Retailer closings during this shaky economy are causing many single-tenant retail real estate buyers to approach purchasing decisions with uncertainty. "The real estate marketplace is a highly competitive, volatile environment, and the current economic setting is only making buyers and landlords more concerned about their purchase and risk," said Tom Georges, Northeast sales executive for Spectrus Real Estate Group.
Before the credit crunch hit the United States last August, even retailers with so-so performances were able to keep operating, noted Ethan Nessen, managing partner for CRIC Capital L.L.C. "But now, we're finding no room for mediocre performers," he said. Among the more recent casualties is Linens 'n Things Inc., which in May filed a voluntary petition under Chapter 11 of the U.S. Bankruptcy Code, announcing the closing of 120 underperforming stores.
Evolution has also played a role in the departure of a number of types of retailers. Movie Gallery Inc., for instance, bought out Hollywood Video in 2005, failing to foresee mail-away services for DVDs taking so much market share, pointed out David Sobelman, executive vice president for Calkain Cos. The retailer filed for bankruptcy under Chapter 11 in October 2007; its most recent round of closures, which the company announced in April, included 160 underperform- ing Hollywood Video and Movie Gallery stores.
Given the atmosphere, even investment-grade tenants have curbed or are likely to curb their expansion plans, added Jeff Hanson, president of Grubb & Ellis Realty Investors L.L.C. The Home Depot announced in May that in addition to closing 15 stores, it would not pursue the development of approximately 50 stores that have been sitting in its pipeline, in some cases for more than 10 years. And even the better-performing Lowe's has reduced its expansion plans.
As a result of such trends, buyers of net lease retail real estate are fleeing to quality, experts report. In many cases, that means the quality of the real estate more than that of the tenant, according to Ryan Butler, senior associate for Stan Johnson Co. Though the financial stability of the tenant and its ability to pay the asking rate still factor in, investors realize that in a wobbly economy, any tenant can pull out for a variety of reasons.
Thus, factors like location, traffic and visibility count, as prime settings are easier to backfill, Sobelman noted. Core markets are faring well, especially those with new assets, investment-grade tenants and long-term leases, while weaker secondary and tertiary markets are seeing some slippage, Hanson said.
Theoretically, landlords should not have to worry about long-term net leases, as investment-grade tenants tend to sign 20-year-guaranteed agreements. "They'd have to go under and disavow the lease, (so) to those who have (tenants with) strong credit, the immediate economy won't affect you," said Bruce MacDonald, president of Net Lease Capital Advisors. "It's the shorter-term lease that may have some problems."
Overall, though, investors are preparing themselves for the worst-case scenario: how to redevelop assets should tenants pull out. "They're looking for quality, so those assets are trading at a premium—roughly the same as before the credit crunch," Sobelman said.
Their best bet is to seek less- customized assets that can be more easily leased to other retailers; Butler observed that buildings with large, wide and deep rectangular floorplates, as well as assets that are smaller than 25,000 square feet, fill in more quickly.
More vulnerable are the small restaurant and pad sites that often host fast-food restaurant chains. Most pad sites are smaller than one acre, according to Georges, who posited, "What will happen if the fast-food chain restaurant moves out?" The only choice might be to re-lease to a lower-credit small restaurant or coffee house, he noted, as the building and the pad are not large enough to accommodate traditional restaurants and the required parking.
In addition, the number of possible replacements may be further limited by the requirements of the establishments. Some buildings are specific to a particular restaurant's use. A chicken chain might not be able to use space formerly occupied by a hamburger chain, for example, explained Gordon Whiting, founder & senior portfolio manager for investment and finance firm Angelo, Gordon & Co.'s net lease real estate business. "If you have a McDonald's that closes, the odds are not good for filling in the space, especially with such a small footprint."
Butler pointed out, however that people are being creative. "We've seen restaurants turned into convenience stores," he said. "That's the beauty of real estate, as people are entrepreneurial, especially with desirable locations." Sobelman has witnessed, for example, an old Walgreens converted to an automotive-parts store and a fast-food restaurant turned into a Colonial Bank branch.
"One of the largest risks with any branded building is closure," Georges said. "The buyer should ask who the franchisee is and what their financial backing is. With any fast-food chain restaurant, the buyer needs to be concerned about replacement tenants."
In the end, landlords must determine risk on a case-by-case basis, as the health of many individual stores may depend on market branding or the franchisee. "You can have a bad market and a good franchisee or a good market and a bad franchisee," Nessen said. The latter situation could make for a dark store in a prime market. "Quality operators will be in a better position to survive the great landscape and competition. It's separating the wheat from the chaff."
Corporate defaults, as a whole, are still low, but Benjamin Harris, managing director & head of domestic investments for W. P. Carey & Co., said he expects them to increase in keeping with the performances of other financial instruments. As of the middle of May, 27 U.S. entities had defaulted in 2008, compared with 22 during all of 2007, according to Standard & Poor's. In addition to Linens 'n Things, retail corporations in this group include Buffet Holdings Inc., which operates 626 restaurants under such brands as Old Country Buffet and Tahoe Joe's Famous Steakhouse, and VICORP Restaurants Inc., which operates approximately 400 Village Inn and Bakers Square restaurants.
As investors in net lease retail properties look toward the remainder of 2008, they will find more opportunities to buy and can afford to be pickier in choosing assets, Whiting reported. "Really underwrite the location and sale figures and see where the tenant stacks up," he advised. "Make sure you have a good retailer."
—Reach Amanda Marsh, associate editor, at amanda.marsh@nielsen.com.
