Investing In Neighborhood Retail

There are a lot of potential avenues to explore as a commercial real estate investor. If you’re just starting out (or looking to diversify your existing portfolio), how do you know which path is right for you?

To help clarify some of this uncertainty, I will be sharing a series of blog posts that outline the benefits to owners of various asset classes. For the first entry, I’d like to start off with neighborhood shopping centers.

Of course, this post isn’t meant to be all encompassing, and if you have any questions, you can reach me at hunter@thecaublegroup.com.

1. Invest Where You Live

One of the best reasons for a novice investor to purchase a neighborhood strip center is the potential to purchase where you live. After all, you likely have a better understanding of the area and the micro-factors that can make a big difference in a neighborhood.

Is that property a couple blocks too far west?

Is the traffic flow on that section of Main Street too difficult for people to want to stop at these businesses?

There are any number of factors that an investor can know with firsthand market experience that would be difficult to see solely from a broker’s marketing flyer.

Additionally, while it is not directly a financial consideration, the confidence in knowing what your neighborhood needs and who is best to fill that space will certainly contribute to the asset’s overall performance.

2. Diversification of Tenants

One of the most important benefits a typical neighborhood shopping center offers is diversification of tenants. Typically, a smaller strip center will have between 2 and 10 tenants, with 3-5 as a more common range.

By leasing to several different tenants in smaller spaces, an investor is able to spread tenant-specific risk across the property. If one tenant out of five were to shut down or just relocate away from the property, only 20% of the building is vacant.

In a larger single tenant scenario, once the tenant moves not only are you not making a profit anymore, you are now left with an asset that costs you money every month.

Frequently, these tenants will be smaller “mom and pop” operators that don’t have the financial backing of a larger investment grade company and they won’t be looking to sign 10 year leases. A more typical lease term for these retail operators could be 2-3 years, with the occasional 5 year term.

With a minimum of 3-5 tenants and terms ranging from 2-5 years, there is still an opportunity for ownership to be proactive about staggering their tenant leases to minimize the number of tenants that have renewals in the same year. This should help them (and their lenders) sleep better at night.

3. Ease of Management

No matter the type of property, proper management is essential to the profitable operation of an asset. Neighborhood centers have a couple of advantages over other types of assets.

First, the tenants you are likely to see in your typical center are the smaller operators described in the previous section - they want to rent a space at a definite price for a certain amount of time. Generally speaking, they are looking for uncomplicated leases and are able to sign relatively quickly compared to larger corporate tenants that will require extensive management and legal review at multiple levels.

Theoretically, with simple leases comes simple management.

That said, if you aren’t going to hire a professional management company to run your asset, be sure you have a professional to assist with writing your leasing documents and be sure you understand them completely. A well-written lease should not be expensive and it will make your life far easier in the long run.

Additionally, there is no substitute for properly screening a new tenant. If you aren’t sure how to do that, we would be more than happy to help answer your questions.

4. Greater Return Potential

Despite sounding like a definite term, the concept of a real estate return deserves its own blog series all together because it can mean 10 different things to 10 different investors. With that in mind, I am going to focus here strictly on capitalization rates (“cap rates”). If you are unfamiliar with cap rates, it is simplest to describe them as the unlevered operating return of a property relative to its value.

As an example, a $1m property with a cap rate of 10% (a “ten cap”) would generate $100,000 per year in Net Operating Income (NOI) before any capital expenditures or financing costs. Cap rates have an inverse relationship to price, so keeping the NOI fixed and increasing the cap rate to 11% would decrease the value of the property and decreasing the cap rate to 9% would increase the value of the property.

Over the past 10 years or so, cap rates have steadily been driven lower across the board (this is known as  “cap rate compression”) as more investors were willing to accept a lower return in exchange for real estate’s general stability. In addition, this lowering of cap rates also had the advantage of increasing exit prices (“appreciation”) for investors and helping to generate a higher total return.

While this has happened throughout all asset classes, it has generally been less severe in smaller commercial centers because they are too small to attract the interest of institutional investors, and the tenants do not have the same credit profile these investors normally target. The lack of institutional competition means there is additional room for small or individual investors to be compensated for their efforts.

One possibility to be aware of is that prime infill strip centers are likely to be offered at lower than expected cap rates because the value of the land has increased to the point where a small strip center is no longer the “highest and best use.” That said, an asset that fits that profile is known as a “covered land play” and could still be the right fit for an investor that understands that investment strategy.

5. Manageable Price Points

Finally, for investors just starting out, an obvious advantage to a neighborhood center is the generally achievable price point. This is attributable to two points discussed above: smaller footprint and a higher cap rate.

All things equal, a 10,000 square foot center should logically cost 10% of a 100,000 square foot center. Higher cap rates can help further shift this balance in favor of a smaller property.

As an example, let's take two properties that generate NOI of $8 per foot - one is 10k sqft and the other is 100k sqft. As such, the NOI of the smaller property is $80k and the NOI of the larger property is $800k.

At an 8 cap, the smaller property would be valued at about $1m, or $100 per square foot. Valued at a 6.5 cap, the larger property would be valued just over $12.3m, or $123 per square foot. The exercise is summarized in the table below:

Because they are valued at different cap rates, the relative price (price per foot) will be different even though they generate the same income on a per foot basis.

Conclusion

Hopefully this outline has helped explain some of the best reasons (financial and otherwise) for an investor to consider adding neighborhood shopping centers to a growing portfolio.

The ability to use his or her own market knowledge to evaluate a market along with the ability to diversify occupancy risk across several tenants can help a newer investor mitigate overall investment risk.

Additionally, the relative ease of management along with generally more achievable price points and preferential return possibilities can help cement this asset class as the right choice for new commercial investors.

As stated earlier, there are a range of asset classes available to investors and I look forward to covering them over the course of this series.

About the author:

Hunter brings a wealth of knowledge and experience to The Cauble Group, with an emphasis on investments. Hunter understands the importance of strong underwriting and market analysis to both buyers and sellers of commercial real estate.

Prior to joining The Cauble Group, he was the Vice President of Acquisitions for a Houston-based family office where he managed the identification and acquisition process for direct and sponsored investments across multiple sectors, including multifamily, medical office, and retail.

Contact Hunter Vigneault