McNellis: Lords of the Pipeline

The worst is over and recovery begins.

November 1, 2011

By John McNellis

At last. September’s ICSC Western States Conference in San Diego was more upbeat than beat-up; it had more site plans than job seekers. In fact, your correspondent—in yet another unreliable, anecdotal survey—encountered only two truly unemployed.

What he did see again and again was the shadow of a distant retail overlord trembling with fear, an all-seeing Sauron who has at last turned his penetrating gaze inward into his personal Mordor and glared down his new-deal pipeline and seen nothing. Nothing but the abyss. Nothing but his own demise at the hands of an angry board of directors. Suddenly remembering his own career depends on new stores, the aerie-dwelling chief executive has bellowed with rage at his deal Orcs (apologies to my dear friends among this group) to scrape the rust from the great pipeline-sealing valves and wrench them wide open.

Whether exactly that has occurred is not apparent, but it is certain that real estate managers are at last scurrying for product. “I know we passed on that site last year, but submit it again; things have loosened up.” Or, “Between you and me, my bonus is based on getting stores open. I gotta find some deals.”

Particularly heated is California’s great race for supermarket locations in the hitherto scoffed-at 20,000 square-foot to 30,000 square-foot range. Long viewed as too small to go toe-to-toe with the great flagship markets of 60,000 feet plus (“We had a destroyer; they had an aircraft carrier. Of course we lost.”), this back-to-the-future size is suddenly all the rage. In addition to the Whole Foods wannabes—Henry’s, Sunflower Markets, Sprout’s and now Fresh Market—jamming this particular food aisle, Wal-Mart is shopping hard with its new small-store concept.

This may bode well for developers, at least for those who can get their hands on a reasonably priced, second-generation box to renovate. Best to keep the champagne on ice though; these tenants all want single-digit annual rent deals. Yet as every developer knows: One tenant interested in a space equals breadline; two tenants competing for the same space equals second home at the lake.

With the truth-stretching hyperbole required for a good story, it might be said that this year the International Council of Shopping Centers was all about food—the welterweight markets and fast food. As to the latter, everyone in retail has finally figured out that the one thing The Endless Bummer didn’t do was cause any of us to lose weight—we’re eating more than ever and, as long as it’s cheap enough, we’re eating out. The QSR’s—quick-serve restaurants—are back, voraciously chasing deals up and down every freeway corridor in NorCal.

As for retail investments, the ICSC confirmed what we already knew: It’s a tale of two shopping centers. Trophy assets (the trophy, by the way, is for paying too much) are back to selling within 25 basis points of their all-time prices. If it went to market at all (a big if), a well-located neighborhood center with a strong grocery anchor would have dozens of bidders and likely go in the low 6 percent cap range. Same, if not more true, for the larger properties. The guys running opportunity funds are finding more challenges than opportunities, and heavy competition is back in the $20 million and up range. The buyers are paying big. Money may never sleep, but money managers do.

The other tale is about ugly, hard-to-renovate, mostly-empty centers in towns your family has never heard of. At least some of those are now priced where one can make a decent profit at today’s rents if (another big if) one can renovate and successfully re-lease the property. Example: a center that’s 70 percent vacant yet priced to yield a 4 percent cash-on-cash return on existing income in a mid-sized, Greater Bay Area town. Given that one can borrow short-term at the same rate—or leave the money in the bank at .01 percent interest—the lease-up risk isn’t that daunting. The huge assumption, of course, is that the location warrants a renovation rather than a bulldozer.

Shifting to the view from 30,000 feet, this ICSC left one concluding that the bad news—at least for Northern California necessity retail—is over. The industry is solidly floored. The retailers who needed to go out of business have done so. The remaining tenants have adjusted to their lowered sales volumes and, if not thriving, are doing well enough, some so well as to be expanding, especially the merchants of food. For developers, the play will be in repositioning empty boxes, neither glamorous nor wildly profitable work, but it will keep the doors open.

One day however, perhaps two years from now, the boxes will all be stacked and put away and the great Saurons of retail will have no alternative but to pay real rent and new ground-up projects will at last return to NorCal, if not Middle Earth.

For more about John McNellis or McNellis Partners, please visit mcnellis.com.