FEATURE ARTICLE, DECEMBER 2006

GROCERY RETAILERS ARE WORTH THE RISK, SOMETIMES
KeyBank Real Estate Capital takes a look at the ups and downs of investing in grocery-anchored retail centers.
Rick Harsch

Rick Harsch, KeyBank Real Estate Capital

Once considered “recession-proof,” grocery-anchored shopping centers have become a different kind of investment than in the past. With the rise of Wal-Mart and the fall of some of the nation’s major grocery chains, finding a grocery-store anchor that will last is more difficult than it used to be. From the lender’s perspective, this property category simply is not as much of “a safe bet.” While lenders still view grocery-anchored shopping centers favorably, financing a new development or acquisition requires more intensive market analysis today than it did in the past.

In Texas, nowhere is this more evident than in Dallas, the epicenter of grocery store competition. Dubbed “the toughest grocery market in America” in a May 2005 Advertising Age article, Dallas is home to more than 1,000 grocery stores serving a population of 5.5 million. Competition in Dallas is not fierce – it is brutal.

As in many other markets nationwide, Wal-Mart is the dominant player in the Dallas market. The impact of Wal-Mart on markets in Texas and beyond cannot be overestimated, as the company’s relentless pursuit of the lowest-cost grocery offerings has made life very difficult for the traditional grocery chains. Lenders, of course, are keenly aware of “the Wal-Mart effect” on grocery stores nationwide.

Until recently, Albertson’s was number two in the Dallas/Fort Worth market, and also has stores in Austin. Of course, its locations now are in question following the company’s highly publicized break-up in spring 2006. The implications for Texas are not entirely clear at present, but the usual pattern in grocery chain consolidations is that at least some locations go dark and are eventually assumed by other retailers or adapted to some other purpose.

In this instance, the Texas locations of Albertson’s were acquired by a Cerberus Capital Management-led group of investors, which includes Kimco Realty Corporation, Schottenstein Stores Corporation, Lubert-Adler Partners and Klaff Realty LP. Albertson’s Texas operations are largely in Dallas/Fort Worth and the Cerberus group said in its announcement of the transaction that it would operate the stores under the Albertson’s name on an ongoing basis. However, Klaff Realty and Lubert Adler have impressive histories of acquiring failed or underperforming retail locations and re-leasing or redeveloping them at significant added value, which suggests that the Dallas/Fort Worth Albertson’s stores may not be long for this world.

In this dynamic, it is not a matter of “only the strong survive.” The grocery chains that survive are those that can differentiate themselves not only from Wal-Mart, but from each other. Property investors and lenders must have a keen understanding of the local market dynamics in order to create a successful grocery-anchored shopping center. If Wal-Mart has captured the cost-conscious consumer, other area grocers must target a well-defined niche or provide superior value-added services to which consumers respond.

The Austin-based Whole Foods chain is a well-known example of a niche player that has very successfully differentiated itself from traditional grocers. By targeting upscale shoppers willing to pay top prices for organic products, Whole Foods is meeting a need in the marketplace very successfully. So successfully, in fact, that Wal-Mart recently an-nounced its plan to provide low-cost organic produce and numerous other grocers offer organic products as well.

Another competitor in the produce category is Sprouts, a Phoenix-based farmers market-style chain that recently announced plans to open up to 30 stores in the Dallas/Fort Worth area. Known for its affordable organic produce selection, Sprouts already has Texas locations in Dallas, Flower Mound, Frisco and Southlake. 

Central and South Texas are dominated by Kroger, Wal-Mart and H.E.B. Central Market. Kroger has been strengthening its competitive edge with new state-of-the-art formats in some stores. H.E.B. is, of course, another Texas grocery success story and an example of a strong regional brand and privately held company that has succeeded where others have failed. Safeway’s Randalls and Tom Thumb stores also are competitors in Central and South Texas.

Houston is another highly competitive Texas market where lenders and investors should conduct additional due diligence. Kroger, H.E.B., Wal-Mart and Safeway’s Randalls brand are the primary contenders. Unlike Dallas/Fort  Worth, Houston has no Albertson’s locations because the company left this market some time ago. Likewise, the North Carolina-based Food Lion chain pulled out of Texas several years ago.

Given the state’s large and growing Hispanic population, it is not surprising that ethnic grocers are capturing increasing market share. Fiesta Mart is the leading grocer in the Hispanic community in Texas, with stores in Houston, Dallas and Austin. The number-two grocer serving the Hispanic community is Minyard’s Carnival Supermarket chain, which operates across north Texas. Both chains offer Hispanic, traditional and international foods. Both focus primarily on the Hispanic consumer, with Spanish being the dominant language on store signage and English secondary. H.E.B. recently introduced a new store concept designed to appeal to Hispanic consumers, an example of the kind of niche targeting that has helped some grocers succeed.

Obviously, all of these currents affect the flow of capital into grocery-anchored shopping centers. From the lender’s perspective, the choice of grocery anchor for a neighborhood shopping center is key to the financing of new construction or an acquisition. As shopping center investors know, the revenue generated by a grocery store’s rent is secondary to its role in driving traffic to other retailers in the center, who usually will pay significantly higher rent. The grocery anchor may also affect the sale(s) or ground leasing of outparcels.

Successful supermarkets create a steady stream of repeat customer traffic, drawing patrons about 2.2 times a week, according to the Food Marketing Institute. Attracting a strong grocery anchor is critical, because in-line tenants often have clauses in their leases that allow them to leave if the anchor goes dark. Thus, the grocery store is the critical piece of the overall puzzle of a grocery-anchored shopping center.

 If a property does not have a grocery anchor that is among the top contenders in the market, more equity or holdbacks may be required to reduce the lender’s risk. If the grocery anchor is perceived as weak, leasing the remainder of the property may be challenging because other retailers naturally are wary of a non-dominant or struggling grocery chain. Thus, the profitability of the property as a whole may be affected. 

As with any commercial property, a lender will look closely at the location of a grocery-anchored shopping center. A nearby Wal-Mart, for instance, is considered a risk factor, as is the possibility of other grocery-anchored shopping centers being built nearby. What lenders like to see are barriers to competition, such as a superior location, or an established community with few developable sites remaining.

If the property is an older shopping center, a lender will look at whether the grocery anchor space can be adapted or enlarged. Today’s sophisticated grocery formats tend to be larger and more complex than those of the past, and not every property investor is prepared for the significant investment required to retrofit an existing grocery space for today’s store formats. It’s not your mother’s grocery store anymore — grocery store formats are evolving as never before to accommodate changing consumer needs and wants.

Despite the uncertainty in the grocery industry and the increased perceptions of risk associated with grocery-anchored centers, property investors and developers need not despair. Lenders still view grocery-anchored centers as solid investments, but are looking more closely at the marketing and operational strategies of prospective grocery store tenants. A lender that understands local market dynamics will be able to determine whether a project is positioned to succeed. Also important, a sophisticated lender will be able to provide a financial solution that addresses the borrower’s business plan for the property.

The fact is, consumers always will need to shop for groceries and grocery providers will always need facilities in which to operate. The bottom line? The smart money will bet on the retailers — and their landlords — who understand their local markets very well.

Rick Harsch is senior vice president and team sales leader of the Houston, Texas office of KeyBank Real Estate Capital.