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In the face of a slowing economy, a rash of bankruptcies and hundreds of store closings, America's shopping centers brace for a rough year.

In the face of a slowing economy, a rash of bankruptcies and hundreds of store closings, America's shopping centers brace for a rough year.

By Howard Rudnitsky
March 2001
Institutional Investor Magazine

Low-end players look most vulnerable.

Montgomery Ward & Co. and Bradlees, two entrenched names in American retailing, filed for bankruptcy in late December - and the long-dreaded recession hasn't even begun.

In the wake of a dismal Christmas, the nation's retailers are expected to report a decline in fourth-quarter profits, an estimated 2 percent drop from 1999, compared with the 5 percent gain that Wall Street analysts expected just a few months ago. With consumer confidence at an five-year low, spending seems certain to fall. The only question is how much and how fast.

Retail landlords, the public and private companies that own the nation's 45,000 shopping centers, are already feeling the sting. Last year their cumulative 5.6 billion square feet of retail space generated $1.2 trillion in sales. That represented a respectable 5.5 percent gain from 1999 but a sobering drop from the 7.5 percent increase in 1998. This year analysts project that growth will slow to perhaps 4 percent.

Though e-tailers pose less of a threat to bricks-and-mortar stores than Internet cheerleaders predicted a year ago, shopping mall landlords face troubles beyond a slowing economy. The number of shopping centers did not significantly increase during the 1990s' economic boom, but there has been a dramatic spike in overall retail construction - the vast majority of it in freestanding megastores like Wal-Mart, Target and Home Depot that pose a direct threat to many shopping centers. Overall, developers added about 300 million square feet of new retail space annually over the past three years, compared with an average annual increase of 200 million square feet between 1992 and 1997, according to Green Street Advisors, a research firm. "The real story has been the rapid increase in new retail space. Its impact cannot be underestimated," notes Green Street analyst Greg Andrews.

"Retailers want to grow, and they have a conviction that a change in store format is going to give them a competitive advantage," says Bernard Winograd, CEO of Parsippany, New Jersey-based Prudential Real Estate Investors, which manages nearly $14 billion in real estate assets. "That leads them to constantly open more stores, but they don't have a way to consistently remove their older stores from the market."

Movie chains, another leading shopping center tenant, are struggling as well. After taking on billions in debt to build new megaplexes, adding 9,000 screens in the past five years, theater owners are now saddled with an estimated 25 percent excess screen capacity. Last year six movie theater operators filed for bankruptcy protection. Loews Cineplex Entertainment Corp. joined the crowd last month, closing 675 screens at 112 locations in the U.S. and Canada.

Invariably, profit margins are narrowing. Growth in funds from operations, net income plus depreciation and amortization, has clearly slowed for retail real estate investment trusts. According to Green Street estimates, at enclosed regional malls (400,000 square feet and up), funds from operations gained 9.1 percent last year, down from a 12.1 percent increase in 1999. At strip shopping centers the slowdown was sharper, from 9.5 percent in 1999 to about 4.4 percent last year.

"Retailers have had enormous problems," sums up Milton Cooper, CEO of New Hyde Park, New York-based Kimco Realty Corp., which owns 498 strip shopping centers. "That means things can't be very good for the mundane retail REIT." Still, the sector's problems are quite different from those of the late 1980s and early 1990s, when developers spent easy S&L money to build a glut of shopping centers and financially sound retailers like Federated Department Stores and Macy's were driven into bankruptcy by overleveraged LBO investors.

Increasingly, it's a two-tiered industry. Analysts project that upscale malls, which generate more than $375 per square foot in sales, will ride out a slowdown with relative ease. Last year high-end centers pulled in 5 to 6 percent sales gains, nearly twice the industry average. One successful player in this elite corps: Atlanta-based Lend Lease Investments' Fashion Valley Mall in San Diego, which raked in more than $500 per square foot in sales last year.

Betting on the high end of the market, Anthony Deering, Rouse chairman and CEO, retained 26 upscale malls and bought four others after selling off 37 low-end properties over the past seven years. The moves helped double Rouse's retail earnings over that period, to $163 million on mall revenues in excess of $500 million. "Low-end malls don't have much of a future," Deering says.

That judgment may be a bit harsh. But certainly many of these malls appear vulnerable. Delivering less than $275 per square foot in sales, these shopping centers (many of which have been around for 20 years or more) often cater to lower-income customers and carry higher-than-average debt loads. Owners of this type of property, such as Johnstown, Pennsylvania-based Crown American Realty Trust (27 malls) and Columbus, Ohio-based Glimcher Realty Trust (21 malls) could be hit harder by a prolonged economic downturn. While Crown American reported a 9.8 percent gain in funds from operations last year, in the fourth quarter the gain had been cut almost in half, and analysts like Green Street's Greg Andrews expect virtually no rise in FFO this year and only 2 percent in 2002.

This older guard confronts keen competition on several fronts. In addition to newer malls in the area, they may face discounters like Wal-Mart Stores and Target Corp. or so-called power centers, 250,000- to 600,000-square-foot centers with three or more category-killer retailers.

Consider the experience of the Westland Mall in Columbus, Ohio. Surrounded by several suburban shopping centers and a large new five-anchor mall, the 36-year-old, low-end Westland struggled for years. Today Westland is decimated, left with just one of its original two anchors. (Sears remains, but J.C. Penney is gone.) Lender Cigna Corp. took back the mall's mortgage a few years ago. In late January its original owner, Cleveland-based developer Richard E. Jacobs Group, and Cigna formed a partnership that took ownership of Westland and another older Columbus mall that Jacobs had owned.

On a brighter note, the 75-year-old Jacobs recently sold off half of his 38 million-square-foot shopping center portfolio to CBL & Associates Properties for operating unit shares in the REIT. The price: about $1.3 billion, including debt assumption. Says Jacobs, "We're delighted with this transaction," which helped his estate planning.

Some companies are finding a profitable niche in 30,000- to 125,000-square-foot neighborhood centers, usually with few nearby competitors. REITs with a presence in these markets include Rockville, Maryland-based Federal Realty Investment Trust; Houston-based Weingarten Realty Investors; Jacksonville, Florida-based Regency Realty Corp.; and Vista, California-based Pan Pacific Retail Properties.

As the economy weakens, some analysts favor these neighborhood shopping centers as a defensive play. Since these malls serve the daily needs of local consumers, they have historically done relatively well during economic slowdowns. Often they sign a supermarket or drug store chain as their anchor. Steve Sakwa, head of REIT research at Merrill Lynch & Co., likes Pan Pacific because 75 percent of its centers are anchored by supermarkets, many of them leaders in their territories.

Although privately owned firms control two thirds of all malls, according to a July 2000 report by Prudential Real Estate Investors, publicly traded real estate companies still own a sizeable number of the premier properties.

After several years of mediocre performance relative to most equity indexes, all REITs enjoyed a terrific 2000. Shopping centers lagged behind the group, though. Retail REITs posted a weighted average total return of 19 percent, versus 26.8 percent for REITs as a whole.

With an average debt-to-capital ratio of 55 percent, compared with a REIT average of 45 percent, retail REITs should especially benefit from lower interest rates. After the Federal Reserve Board cut rates in early January, Morgan Stanley Dean Witter analyst Gregory Whyte raised his ratings on two high-end REITs, Simon Property Group and Rouse, from outperform to strong buy, concluding that their lowered cost of capital would compensate for slowing retail sales.

Surveying the sector's well-positioned high-end malls, Douglas Healy, head of the retail real estate group at Atlanta-based Lend Lease Investments, a real estate adviser, favors higher-quality malls with sales of at least $375 per square foot, particularly what he calls fortress malls. Says Healy, "These centers - and there are only about 100 of them in the U.S. - generate $500 or $600 per square foot in sales, they boast four or five anchors, and they dominate a large trade area of half a million people." In addition to private investors like Lend Lease and AEW Capital Management, owners of these prize sites also include such REITs as General Growth Properties, Rouse, Simon Property and Taubman Centers.

"There's been a real bifurcation among retail REITs," says Sakwa. "The top malls should do fine." In low-end retail REITs he sees "assets that are in a long-term state of decline."

Still, the upscale malls already compete against outlet centers. Now they could face a new niche competitor, so-called lifestyle centers. These open-air centers in high-income neighborhoods average about 300,000 square feet and include tony tenants like Williams-Sonoma, Abercrombie & Fitch and Crate and Barrel. In the past four years, developers have built an estimated 20 to 25 lifestyle centers, totaling some 7 million square feet of retail space. They are usually located just two or three miles from a town center, versus five or six miles for regional malls.

"Make no doubt about it. Lifestyle centers are after mall shoppers," says Green Street's Andrews. "They inevitably eat into sales that would otherwise go to traditional malls."

Still, Healy concludes, "upscale malls may not be as greatly advantaged as they were ten to 15 years ago, when they didn't have new competitors to contend with and people weren't thinking about the Internet. But they've managed to absorb all that new competition and have still held up pretty well."

Low-income regional malls, by contrast, are struggling to compete with the power centers that took off during the past decade. They flourished largely because of the growing appeal of their category-killer and warehouse tenants like Sam's Club and Costco. Customers find shopping at power centers more manageable - and far less draining - than a typical afternoon at a huge, sprawling mall.

But not all power centers are thriving. Those anchored by office products stores, sporting goods retailers and electronics chains have been scrambling to find new tenants when stores shut down. Soon, Office Depot and Office Max will have shut down 120 of their stores, and many power center owners will feel the fallout.

Meanwhile, many low-income regional malls face an onslaught from the fastest-growing type of retail outlet: freestanding stores. The strongest growth has come from large store structures that house volume retailers like Wal-Mart.

The freestanding category more than doubled construction, from 107 million square feet a year in 1991 to 230 million square feet in 1999. During the same period shopping center construction grew about 60 percent, from 47 million to 75 million square feet a year.

Says David Jacobstein, president of Developers Diversified Realty, a REIT that owns 190 shopping centers: "Wal-Mart's sales increase of $26 billion last year exceeded the total sales of all Federated Department Stores, the largest pure department store group. That tells you where the growth is in retailing."

Eyeing the weakness, some owners spot opportunity. Kimco's Cooper is looking for failed retailers that have stores in good locations. He aims to take over their leases and charge new tenants more than the struggling retailers had been paying. For the most part, though, says Lehman Brothers analyst David Shulman, landlords will find it tougher to impose rent hikes when leases are renewed.

In the end, suggests Rouse's Deering, regional malls with low sales volumes will be forced to reinvent themselves. "Many regional malls have no future as regional malls," he says. "I expect about 30 percent of them over the next five to ten years will convert to another use."

Naturally, most mall owners have more immediate concerns. At the moment they are keeping an eye on J.C. Penney Co.; the ailing retailer has a presence in 70 percent of all REIT-owned malls, according to Green Street Advisors. Penney will have closed 95 of its 1,100 stores over a roughly 16-month period and could shut even more over the next few years. If the chain were forced to file for bankruptcy protection - a scenario that now appears remote - many landlords would be hard-pressed to quickly fill the empty space.

Beyond the spate of store closings, a key test for developers comes in two months in Las Vegas, at the annual meeting of the International Council of Shopping Centers. Amid that city's gaudy charms, retailers will give shopping center owners a sense of what their space needs might be for 2002. If the numbers look really bad, landlords can retreat to the blackjack tables, where the drinks, at least, are free.