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Trademark CEO and President Interview Dr. Peter Linneman

Recently, our President Tommy Miller and I had an opportunity to interview Dr. Peter Linneman, the renowned real estate economist and publisher of The Linneman Letter. We asked him for his assessment of the retail and retail real estate business in the U.S. In the interview, we discussed malls, online sales, retailer credit, and retail and mixed-use investments.

Dr. Peter Linneman Interview

Terry: Peter, in the mall, lifestyle or mixed-use business, where do you think the opportunity is in retail investments today?

Peter: Let’s start middle/tertiary markets. First of all, as an investor, malls are impossible if they are good malls in good markets. You’re signing into a mid-single digit guaranteed return almost… at today’s pricing.

Terry: You mean from an acquisition return standpoint?

Peter: Yes. If your cost of capital is 4% on the debt with a maturity of 6-7 years, …as a blend, and your cost of equity is 7-8% total return, 50/50 debt. You can do it, but you’re going in for a 6% IRR unlevered and you get 8 on equity and 4 on the debt. If it’s a good mall – that’s the reality. That’s whether it’s a in a major market or a secondary market. But even in second tier market, classic GGP cities, if it’s the good mall in the city and it’s doing $450/foot, the pricing is still that way. It’s because what these malls have really become are locations and not stores.

This means it’s a bulletproof mall. You could lose tenants, dropping your sales from $650 to $575. You’ll replace them with a better tenant, bringing up the value. Those great malls, irrespective of where they are, are difficult to buy (unless you have institutional money i.e. a REIT, CalPer, etc)…

And I don’t think the capital market perceives anything below $350-400/foot as viable. So there’s kind of a discontinuity in the pricing as you get below $400 a foot. There are some poorly managed malls. Just so you have my background, I was trained by Al Taubman. My biases are Taubman like. I never worked for him, but it’s really who I learned the business from at a personal level. The one thing I think he was dead right on is that people basically shop where they live. If you have a center that’s weak, it’s probably a place where people don’t want to live or don’t have the money to spend. You show me a mall that once did $400/sf and is doing $300/sf now – unless it’s transitory because of a particular weak tenant – like a Montgomery Ward, it’s hard to do well when you have one of those in there. If you can get rid of a weak tenant in a market that used to do $400-500 a foot, then you can win. If you have a pretty good line up of tenants and you’re not doing the sales, it says more about the neighborhood and their shopping patterns, and changing those is quite difficult.

If you ask me my favorite kind of mall or shopping center: its decent numbers in spite of weak retailers. I was really bullish – and talked to clients – about buying centers with Circuit City or Mervyn’s figuring that if you show me a center that has decent numbers with those types, would be a positive indicator, and getting rid of them is the best thing you’ve got going. I guess what I’m saying is that you have to try to distinguish: Is it doing bad because of the retailer or is it doing bad because of the location? Those are hard to sort out. If it’s one of the highest selling stores of a weak retailer, then I like it. I tend to like centers that have high performing retailers, in their chain, which means there’s something there that does better than elsewhere. It’s unlikely be the merchandise, it’s unlikely to be the manager, it almost certainly has to do with the location and as a real estate owner – I own the location. That’s why in some cases you want a weak retailer instead of a stronger one because you know you’ll get rid of them eventually.

Terry: What is your take on the effects of online retailing on our business?

Peter: E-commerce has been wildly successful, but not as successful as people though 10 years ago, but it’s about 6% – 7% of all non-auto retail at this point (up from nothing a decade ago), and I think that will continue. The challenge of e-tailing is soft goods. It ends up being a very expensive way to shop in soft goods. Let’s say you order five pairs of jeans in different sizes and colors – with the shipping costs associated with that kind of order – you try them on, keep one and send 4 back. That’s a very inefficient distribution model.

What it’s been very good at is “I want that record” or “I want that book”. You never order 6 books, try 5 and send the other 4 back, they always fit. Where they’ve had a hard time succeeding is when “It may not fit”. The tenants where it may not fit, look right, move right, hang right or have the right color – have trouble. The way people solve the problem is order a whole bunch. Just think about it as a shipping model, it can’t work. I don’t think e-commerce wipes out traditional retail. The way it works is you try it on before you shop online and you know it fits. That’s not what people buy on impulse, it’s what people buy on destination. You then have to look at the mix. If you asked me what the biggest threat e-tailing poses, I think it’s supermarkets. What occupies supermarket shelves? Things you know that fit like V8 or other brand name goods. A lot on supermarket shelves are pure “I know what I want” goods. To the extent that eventually gets done on the internet, what do you do with the shelf space? Let’s say that takes only 10% of the products supermarkets now do. They won’t wipe out most of what they sell, it’s that they wipe out selected things of what they sell and then you have to amortize the overhead over a narrower set of selections. If you think about it, supermarkets today are the old line department stores that had a furniture department and the like. If the internet effectively deals with that, it will be a challenge to the anchors in grocery centers, even if it only takes 5-10% of their business. It’s the same thing that happened to department stores: the record department went, the toy department went, etc. That hasn’t really happened yet to supermarkets, but it is an area that has more risk than people think, I believe. It can be the death by 1,000 cuts more than wiping them out.

Terry: What other issues do you see that others are not talking about?

Peter: Moving forward, I would assume tenant credit doesn’t exist. I think the great mistake people have made with retail in the past is they still view retail as a credit business. My view is that competition (think CC and BB) or Wall Street (Someone who over leveraged) or the internet (booksellers), is sooner or later going to erode their credit. Don’t view retail as credit, view it as a location. Credit is secondary because it will fade. Good credit today may be a poor credit in 5-7 years. I promise you within the next 10 years that Wal-Mart won’t be nearly as good a credit as today. The history of retailing over the last 100 years is that competition or Wall Street will erode their credit given half a chance. Don’t buy credit, buy location: neighborhood, its stability, the transportation system and its growth potential.

While we’re talking about location – the empty shopping centers aren’t worth the effort. You know, the ones that were built in 2005-6 far west of Phoenix or far east side of the inland empire or in Ft Meyers because there were going to be 20K homes built in the next 10 years. Those aren’t retail, those are just stacks of bricks. You don’t want to bet on when roofs will come in retail. Buy the location. It’s hard enough to figure out the right price and manage it correctly when the rooftops are already there. Someone may make money in them, but they’re more likely to lose money.

Terry: In the future, where do we make money in the retail and mixed-use business?

Peter: I think mixed-use is a hard product. Everyone thought it was an easy product. I have watched a lot of them…they’re more hard than they are easy. In very few of them does the office component work. There’s not much synergy there.

Terry: What we’ve found is that when you build a mixed-use development in trade areas where there is an existing vibrant office market, the office component can work extremely well. It doesn’t work in a traditional suburban retail location environment.

Peter: And that’s the kind of project I was talking about. There were retail guys who said “I’ll throw some office up above.” It works about as well as second story retail generally works: really well on paper but not any other way. I think I would take your answer exactly. There’s no future for that kind of “I had a great retail site and put some office in it”. That’s just wasted second floor money. The residential side is a little more complex in the mix. From my experience, you’d be better off not putting the residential above, but adjacent. The problem I’ve seen with residential above is that you’ve have to do structured parking, which runs up your costs. The second thing is that you’re not going to build the first floor (the retail) until you get the retailers tied down. While you’re waiting for the retail deal to get tied down, you may have missed the market window on the residential. So there is some limited synergy between the retail and residential (suburban), but putting it above makes it more complicated and expensive.

Terry: You’re right on. Again, it’s the same thing. I am writing an article for ULI called “does mixed use work”. Many say no because they built apartments with retail on ground floor in a residential location. When you have a healthy multi-family market that happens to coincide with a great retail location, it can work.

Peter: The only thing I would add to that is: if they’re both at the same point in the cycle at the same time. This is so you’re not doing the tap dance of parking/retailer/apartment. If not, it’s awkward. Doesn’t show up as a cost, but it is when you miss windows that way.

Terry: What is the most important factor for growth in the retail sector?

Peter: For retail, with the exception of groceries, it’s jobs. You know? The kid gets a job, buys a flat screen TV for the new apartment and it gets the ball rolling. Absent the job, he watches TV at home. Job creation not only gives the kid an ability to buy a new TV, it gives us the comfort to shop knowing that it’s 4-8 weeks to get a job as opposed to 25-50 weeks. So, we keep spending.”

As retailers contemplate where to focus their limited U.S. expansion, they are targeting Texas and DFW for several reasons. First, Texas is the only area in the country that has regained 100% of the jobs lost during the recent recession, versus only 28% regained in the U.S. The fact that 3 of the top 7 U.S. cities for job growth are in Texas, places the state atop many retailers’ expansion lists. DFW, consistently in the Top 2 in the U.S. for Job growth, typically tops the list of Texas markets. Tarrant County continues to strengthen its relative position in the state with standout population growth in 2011 of 2.52% in Tarrant County, versus 1.01% in the U.S.

Terry: It seems to me that there would be pent-up demand in housing with the reclamation of so many jobs, is that fair?

Peter: There are about 2,000,000 houses in pent up demand. You should be adding about 1.2 million households per year. In 2008 we added about 400,000. There’s 800,000 pent up. About the same in 2009, that’s 1.6 million. In ’10 it was about 600,000 added leaving us with about 2.2 million houses. In the last ten months, we’ve started to catch up, but it’s sitting at 2 million right now. Think about it, that’s 2 million apartments or homes, 2 million televisions, 2 million sets of silverware, etc! So when you think about that not just as a housing matter but as a retail matter – it’s out there.

There’s a flip-side to this coin, though. The good news is that it will create a surge beyond normal population when it occurs. Here’s the bad news of that: people are going to draw charts, assuming it happens, showing the upswing of normal retail plus the pent-up demand for three years. You can imagine that people will extrapolate those three years to forecast the nextthree years forgetting that the last three years were so strong because of the pent up. You have to make sure not to fool yourself, as it happens, to believe it’s permanent.

Terry: Thank you for your time today Peter.

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