Strategy For Shopping Center Investments in California
Investing in shopping centers in California presents a real challenge for many investors. Most shopping centers in the state offer very low if not the lowest cap rate in the nation, e.g. 4-6% range. As a result, the cash flow is weak compare to shopping centers in other states. Investors will also need more money for a down payment, e.g. 40-70% of the purchase price to qualify for a loan.
The upside is that the vacancy rate for retail properties in the state is among the lowest in all 50 states. For example, the retail vacancy rate in San Jose is only about 4%, the second lowest in all major metro areas (Oakland has the lowest vacancy). This means the income stream should be very stable. So, as an investor, if you don’t achieve strong cash flow, you must look for property with strong potential for appreciation to achieve better investment returns. To accomplish this, you could:
1. Sell the property at a lower cap rate. If you purchased a shopping center at a higher cap rate 5-10 years ago then you will be able to capture strong appreciation. However, if you purchased the property recently at a low cap rate already, it’s not possible to reduce the cap rate much lower. So this approach probably won’t work.
2. Increase the rental income. Most NNN leases have a fixed 3% annual rent increase. Assuming the market cap rate remains the same, this will only equate into an unimpressive 3% annual appreciation, unless you want to achieve appreciation in different ways.
Property Analysis
The goal to increase the rental income begins with the analysis of your purchase. While most retail properties in California offer 4-6% cap rate, many properties charge tenants below market rent due to
1. Poor property management and/or simply ignorance about market rent. Some property owners choose to manage their own properties to save expenses. However, they are among the worst property manager if the collected rent is used to measure their performance. They often are not aware of the market rent and so they often lease to the first tenant to ensure the unit is occupied quickly.
2. Long term leases signed when the rent was low.
So the key is to identify properties with below market rents and a low price per square foot. These properties will provide you with upside potentials. However, the market rents often have a wide range. For example retail space in San Jose commands between $2-5/SF a month. It’s not easy to determine if the tenants of the property pay below market rent. The following are some properties that have low upside potential that we may want to screen out:
1. Big-box properties with anchor tenants, e.g. Wal-Mart, Target, or Safeway. These big national tenants often sign long term lease with low rent due to its creditworthiness and large rental space. Once the lease is signed, the rent is locked in for 20-30 years. So it’s almost impossible to drastically increase the income within a short time. As a matter of fact, many big-box retail properties in California are listed at below replacement cost. This is because they have long term leases with below market rent. They are on the market for a long time and yet is not sold because the cap is low, e.g. 4%. The prospect for higher income is sometimes 15-20 years away when the lease expires.
2. Retail centers with very high price per square foot, e.g. more than $800/SF. You will need to charge the tenant $4/SF a month plus NNN to achieve 6% cap. This is almost the highest rent in the market so it’s hard to push it up even higher.
3. Retail centers with long term options AND fixed 3-5% rent increase instead of being adjusted to market rent. You should pay attention to this little detail in the lease as it may have major impact on the rent you collected. The problem is the appreciation is often higher than 3-5% annually in California. So if rent is not adjusted to the new fair market rent at the beginning of a new lease option, the rent is most likely below market rent and it may not sell at the highest market price.
On the other hand, if you see multi-tenant shopping centers offered at 4-5% cap but priced at only $200-300/SF it’s very likely the property has below market rent. This kind of property will offer strong potential for appreciation. Once you see this property, you should also see if the property is:
1. Adjacent to an anchored tenant. Business owners prefer to be near an anchored tenant as this anchored tenant will bring in more traffic to the center. The business owners are willing to pay higher rent for this location.
2. A multi-tenant strip with small units. In general the rent is higher for small units, e.g. 1000 SF than for larger 4-5000SF because there are more tenants looking for 1000 SF units.
3. On a major artery or near the freeway. More traffic and convenience are always good for business.
4. In a stable or growing area with higher household income. When the local residents have higher disposable income, they will spend more time and money for good and services offered in the retail centers.
5. Located in an area with low vacancy rate and high rents. Ideally, you want a property lease that will expire within 1-5 years. This will allow you to adjust to the higher market rent quickly.
Sometimes it helps to see problems as opportunities. For example:
1. Most investors don’t like retail strip with gross leases. However, if you can convert these gross leases into NNN you will be able to get strong appreciation.
2. Most investors don’t like a shopping center with high vacancy. However, you may be able to buy at a low price. If you can turn around and improve the occupancy rate quickly, you will be able to realize good appreciation.
Property Management:
Once you purchase a property, you will need a good property manager to help increase the rent. The property manager is a key partner to implement your investment strategy. In order to increase the rent substantially, e.g. 30-50% more compared to the rent in the previous lease, the property manager must demonstrate to the tenants that the new market rent is a fair market rent. Otherwise, the tenants may make a wrong decision and move out. This involves research to determine fair market rent and providing comparables to the tenants. So as a fair business person, you want to make sure the property manager has an incentive to do the extra work. One way to accomplish this is to compensate the property manager a certain percentage of the appreciation when the property is sold in addition to the typical 4-5% property management fees. This is a win-win for both the property manager and landlord when the property appreciates in value due to higher net operating income. Otherwise with a typical 4% fee in a property management contract, you will likely receive a 3-5% rent increase when the lease is renewed. Both you and the property manager lose when this happens.
Of course, some tenants with marginal profits won’t be able to afford the higher rent and will move out. The property manager will have to evaluate the financial and business strengths of all the tenants and identify potential move-out’s. She will plan accordingly to find replacement tenants to minimize income disruption.
Prior to a substantial rent increase, you may want to make cosmetic changes to the center to give it a new look. You may want to consider the following:
1. Re-paint the center.
2. Re-surface and paint the parking lot.
3. Ensure the air conditioners and heaters are in working condition.
4. Fix any leaks in the roof.
When the tenants see these improvements, they may convince themselves that it’s too risky to move the business to another lower rent location.
Favorable Financing:
You can also improve cash flow by obtaining financing with favorable terms from unconventional sources, e.g. insurance companies or conduit lenders instead of typical commercial lenders. While you have to pay higher loan fees and closing costs, the long term savings in interest payment are substantial. This should lower your interest rate from about 6.75% to 5.8% for multi-tenant shopping centers.
Conclusion:
The commercial real estate market in California is very different due to its very low cap rate. To achieve strong investment return, you will need to be a creative business person with this “so-called” passive investment. By choosing the right property with below market rent, hiring a highly-motivated property manager, and selecting low-interest financing, you will achieve strong cash flow and robust appreciation within a relative short time.
Disclaimer: The investment strategy and investment management information presented in this article should not be construed to be formal financial planning advice or the formation of a financial manager/client relationship. The authors intend to provide information to the general public based on our recommendations of investment management and investment strategies and is not designed to be representative of your own financial needs. Nor does the information contained herein constitute financial management advice. The authors makes no warranty or representation regarding the accuracy or legality of any information contained in this article, and assume no liability for the use of said information. Please do not make any decisions about any investment management or investment strategy matter without consulting with a qualified professional.
Ala Moana Shopping Center – Shop Until You Drop in Honolulu
A Little History
Walter Dillingham purchased 50 acres of unwanted swampland in 1912 from Bishop Estates for $25,000. Actually Waikiki was mostly swampland as well into the 1800′s.
Plans were announced in 1948 for the shopping complex. The Ground breaking ceremony occurred in 1955 and construction began in 1957.
When it first opened in 1959, it was the largest mall in the entire United States with 89 stores and 4,000 parking spaces. The Mall of America built in Bloomington, Minnesota became the next mall to become the largest in America. Today Ala Moana is one of the 15 largest malls in the U.S.
In 1966 the mall doubled in size and added J.C. Penney and Liberty House.
In 1987 a food court with 19 restaurants and 900 seats was added.
The current owners of Ala Moana (General Growth Properties) use it as a template, and have invested a billion dollars to remodel other centers across Canada and the United States.
The Ho’okipa Terrace was opened in 2005. It has ten incredible restaurants all in one place including Bubba Gump Shrimp Co., California Pizza Kitchen, Islands Fine Burgers & Drinks, Mai Tai Bar, Pearl, Romano’s Macaroni Grill, Ruby Tuesday, Tanaka of Tokyo, and Tsukiji Fish Market and Restaurant.
Ala Moana Shopping Center Today
The mall is very close to Waikiki, so it is convenient for tourists. A shuttle runs every ten minutes from Waikiki seven days a week. It also has plenty of parking for those who are driving, and it is within walking distance of the Ala Moana Beach Park.
For the locals, the mall includes a grocery store, post office and a night club (Pearl Ultralounge). For all, it includes a huge international food court. You can also find fine dining facilities.
Interesting facts about Ala Moana Shopping Center:
“Ala” means street, and “Moana” means ocean in Hawaiian. The Developers chose the name “Ala Moana” because it explained the location of the center.
Hawaii became the 50th state eight days after Ala Moana Center opened Hawaii in August 1959.
Eleven of the original mall retailers from 1959 are still at the mall today, although they may not be in the same location.
Sears Longs Foodland Slipper House Crack Seed Center Reyn’s Shirokiya Watumul’s Territorial Savings U.S. Post Office Dairy Queen
Unique to Ala Moana
The mall features open-air corridors, which are lined with palm trees and tropical vegetation including real banana trees.
There is a center stage for performances which feature local entertainment including dancing, singing, and much more. The Royal Hawaiian Band (accompanied by hula dancers) frequently plays at Center Stage, which is one of the most popular amphitheatres in Hawaii.
They often have fashion shows on the center stage and since it is open air, they can have fireworks for special celebrations.
Down the center of some walkways are koi (fish) ponds with lilies where you can sit on the rocks and relax. There are also amazing waterfalls to enjoy.
The mall has high-end shops including Gucci, Louis Vuitton, Versace and Armani, as well as department stores like Macy’s and Neiman Marcus.
Ala Moana covers 2.1 million square feet and has four levels of shopping and dining options.
Strip Mall Ownership
One of the unexpected truths of the industrial age is that people enjoy shopping. They enjoy picking things up, and comparing them; it’s all the pleasure responses from being hunter-gatherers, without having to watch out for leopards or hyenas. The modern extension of this is retail space that packs a lot of retailers together in close proximity. We’ve all seen this pattern – it’s the shopping mall or strip mall.
The strip mall is a solid vehicle for commercial real estate investment, provided you’re in a part of the country with significant and real job growth. Current figures show that occupancy rates are increasing, with a nationwide vacancy rate of under 8%, and a number of hot markets under 3%. What this means is that you can expect over 90% occupancy rates through most of the urban areas of the country (it’s harder to fill rural strip malls, so be warned), and expect on average about 15% churn (new tenants moving out and being replaced) per year. Over the last year, strip mall rents have risen by between 1 and 6%, depending on the market, outstripping inflation, and making them a prime candidate for a buy-and-hold strategy.
Strip malls are a poor choice for a buy-and-flip real estate investor, so make sure that one fits your overall investment strategy. A good strip mall produces a revenue stream that’s fairly even, but won’t give much more than a 5-6% annual rate of return on your investment. Like all rental properties, you are dependent on the cycle of job growth and the local humps and bumps of the economic cycle; make sure that your rental income is generating a significant cash flow even at low levels of occupancy, because economic news and job creation and loss, like the tides, will ebb and flow, and they’re your bread and butter indicator for how to plan with your investment.
Cities that have grown out, rather than up, such as Houston, are good candidates for strip mall ownership. If you’re constructing a new facility rather than buying an existing one, do what you can to drum up clients before the mall is completed; when you know when the doors are open, you’ll want to have at least one or two “anchor” businesses in the mall immediately. (An anchor business is generally a large national chain, usually electronics or clothing driven, depending on the demographic chosen).
Strip mall and shopping center design is a mixture of planning and artistry. Look at your local demographic trends, and consider all your options. One of the newer trends in shopping centers are what are called lifestyle centers. Catering to people who are looking for entertainment options as well as shopping, lifestyle centers offer theaters, restaurants beyond the basic food court, and are laid out with a wider array of parking options are a fast growing trend. Many are more open air, and a number of cities (like Philadelphia and Houston) offer grants for making some of your shopping center into parkland. Focus on who you want to come to your center, and build relationships with businesses that will pull in those customers for you.
Recall that shopping centers are, in today’s hectic world, family centers, and plan appropriately. If you have a suboptimal space (one that’s hard to rent, and every mall has at least one), consider leasing it at cost (or marginally above) to the YMCA or another charitable organization that provides facilities for children with some modicum of supervision. The loyalty you build from harried parents for your other tenants will be greatly appreciated if your mall has a place where children can be sent to play that’s safe and well lit while they go and shop without having to mind them.
Don’t overlook the cultural opportunities for a shopping center; many of the layout arrangements that make for aesthetically pleasing, friendly shopping experiences can also be used for small open air concerts or small theater productions; in addition to pulling more customers into the mall, it’s a point of differentiation that, in a world where over 800 shopping centers, totaling 106 million feet of floor space were opened last year, is critical.
Ultimately, your shopping center is an investment in your community, and an investment you get a solid return on.