Commercial Real Estate Podcast

JF2860: Investing in Retail Pt. 2 | Beyond Multifamily ft. Ash Patel

Written by Joe Fairless | Jul 2, 2022 11:00:00 AM

The Beyond Multifamily series is hosted by non-residential commercial real estate investor and Best Ever Show host, Ash Patel. Ash’s goal for this series is to introduce you to the world of non-residential commercial real estate investing and teach you how to look at and underwrite different commercial asset classes. 

In this episode, Ash picks up where he left off from last week’s discussion on investing in retail properties (Investing in Retail Pt. 1). Learn about non-anchored versus anchored strip malls, different types of anchored strips, and the pros and cons of investing in each type.

 

 

What Is an Anchor?

Kroger, Wal-Mart, Target, and Costco are all considered anchor tenants. Typically, these stores have a strip mall right next to them, creating an anchored strip. The anchor tenant benefits the other tenants on the strip by drawing foot traffic to their stores. For this reason, anchor tenants usually command a much higher leasing price.

 

Types of Strip Malls

1. Class A Anchored Strip Malls (Fully Leased)

A fully-leased, class A anchored strip mall is typically made up of top-notch retailers with excellent credit and long-term leases. Because this type of property is considered a safe investment, you will be able to get optimal financing with some of the lowest rates available. 

 

2. Class B Anchored Strip Malls

Class B anchored strip malls are typically anchored by a tenant like Dollar Tree or T.J. Maxx, with a combination of national, mom-and-pop, and regional tenants. Tenant leases can vary, but as they expire, you can convert any gross leases to triple-net, making the property easier to manage with more predictable finances.

 

3. Class C Anchored Strip Malls

Class C anchored strip malls often have a high vacancy and are located in rundown neighborhoods. They typically come with deferred maintenance, roof leaks, signage problems, and more. Ash recommends only investing in this type of strip if you have enough experience to perform a considerably heavy lift. 

 

4. Non-Anchored Strip Malls

These are often typical neighborhood service strip malls with a mix of national, mom-and-pop, and regional tenants. With this type of strip, there isn’t any risk of losing an anchor and becoming an eyesore with a large, vacant storefront. Non-anchored strip malls are easy to keep rented and easy to keep cash flowing. Ash recommends investing in a non-anchored strip before diving into an anchored strip.

 

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TRANSCRIPT

Ash Patel: Hello, Best Ever listeners. Welcome to the best real estate investing advice ever show. I'm Ash Patel, and this is an episode of Beyond Multifamily, where we discuss topics other than multifamily investing. Today, we're going to continue Part 2 of How to Invest in Retail. If you did not listen to the previous episode, I urge you to go back and listen to that one first. We dove into mom-and-pop strip malls and how there's lower competition. There's a perception that they're very difficult to manage. We dove into how to manage them, how to find them, how to improve the value of them. Let's dive right into today's episode - Non-anchored Versus Anchored Strip.

What is an anchor? Think about the Kroger, the Jewel, the Target, the Costco, the Walmart anchor, and then there's a strip mall typically right next to it, you'll also see the term "shadow-anchored", which means - it's a pretty loose term; it's in the vicinity of the Walmart, of The Home Depot. So when you see anchor tenant, that's going to be the reason that most people go to that center.

Best Ever listeners, the example that I love showcasing when we talk about anchor tenants and the remaining tenants in the strip is think about a JCPenney with a line of stores next to it, and one of them is that hobby store, the store that you never otherwise would've gone to, unless you're in the car, your wife wants to stop at JCPenney real quick. You refuse to go in there. Maybe you've got your kids with you and you tell your wife you're going to go check out the hobby store. That is the benefits of being next to an anchor tenant. The anchor will draw a lot of traffic to your store. And being next to an anchor tenant usually commands a much higher lease price.

So let's dive into different types of anchored strip malls. The first one is a class A, fully leased anchored strip. Now, think about the Whole Foods strip mall, where every retailer next to it, around it is just top-notch, best credit, not going anywhere, long-term leases, often 10 years with multiple renewals. Now, this is a place where a lot of institutions go to park money. You know that Whole Foods who just got bought out by Amazon a couple years ago; they're not going out of business, so there's no way they're able to break their lease unless there's a specific provision in that lease. So with fully-leased class A, top-quality strip malls, what is the upside if you're competing with institutional money that literally just wants to park money?

There's some upside in that if you have a giant parking lot, a lot of municipalities today are reducing their parking requirements, so you can get a variance, or if they've already changed their parking allotment, you can look at adding an out lot. If you have an excessive number of parking spots, maybe you can add anything, from a drive-through coffee store; Starbucks now, there's a lot of regional players that are doing drive-through only skinny kiosk type locations. If you have enough room, you can add a Chipotle or another national tenant in your outlot and command a much higher value for that property.

Another upside is when you dive into the leases, look at what kind of renewals are in there. This is a double-edged sword, because if there's 15 years' worth of renewals, let's say three five-year renewals, and rent increase is nominal - now, this is going to hurt, because 15 years from now if they're only paying $2 or $3 more per square foot than today's rates, it's not going to keep up with inflation.

And one thing to remember is renewals only help tenants, they never help landlords. If you, as a landlord, are drafting a lease, I want you to put in "renewal at market rates" or renewal option first right of refusal, something that leaves the lease rate open-ended. Because let's think about this... If the market goes down and there's a ton of vacancy, the tenant is going to say, "Look, I know I have this renewal option where I have to pay an additional $2 a square foot, but let's be honest, the strip mall is half empty. If you want me to stay, I want a reduction of $2 a square foot." So that renewal option protects the tenant, not the landlord, because they can renegotiate their renewal when the time comes to a lower rate if that's a supply and demand issue. But as a landlord, you can't say, "Hey, tenants, I know you have these built-in renewals; market's through the roof, everybody wants this space. I want to charge you more money", you're not able to do that, because you're contractually bound by those renewals.

Historically, we wanted long-term leases. In today's world where there's high inflation, rents are going up everywhere for apartments, houses... If the demand is high enough for a particular area, we actually don't want renewals. As a matter of fact, we want leases that are coming due soon. Historically, that was a risk if the lease expires and the tenant doesn't renew, "Oh, my God, what do I do?" But today, if a lease expires, you have the option to renew at market rates, or bring in another tenant if they're leaving, and likely charge a much higher lease rate. So for the first time in a very long time, we actually look for properties who have leases that are expiring soon.

And this goes for all of the tenants, except the anchor tenant. If you are buying a strip mall and the anchor has five, six, seven years left - great. If they have two years or less left, you want to do a blend and extend or somehow find a way to renew that lease or find out if they plan on renewing the lease. A blend and extend is where you say, "Hey, anchor tenant, I want you to stay. I'll tell you what, if you sign a lease renewal early, I'll keep your rate the same, or instead of increasing at 10%, I'll increase at 5%." You don't want your anchor tenant to leave, unless you have other anchors knocking down your door, wanting that space. Often, anchors have very large square foot footprints, 30,000 or more square feet. That's a tough space to find tenants today.

Another way to get upside on class A strip malls is let's say you reduced the rent for a particular tenant, because they were going to do a build-out. Let's say the previous owner had a tenant that came in, they were given a very plain white box space and the tenant put a restaurant in there. They put a hood, they put a fire suppression, they put a grease trap, they put all the plumbing in for a restaurant, and in return, the landlord had signed a long-term lease at very low initial rates. Now that that lease is expiring and all of that equipment has to stay, you now have the ability to charge a lot more money for that space. And if that tenant ever leaves, you can find another tenant with a turnkey restaurant ready to go.

Another way to increase class A strip mall value is increase the quality of the tenants. So if you have great tenants, but maybe one or two mom-and-pops and regionals, you can call up other franchises, other corporate tenants and say, "Hey, look, I've got some availability. There's a Starbucks and an Old Navy, you could be right in between them." And if you increase the quality of your tenant mix, the cap rate goes down, you're available to more institutional buyers, and all around it improves the value of your center.

Other attributes of fully leased class A strip malls is you will get the best financing around. Not only is institutional money trying to buy these properties, but there's institutional lenders that want to lend on these very safe properties. You can get some of the lowest rates available. You can use brokers, in this case, to find the very lowest rates, the best terms.

Let's move on to one of my favorite categories, class B strip malls. Now, these are typically anchored by a tenants that could be a Dollar Tree, it could be a TJ Maxx, and there's a number of other tenants alongside of it. The reason I love these is there's usually a combination of national, mom-and-pop and regional tenants in these centers, and the leases vary from triple-net, where the tenant pays all of the insurance taxes, maintenance, pro rata on their square footage. So if you have an anchor that occupies 25% of the gross leaseable area, they are now responsible for 25% of the annual taxes, insurance, and maintenance as outlined in the lease. But right next to them, you can have a mom-and-pop pizza shop that is just paying a gross lease. As those leases expire, you can redo them and convert them to triple net. So when you position this property for a sale, the next buyer will see, "Oh, wow, this is a fully leased triple net strip mall, no gross leases, easier to manage, and the finances are more predictable."

These class B strips often have some deferred maintenance. There are some roofs that are the end of their life. Signage could be improved, lighting can be improved, a lot of HVAC units may have been band-aided over the years. So you'll have to be prepared for some CapEx spending. You definitely want to get your inspections, get a property condition report, and that gives you a pretty thorough overview of what this property will need in the future in terms of CapEx.

Another thing to look for when you're buying a class B strip center is look for some vacancy. If you have a fully leased center, you're paying fully leased prices. If you have some vacancy, maybe it's been mismanaged or maybe it's an out-of-state, out-of-town owner that this might not be their core holding, or it might not be their favorite holding that gets any attention at all, and they've just neglected it. You, with a little bit of effort, maybe some help from brokers, some guerilla marketing, you can fully lease this center and add a lot of upside to the property.

One of the things you want to do in due diligence is find out what's been done to fill these vacancies. And I've literally had brokers during due diligence, say, "Ash, we've had so many calls for people that wanted to lease the vacancies. We just don't have time to return their calls." That tells me that there's easy upside in filling the vacancies.

With these Class B strip centers that might have some vacancy, you typically cannot use brokers for your lending. This is where those lender relationships come in. Remember, with the Class A, the Whole Foods strip mall, you can get a broker, you'll find the lowest, best loan in the country. With these Class B and C strips, especially if there's vacancy, your lender has to be somebody that you've done business with before. Typically, that lender relationship is so important, because your typical big banks are not going to finance a deal like this. They typically want fully-leased properties that have been stabilized for a number of years.

Break: [00:14:58] to [00:16:39]

Ash Patel: So a lot of these barriers to entry - difficult in underwriting, difficult getting lending on it, difficult trying to fill leases, or at least the perception it's difficult trying to fill vacancies- a lot of these factors keeps the competition away and keeps the prices a little bit more elevated on these Class B, partially vacant strips, so the upside potential is massive for you.

And finally, the Class C anchored strips. These are the ones that are going to have a lot of vacancy. They're going to be in rundown neighborhoods. A lot of deferred maintenance, roof leaks, signage problems, crime, people loitering. These are the ones that you have to be a little bit experienced to take on because they're often a heavy lift. You're going to want some preexisting tenant relationships. So you want a number of preexisting relationships with some national lenders, some regional lenders, some leasing brokers. And if you buy a strip mall that's 50% vacant, you want to be confident that you're going to be able to increase some of that occupied square footage, you're going to be able to fill some of those vacancies, and often, you want to do that during due diligence. A Class C strip mall that has a lot of deferred maintenance - it's not uncommon to get 60 to 90 days of due diligence, and in that due diligence time, you need to go out and try to recruit tenants for this location, see what the feedback is.

Again, if you have a lot of positive response to some advertisement or to some conversations you're having, you can feel more confident that you'll be able to lease up some of the vacancy. If every time you approach somebody for possibly leasing space there, they have zero interest, you may want to check your numbers and your confidence level. This may be a much harder deal than you anticipated. But again, just like Class C apartments, Class C neighborhoods for residential, the upside potential is probably the highest here. These properties typically cash flow the highest, and they have to market and sell them that way because there's a limited pool of buyers buying strip malls in war zones.

In terms of lending, it's also the most difficult property to get lending on. You need a preexisting relationship with a lender, for sure, and they're typically doing you a favor by giving you a loan on these properties and hopefully, they're confident in your ability to turn these around because you've done it before.

Managing these Class C strip centers is also the most difficult. I would be very cautious in just giving something like this to a property manager and assuming they're going to do the best with it. You almost want to manage these yourself or be very close to your property manager, so that all of the calls they get for broken windows, loitering, people tagging your walls, you're on top of. Because perception for these properties is very important. If it's known as a declining center, a place where there's a lot of crime in the parking lot, that's a problem. If it is a place where new tenants are coming in, there's new life being brought into it, the lighting is much better, cops are patrolling, maybe you have a security vehicle there on nights and evenings, the neighborhood will know that and now other tenants may be more apt to lease space in that center.

I want to circle back, Best Ever listeners, to the anchored strip mall versus the non-anchored strip mall. If you recall from our previous talk, we talked about mom-and-pop strip malls, and today we spent a lot of time talking about the anchored strip malls. The non-anchored strip malls are just your typical neighborhood service strip malls that have some national tenants, maybe some mom-and-pop, some regional, but there's no risk of an anchor leaving.

Think about that for a second... If you have, again, two years left on your 50,000 square foot Kroger, Dollar Tree anchor and they leave, you now have a giant eyesore where other tenants, as soon as they come in there to look at additional vacant space, they're going to see a giant big box with no sign on it, and they're going to think, "Oh, my God, this is a declining strip mall." If you have an unanchored strip, there's no risk of that. It's just kind of an even flow, tenants come and go, all of your spaces are maybe between three and 6,000 square foot, just easy to keep rented and easy to keep cash-flowing. So if you start at mom-and-pop strips, I would progress to the non-anchored strips before you dive into the anchored strip mall.

Other things to look for - obviously, job growth, population growth. You want to look at traffic counts. Make sure there's adequate traffic relative to other centers, so that your tenants have a good base to pull from. Adequate parking is very important. I can't tell you how many properties I've had over the years where beautiful buildings, beautiful location, incredible 50,000 cars per day traffic count, and I get some national tenants coming to look at the space, only to find out we have 13 parking spots, or I had a 15,000 square foot building with 24 parking spots. You have such a small pool of potential tenants, so you need a very low volume, high occupancy tenant, like a furniture store, somebody that just needs a ton of space, but doesn't require a ton of foot traffic; very, very difficult. I keep telling myself, no more properties that don't have adequate parking, and somehow I keep getting sucked back into those. Anyway, so adequate parking will just make your life so much easier. And the ease of entry and exit into the center - I can't tell you how overlooked this is.

We looked at some strip malls in New Jersey where they had everything going for it - great tenants, traffic count was there, population was there, household income was there, but when you get on Google Maps and do an aerial view, you don't understand how to get into this property. You've got to take a couple different exits, make a couple different weird turns, almost go through some neighborhoods to get into them. And if it's that difficult to get into, people are just not going to do it. I've literally had properties that you can see from very busy highways, but it's just very difficult to figure out how to get in there, and today, people just are not going to take the time to do that.

Signaled intersections are great. Believe it or not, as the population ages, a lot of elderly people will not make a left turn unless there's a signal there. I had a friend of mine who had a breakfast spot in a strip mall, in a nice, beautiful town, a lot of old money there, and the strip mall across the street wanted to lure him in. They said, "Hey, we'll give you six months of free rent. We'll build you an outdoor patio." The problem is if people were coming from the opposite direction, they would have to make a left turn using a center turn lane, and no signalized intersection. So his older clientele just isn't going to do it. So keep that in mind. Sometimes older populations won't make left turns, unless there's a signaled intersection. But just in general, having a signalized intersection makes it so much easier for people to go into your center.

You also want to look for lack of competition or lack of buildable land nearby. If you buy a strip mall that is 5, 10, 15, 20 years old, and there's a ton of vacant land all around you where they can build a new, shiny strip mall and lure all of your tenants away, that is a risk. You also want to make sure if you have a grocery anchor tenant and there's a brand new grocery store being built or has been built very close by, your tenants may not renew, or it might be difficult getting a future tenant into an older building when they're competing with brand new space.

Best Ever listeners, hopefully I haven't blown your minds too much today. I'm trying to add value and trying to get you to look at other asset classes. Finally, we'll dive into how do you find these Class, A, B, C anchored or unanchored strip malls. This one is a little bit easier to find than mom-and-pop strip malls. You can rely on brokers for this. Even some of the national listing services, Crexi, LoopNet, they'll be on there. Direct marketing, a little bit more difficult.

And again, look at for lease listings. When you find somebody that is posting a for lease ad, they have some kind of pain point that they need filled. So if you call them up and say, "Calling to inquire about this space. Tell me about it. What's your story? How long have you owned it?", build that rapport and then go in for the kill and say, "Look, I'd love to buy this center." They're going to be taken aback. Again, whether you're talking to a broker, a property manager or the owner, they're going to say, "This is not for sale. It's for lease", because you've now just blown their mind. So what you need to do is plant that seed, let them know you'll follow up. They're going to go home and think about it that evening. And I've done this where I thought, "This is stupid. I'm not selling this. I'm leasing it", and then the wheels start turning and I think, "You know what? Why not sell this? Cash-out. I've got enough equity", or it's a property I don't want to deal with. It's a pain, whatever. Follow up with that individual and say, "Hey, we had a conversation a week ago. Listen, I want to find out, are you ready to sell? Would love to buy the center." Keep that conversation going and you'll be amazed at how many opportunities you can acquire by calling for lease listings, because very few people are doing it.

Best Ever listeners, thank you so much for joining me today. I hope I was able to inspire some of you to look at retail properties. Even if you don't want to dive in, it doesn't hurt to get Crexi, look at some of the properties that are available. And a lot of them have a due diligence vault where you can download all of their financials. You can look at all of the leases and start looking at what commercial leases look like. Look at a commercial proforma. Look at what rent bumps will add to your NOI in future years. Maybe do a risk assessment on some of these expiring leases or look at market rents versus what your center is bringing in. But if you're passionate about real estate, I really urge you, look into other asset classes beyond multifamily.

And finally, Best Ever listeners, if you enjoy this episode, please leave us a five-star review, share this episode with somebody you think can benefit from it, and as always, like, subscribe and have a best ever day.

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