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RETAIL CONDOS HOT COMMODITY IN DENSEST U.S. MARKETS

By Steve Bergsman

The U.S. is undergoing a retail condominium boom, but only developers and landlords in Chicago, New York City and similar densely populated markets are in a position to benefit, sources say.

Tenants and investors have been buying retail space from developers at a clip in select markets since the condo boom began its liftoff around 2004. In 2003 the sales volume for retail condos totaled $44.9 million, but by last year that had exploded to $654.1 million, reports Real Capital Analytics, a New York City-based research firm. The momentum is still there, as the pace of deal making so far this year is a blistering $498.8 million.

These numbers do not represent a nationwide phenomenon, however. More than half of last year’s and this year’s sales were in Manhattan, says Dan Fasulo, Real Capital’s director of market analysis. Already this year, retail condo sales in the New York City borough totaled $291.4 million, slightly less than 60 percent of sales nationwide. Last year Manhattan and Chicago alone accounted for 78 percent of total retail condo sales.

New York City-based W&M Properties is among the investment firms buying Manhattan retail condos. Other New York firms buying in include Vornado Realty Trust and Donald Zucker Co. Retail rents in Manhattan are going through the roof, says Fred C. Posniak, W&M’s senior vice president. “In 1996 we bought an asset in the Union Square area for $100 a square foot,” Posniak said. “We are getting ready to close a lease with a bank at $350 a square foot.”

Other densely populated regions with major retail condo sales include Boston, Miami, Orange County, Calif., and Washington, D.C.

Expect a flood of retail condo space over the next two years, says Alvin Mansour, director of the national retail group at Palo Alto, Calif.-based Marcus & Millichap. Mansour has been doing retail condo deals in Chicago and Washington. This would follow a sharp increase in mixed-use development. In today’s mixed-use projects, when ground-floor retail is combined with residential towers (and sometimes with office space), developers sell the stores separately.

A couple of factors are at work here, says Mansour. First, developers are in the business of building and then selling. Second, residential investors and developers prefer not to deal with retail, so they sell that piece off. Third, the cap rate on a sale, about 6.5 percent, is roughly the same return as on a leasing deal, so developers figure they might as well sell and avoid the hassles of ownership.

But retail condos have not taken off everywhere, not even in otherwise hot markets such as the Sun Belt. Two years ago Retail Condo Development Co. was formed in the Atlanta suburb of Alpharetta to build the area’s first shopping center for retail condos. So far nothing has gotten built, says Mel Lee, Retail Condo’s president. In Scottsdale, Ariz., Shea Commercial, which bills itself as the largest U.S. developer of office condos, has yet to build its first retail condo. Most of its projects are in the Phoenix and Las Vegas areas.

One of the problems with retail condos is that mom-and-pop and midsize retailers should be using their cash for such things as inventory rather than real estate, says Neal Waldman, Shea’s senior vice president of acquisitions and development. This is not a problem in dense places, where the end users are upscale retailers. Not that Shea is unlikely ever to make the leap. “Given the right project in the right location, we would certainly entertain doing retail condos as part of a mixed-use development,” said Waldman. Outside the major cities of the Northeast and the Midwest, retail condos are so location-specific as to preclude even those developers that have succeeded with the product in the past from always making it work a second or third time.

Atlantic Realty Cos. is a good example. The Vienna, Va.-based real estate development, investment and management firm works mostly in the Washington-Baltimore corridor. In 2002 the firm bought a group of four Herndon, Va., buildings occupied by an odd mix of retail, wholesale-retail and warehouse-retail tenants. There was a deli and ethnic grocery store, a bakery that did its commercial baking on-site, a restaurant with a catering operation in the back, a dry cleaner with an on-site plant, a cabinet showroom, and a floor-tile and carpet store. The leased properties ranged from 1,000 square feet to 3,000 square feet.

“After the acquisition, we decided to go through a conversion process to a retail condominium,” said David Ross, Atlantic Realty’s president. “We lost a few tenants that didn’t want to own their own space, but we replaced them with comparable-use tenants.”

The project was sold out within its first 12 months of operation, says Ross. “We did so well, we thought this concept would make sense in other markets,” he said. “Our thinking was that in high-traffic areas, it’s possible to congregate those kinds of businesses and do retail condominiums.”

Early last year Atlantic Realty acquired the 172,000-square-foot Eastgate Shopping Center, a former outlet center in Jessup, Md., intending to renovate it into retail condos. The facility, two buildings on 14 acres, had a troubled history, having fallen into foreclosure before being resold to Burlington Coat Factory. Atlantic Realty bought it from Burlington. “We found we could attract a lot of the same types of users as our first retail condo project,” Ross said. “But the difference between the two projects was that with Eastgate there were a lot of larger blocks of space — 70,000 to 80,000 square feet that needed to be marketed to larger operators. We were nervous about who we would attract into the larger blocks.”

The good news was that the large-space problem was quickly resolved when My Organic Market, a regional grocer, said it would enter. The bad news was that the grocer killed the retail condo concept. It only wanted to lease, and it was squeamish about the whole condominium idea, Ross recalls, because it wanted to be sure Atlantic Realty had control and certainty over the other tenants.

Atlantic Realty decided to lease the space to My Organic Market. Then Starbucks and Performance Bikes also wanted in on a lease-only basis. “Frankly, at that point we abandoned the condo concept, because the tenants we were attracting wanted to be absolutely certain that they knew the landlord has control over the property,” Ross said. “They didn’t want obnoxious or competitive users. In a condominium setting, that is the risk.”

Ross realized that though a developer can write covenant clauses against certain uses and then have all the controls in the condo documents, its only option against those who violate the agreement is a legal battle. When the developer gets caught up in that, the center ends up in decline.

“In smaller blocks of space, the condo concept absolutely works, but you have to dot your i’s and cross your t’s in documenting what goes into the covenants,” said Ross. “You want your users to stay as compatible as possible and to some extent limit what buyers can do with their units. Otherwise, over time, you might have five hair salons in one project, which I’ve seen happen.”