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DISTRESSED PROPERTIES HAPPY SIGHT FOR SOME DEVELOPERS

BY DEBRA HAZEL

With real estate ever at a premium, retailers and developers have adopted a decidedly unpremium strategy: They’re turning to distressed stores and centers.

Retailer bankruptcies, surplus stores and industry consolidation have increased the amount of “troubled” space available in what are frequently good locations, say some of the developers pursuing this strategy. Adding new tenants to such projects can raise returns dramatically compared with those of simple acquisitions. As a result, major companies are redeveloping more of these troubled stores and properties.

“It definitely is increasing,” said Daniel J. Hughes, president of Mount Laurel, N.J.–based Metro Commercial Real Estate, which recently redeveloped the 375,000-square-foot Boulevard Plaza, in northeast Philadelphia. The center, which contained 13 vacant storefronts in 2001, is now completely leased.

Similarly, Acadia Realty Trust, Kimco Realty Corp., Pennsylvania Real Estate Investment Trust and others have announced deals or their plans to turn distressed retail spaces and centers around.

To be sure, faced with an environment that makes land acquisition harder by the day, retailers and developers find they now have eyes for these down-on-their-luck centers.

Redeveloping such projects satisfies three very different groups: the developers of centers that need anchors, the owners of the stores being vacated (eager as they are to get out of their leases) and the new tenants that are in expansion mode.

In January White Plains, N.Y.–based Acadia Realty formed a joint venture with Klaff Realty, Chicago, and Lubert-Adler Funds, Philadelphia, to acquire such struggling retail stores and re-lease them at a healthy profit. The three will invest a total of about $300 million in equity over the next three years.

Steve Smith, a principal of Chicago-based Bryanston Realty Partners, a new entity created by Klaff Realty staff, says the strategy is simple: The partnership buys retail stores that are in bankruptcy, or the excess units of successful companies. “We bring in fresh capital,” he said.

Kimco, too, is focusing more on distressed properties, as chairman Milton Cooper told analysts in a February conference call. The company is no stranger to the strategy, having acquired defunct discounter Ames’ real estate assets in 2002, to cite just one such deal.

“Our prognosis is not very exciting for acquisitions in light of the disconnect between the availability of money and the availability of returns” for more-stable properties, Cooper said. “We’ll do them if they’re there. But we do see increased activity in the distressed area.”

Philadelphia-based PREIT has a long history of acquiring and turning around underperforming assets, said Chairman and CEO Ronald Rubin at the NAREIT Institutional Investor Forum in New York City in June. The firm plans to improve assets acquired last year from The Rouse Co. and Crown American Realty Trust, Rubin reported. These include a soon-to-be announced “major transaction” to improve Echelon Mall, in Voorhees, N.J., which now has two vacant anchors. PREIT will also continue to pursue ground-up development.

“The problem is that [ground-up development] takes a lot longer today,” Rubin said. “Consequently, for a REIT that wants to invest capital and get immediate returns, we find we can do that a lot better with existing assets, and adding to and creating value to them.”

That strategy will continue, he added.

“We’re not looking for stabilized assets,” Rubin said. “We’re looking to buy assets where we use our creativity to create value.”

The concept is unusual but not new, says Joel Braun, Acadia’s chief investment officer and director of acquisitions. In 1980 Vornado Properties liquidated its Two Guys chain of department stores and sold the spaces to other retailers. More recently, Miami-based Swerdlow Group spent years rescuing underperforming centers for re-leasing, including the Great Mall of the Bay Area in Milpitas, Calif. In August the firm sold Great Mall to The Mills Corp.

Even so, there may never be as much opportunity as now, with centers aging and the retail industry continuing to consolidate. As a result, it is important to define exactly what constitutes distressed space, notes Howard Makler, chairman of Huntington Beach, Calif.–based Excess Space Retail Services.

“Surplus is this huge umbrella term,” Makler said.

Some space does become available through liquidation; the collapses of Bradlees, Caldor and Service Merchandise are examples. But not all distressed-property opportunities come about through Chapter 11, Makler says. Some successful retailers prefer selling off outmoded stores to a retail real estate developer rather than re-leasing them themselves, he says.

All this can add up to a lot of vacant space. The Philadelphia market, Hughes notes, has seen the departures of Ames, Bradlees and Montgomery Ward, as well as a number of Kmart stores, many of which were located at major intersections.

“Landlords find themselves in the position of having a center [that is] in a very good location” but also contains vacancies, Hughes says.

Fortunately, other retailers are expanding. Costco, The Home Depot, Lowe’s, Target and, of course, Wal-Mart are among these.

“Every time one person has problems, another is exploding,” said Smith.

But that doesn’t mean the retenanting is easy. The 80,000-to-100,000-square-foot spaces vacated by the discounters are too small for today’s mega-anchors. Developers working on such centers often have to relocate neighboring stores to clear a large enough space to attract one of these anchors.

So why bother? Because the expense and the effort can yield rich reward. Bryanston’s Smith says he expects return on investment in excess of 20 percent on his firm’s distressed properties, far above the single-digit returns on new developments. Swerdlow acquired the Great Mall for $130 million, poured in an additional $60 million and then rolled it over to Mills for $266 million.

“The return was much greater than anticipated,” said Brett M. Dill, Swerdlow’s president, adding that the deal was a “unique” situation.

“The returns have been great,” Smith said. “We’re getting paid back commensurate with the risk we’re taking.”

Many older department stores, Hughes says, paid rents of about $3 to $4 per square foot on what were often gross leases, which include nearly all costs. New tenants pay much more.

Even so, the tenants themselves have no problem taking what others might consider castoffs. The locations are often good ones, particularly in areas that are built out.

“[Retailers] are very sophisticated,” Hughes said, noting that tenants are keenly aware of market demographics. “Their research is very strong.”

Sometimes retail isn’t the answer. Recently, a church was the acquirer of a vacant Burlington Coat Factory in Huntington Beach, Calif., Makler says. And the Great Mall location, if built today, could easily have been another format, Dill says.

“Finding 120 acres in Silicon Valley was almost unheard of,” said Makler. “But if you had that same land today, it would have been more profitable to build residential space.”

And there is likely to be plenty of opportunity going forward. Though the level of store bankruptcies has declined since the early 1990s, distressed stores continue to crop up as formats change and retailers abandon older facilities for newer ones.

There will always be another source of vacant real estate, says Braun. He predicts that supermarkets will provide a new supply now that the discount store shakeout is nearly complete.

And older markets will continue to provide good locations for those stores seeking to expand and replace distressed retailers.

“Philadelphia is not unique,” said Hughes. “In any mature market, there is unmet demand by tenants for spaces.”

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