Grocery-anchored retail has weathered the e-commerce storm better than the greater retail sector.
I recently caught up with John Grellner, a grocery-anchored retail expert who freelances through Bullpen. Before becoming a freelancer, John worked for Forge Capital Partners, an investment firm that focuses on grocery-anchored retail. In John’s time with Forge, the firm operated a couple of value-add funds where they would purchase grocery centers in the Southeast and Texas.
By way of being a value-add fund, Forge purchased lots of their properties from REITs. Internally, Forge would say they buy mismanaged retail centers from REITs, make them better, then sell them back to REITs.
In my interview with John, we did a deep dive on how to analyze grocery-anchored retail properties, as well as their drivers of value.
Retail real estate comes with its own set of terminology. I’ve defined some of the most common terms, many of which you’ll see in this article.
Anchor Tenant - The anchor tenant on a retail property is typically the largest tenant on the property. In the case of grocery-anchored retail, the “anchor tenant” is the grocery store. Some large retail properties can have multiple anchor tenants.
Grocery Center - A “grocery center” describes a retail property with a grocer as the anchor tenant. This term is short-hand for grocery-anchored retail.
In-line Retail - The term “in-line” refers to the additional, smaller retail spaces on a property that are attached to the larger “anchor” tenant.
Power Center - A "power center" refers to a retail property with a big box like Ross or Michaels, accompanied by smaller in-line retail tenants.
Outparcel - Have you ever seen a Starbucks building in the parking lot of a grocery store? This building is called an outparcel. The development of outparcels is typically a value-add strategy for a retail center with an oversized parking lot. Typical outparcel tenants are restaurants and fast food.
Over the past 10 years, retail commercial real estate has quickly fallen out of favor. Largely due to the rise of e-commerce, capitalization rates for power centers have been expanding while other sectors have seen cap rates fall to record lows.
However, grocery-anchored retail properties have thrived. Grocery centers continue to experience strong foot traffic, which can be attributed to people’s desire to see their fruits and vegetables before buying.
From an investor’s perspective, the most attractive grocery-anchored retail centers have the majority of their leasable area consumed by the grocery tenant. Additionally, the best grocery centers have experiential retail in the in-line units.
Double-clicking on this, when the grocer is 80% of the total leasable area, and the other 20% is out parcels or experiential, then the property can sell for a very low cap rate.
Grocery valuations will be largely driven by the local brand following of the store.
While Publix has a big following in most of the southeast, HEB has a cult-like following in Texas.
A Kroger in Florida isn’t as attractive as a Kroger in Ohio, where their headquarters is located.
You also want to consider the local demographics of the area when determining the value of a grocery store. A Food Lion in an area with a high median income will not perform as well as a Whole Foods or Trader Joe's.
Fun fact … according to John, Publix bought about 50% of the listings for shopping centers that had their stores between 2013 and 2017.
When a grocery-anchored retail center is listed for sale, you’d hope there are at least 10 years left on the grocery lease. A shorter remaining lease term should be dug into and might be a red flag.
Grocery leases are typically for a 20-year term, plus a number of options for the grocer to extend the lease. After the first 10 years of the lease, the landlord is incentivized to renegotiate a new lease with the grocery store - it reduces the risk of their portfolio and gives them an option to sell the property.
A short lease term on the anchor tenant is an enormous risk to a buyer, and most wouldn’t take that risk without a considerable reduction in the valuation. As such, most owners will renegotiate the lease ahead of listing the property.
When the remaining lease term is short on the anchor tenant, you’ll want to first consider the type of seller and why they may have not pursued a renegotiation of the lease. If the owner is a wealthy individual without the infrastructure and managing office to approach and renegotiate the lease, the grocer might just be happy paying their low rent and using their extension options. This wouldn’t be considered a red flag.
However, if the owner has the means and knowledge to follow up with the grocer but hasn’t renegotiated the lease … this is a red flag.
When considering the health of a grocery tenant, the most important metric is their occupancy cost.
Occupancy cost is calculated by dividing the store’s all-in rent payment (including CAM) by their store’s sales. A healthy store will have an occupancy cost that is between 2% and 4% of its sales.
When occupancy cost is below 1%, you probably have the power to negotiate an increase to the lease price. When occupancy cost is above 5%, you might have concern that the store will close. Most Publix properties have a lease cost between 2.3% and 2.7%.
A new lease typically doesn’t mean a rent concession for a grocer. More common, grocery stores will negotiate improvements with the new lease. Common improvements include a new facade or parking lot renovations.
For example, a value-add investor might purchase a grocery-anchored retail property with a Publix that is paying $2.60 per SF. During lease negotiations, the investor might offer to redo the entire box, costing $70-$100 per SF. Upon completion, the new rent might be upwards of $7-$10 per SF.
Diligence for a grocery center is a bit different than for other types of retail assets. I’ve listed a few things to consider below:
Market Conditions - When you look at the market, you want to make sure that the tenants and the median income data for the surrounding market match. A Food for Less in a wealthy area wouldn't make sense.
Competing Locations - Look at what other grocery stores exist. If your anchor tenant has a new location within a mile or two, you might worry that they are going to decommission the old store.
Grocery Anchor Diligence - In diligence, you’ll have a call with someone in corporate to ask questions. They will never give you what you want to hear, but you’ll be able to read between the lines. With a big grocery chain, real estate is a big component, and they have big real estate departments. They want to keep negotiating power, so they typically won’t give you all the information you need.
Site Visit - Make sure that your site visit is at the same time the store manager is on-site. You'll want to ask questions about the property, location, and relationship with the current landlord.
During property diligence, it’s common to interview all in-line tenants. A few common questions include:
Additionally, you’ll want to confirm the remaining lease terms on the current tenants. Short in-line leases aren't as big of a red flag as a short anchor lease, but they still should impact your analysis.
Be sure to review the property’s general ledger to confirm timely payments by in-line tenants. Consistent late payments might signal an issue.
An interesting diligence story from John … While at Forge, John led a Publix site visit while his boss was on maternity leave. As part of the visit, John interviewed the property’s inline tenants, asking their thoughts on the center.
Oddly, 4 of the 8 inline tenants gave weird answers, indicating there had been issues, but they are all worked out now. All of their complaints were a little bit different.
Upon review of the general ledger, John found that those same tenants were way behind on rent, and then paid it all off at once.
It turns out that the landlord paid his tenants so they could pay rent to the center. This made the rent roll look way healthier than it actually was. John and his manager called the guy … and they never heard from him again.
All retail properties will have a general vacancy assumption in their underwriting, typically between 5-10%. When underwriting vacant units in excess of the 5-10% general vacancy, you’ll want to account for a lease-up period for the empty units.
For an anchor tenant, you might assume 12 to 24 months of vacancy. For inline tenants, you’ll most commonly see a 6-month lease-up before the first unit is leased, and 3 months between subsequent leases.
Value-add retail funds typically won’t purchase a retail property with more than 90% of the property leased.
Keep in mind that a broker will typically send you aggressive lease-up assumptions. Your job is to bring their numbers down to reality.
A few common value-add strategies for retail:
Essential commercial real estate principles and information.