SEHGAL: We have about 40 shopping centers in our portfolio spread across the United States. Some of them are in secondary and tertiary markets, and we see an increase in demand for them. A large part of that goes back to the lack of supply, and part of that goes back to the cap-rate compression for class A. Investors are chasing yield and realizing that if the demographics aren't that different, they are choosing a secondary rather than primary market and can underwrite based on most of the factors that we would look at—lease term remaining, probability of renewal and the credit quality of the tenant. We are starting to see cap rates compress in those markets, but only since late 2013.

Since we have the ability to raise capital for a variety of funds at the same time, we have always looked at secondary markets because there has been more opportunity. But now since the secondary and tertiary markets are seeing such an increase in demand, we're also looking at how to be creative and innovative. We're even expanding into other asset classes such as medical office and storage and figuring out other ways to create value.

PHILLIPS: We have not been focused on the coastal regions. We are looking for properties where there is good, solid growth over a sustained period. We've been doing it for a long time privately through a lot of different funds. When we started out, we did mostly opportunistic properties and a lot of them were in secondary markets.

Today, our largest fund is the non-traded PECO-ARC fund, which has about 120 centers and specializes in stabilized grocery-anchored assets. Those can be distributed throughout the country. We look for solid sales, the number-one grocer in the market, and if they happen to be in the Los Angeles area, Phoenix, Dallas, Houston or any of those areas, we like that, but we've always bought a number of things in the Midwest, Southeast and Mid-Atlantic states.

ROSE: It's good to see the middle market start to blossom. As we came out of the recovery, everyone wanted to invest along the coasts, and then yields compressed, so investors today are now pursuing yield in the middle markets. That means Denver's a great market. Chicagoland is still a very solid market with good growth opportunities. Texas has always been a wonderful market, and if you consider centers in San Antonio or Austin, there's enticing yield to be found.

Yields are usually a seven cap in these markets, which is favorable considering the financing terms available. Investors can also grow rents and retool a center in a market that's at a crossroads of growth and income.

RITTER: What investors are entering the market right now?

De LEON: We've witnessed a great influx of foreign equity capital. On the debt side, in 2009, we were an equity investor in a bridge-debt program intending to take advantage of the capital markets dislocation. We were originally on track to originate about $800 million annually and today we've basically stopped originating new loans. From 2009-2012 we were competing against one or two term sheets, and today we are competing against seven or eight. With so many new market entrants, margins have compressed to a level where we can deploy capital elsewhere for the same risk/return.

PHILLIPS: We're seeing more foreign capital looking for places to put money, and I don't think it's so much about yield anymore. It's security. That seems to be a motivation, and we're seeing more of the institutional-market capital markets coming to life and migrating here.

ROSE: In the private-client sector, foreign dominance is clearly from Canada, but we're seeing a lot of really good-quality investment, meaning deal size of $10-million plus, from Argentina and from the southeastern part of the world. Clients from Venezuela and Brazil are investing heavily into Florida. It's really a safe-haven play; they've got high inflation in those markets. In New York, it's from China and Russia. In California we see a big push coming in from China.

RITTER: Are you hearing of ground-up development coming back soon? Is there financing for it?

FRUMKIN: We're still seeing banks remain conservative when it comes to new construction, so my guess is that we'll sustain the status quo for the time being. The size of new ground-up projects continues to be small and we still see the advent of preferred development programs between retailers and a select few independent developers.

SEHGAL: Everything is a little bit more stringent than it was before. That's OK because, if you have a viable plan, we still have seen the financing available for those projects.

De LEON: In the Southwest, where we have strong household formation, we find the economics of ground-up power-center development difficult. Based on available market voids, rent structure, land and construction costs, it's tough to arrive at a healthy development yield. Occupancy costs for retailers have also reset. We're having more luck in infill and specialty developments and redevelopments.

PHILLIPS: We're just not seeing the deals for multi-tenant that have the returns we can achieve if we buy opportunistically and reposition a center. It's less risky.

The users that can drive development have not been bullish on getting out in front on the development cycle. They've been more concerned about making sure that their existing space is current and they have taken advantage of all of the expansion possibilities where they can improve sales.

ROSE: Deliverables this year are slated at 50 million square feet. This is year five of stagnant development at that rate, compared to 2007's height of over 220 million square feet. It's great news for rent growth, but is there a large power center being developed? There's a handful, but not what we've had in the past, and that's good news for the industry. The growth in mixed-used and urban-infill projects is healthy.

RITTER: How does everyone feel about the consumer right now? Are you comfortable with the “new normal” of unemployment rates and the different ways they're shopping?

ROSE: The consumer is very comfortable today. When I walk shopping centers, there's strong traffic. When I hear about new store openings, there are new concepts rolling out. Is it foolish and are people buying like crazy? I haven't seen it yet, but you also see very strong earnings by Nordstrom, Neiman Marcus and Saks, showing that luxury-good items are back in fashion.

PHILLIPS: Customers are a lot smarter than they've ever been. They have access to so much more information about products—where to get them, how to get them, how to price them—so as an owner of shopping centers, we're paying a lot of attention to that. We're trying to understand from a retailer's perspective if are they addressing that. We want to know what they're doing in the future and how they're addressing a consumer who's much more sophisticated than 10 or 15 years ago.

SEHGAL: Consumers are staying with the discount mentality. They're smarter, and although we've seen an improvement in the economy over the past 18 months, we're still seeing strong sales by discount retailers in our portfolio. Although the average consumer is doing better than just a few years ago, they're still looking at every dollar and spending much more wisely, remembering what happened before.

FRUMKIN: Since day one at Sprouts, we have been keenly focused on offering value and we remain heavily promotional. This strategy was consistent during the recession and remains so today. We sell produce for 25-30% below the conventional supermarkets on average, and this attracts both the natural lifestyle customer and the everyday grocery shopper. This is an important element of our success because it allows us to take market share from both our natural foods and supermarket competitors.