Qualifying the Income in a Retail Property Acquisition

By:  Jack Nugent, Director | Newmark, Global Managed Services and
Rudolph E. Milian, President & CEO Woodcliff Realty Advisors, LLC

Due diligence can be cumbersome, but rushing through the process can cause a buyer to pay more than the shopping center is worth.

With borrowing costs expected to continue trending down next year, transactions of open-air community centers are likely to increase, possibly to a level not seen since 2021, as interest rates level off and valuations become more apparent to sellers and buyers. After two years of sluggish dispositions, sellers will want to monetize their real estate assets, some burdened by high-interest-rate loans.

As the market for retail properties ramps up, many new buyers will seek to acquire “value-add” retail properties that can be leased up and fixed to improve cash flow and valuation. Many of the acquisition targets will be properties whose anchors shuttered in the past few years where owners didn’t have the resources to replace the vacant anchor spaces. Vacating anchors not only reduce the properties’ cash flow, but these vacancies can topple specialty tenants as part of a domino effect.

On “value-add” acquisitions, it is important to fill existing vacancies

On “value-add” acquisitions, it is important to fill existing vacancies, increase the leasable area to attract additional rental income or replace tenants with expiring leases to bring them to market rents.

Today, the national vacancy rate in open-air power centers, community centers, and neighborhood centers is 4.5%, the lowest in decades, according to CoStar data. Yet, more than 75% of the retail space available for lease is in older, lower-quality properties built before the turn of the century. Just 11% of available retail space was built after 2010, which indicates that modern or modernized retail spaces are in the highest demand by tenants looking to lease space, and those types of shopping centers will not qualify as “value-add” acquisitions.

Therefore, to acquire truly “value-add” centers, you should look for centers in healthy markets with a vacant anchor or two that can be leased after the center is renovated and expanded.

How to find shopping centers with vacant anchors

Most shopping centers offered for sale will be listed by national brokers, such as Colliers International, Cushman & Wakefield, Marcus & Millichap, Newmark and others. Still, not all centers that could be available for sale or could be seeking an equity infusion are listed by the large brokers.

Instead,  you might want to first identify the centers with vacant anchors, then do some research to see if they are available for sale or are seeking an equity investment. One way to identify shopping centers with vacant anchors is to search the ShoppingCenters.com and Directory of Major Malls database. Search for shopping centers and malls with “closed, closing or vacant anchor stores.” You can also run an overall search or identify specific “named” vacant anchor stores, such as vacant Bed Bath & Beyond or T. J. Maxx.

You can tailor your search by center types, e.g., lifestyle/specialty/mixed-use, community center, power center, and you can also search by city and state. The DMM data also include the names of the shopping center owners/developers and their authorized agents.

Once you identify your target acquisition and have contacted the seller, you’ll need to examine the offering memorandum (OM) to assign the proper cap rate you are willing to pay. The next step is to begin due diligence in order to shed light on the potential risks and opportunities of the proposed transaction. The most crucial part is ensuring all the income implied in the OM and the leases are reliable.

Are the seller’s assumptions reliable?

As the buyer, the price you pay to acquire a retail asset is one of the most critical factors in determining how much the investment will ultimately return to you and your equity investors. If you pay too much, it can be challenging to achieve your projected returns and ultimately meet your goals for the asset’s ultimate appreciation.

For the seller, the reverse is true. The seller wants to achieve the highest price possible to obtain a healthy return for the seller’s investors. As the buyer, your goal is to establish that the cash flow presented by the seller/broker is fully substantiated by the documents in place. However, quite often, you may find the seller’s own missed opportunities. Ideally, the goal is to identify the seller’s overstatements of cash flow based on the documents in place to get them to acknowledge the reduction in cash flow. At the same time, the buyer should ensure they are not “offsetting” the found revenue against these reductions. This creates an “acquisition spread” – essentially instant equity upon close.

“acquisition spread” – essentially instant equity upon close

We often uncover instances when buyers inadvertently give up equity when they casually offset additional found revenues against overstatements rather than treating them as two separate adjustments in their cash flow analysis.

For example, the buyer reviews the OM. The seller and broker have presented an NOI for the first year of $3 million. Based upon the seller and broker’s representations, the buyer presents an offer of $40 million – a 7.5% cap rate – and the seller accepts the offer. The buyer then begins due diligence to ensure that the leases support the $3 million NOI.

Based on the information presented, the seller and broker made one material overstatement: the first rent escalation of a big-box anchor lease is incorrectly projected to kick in on 1/1/25, while the lease actually states that the first increase begins on 1/1/26. This seemingly immaterial error amounts to a whopping $100,000 a year. The first-year NOI is $2,900,000 per year instead of $3 million based on the incorrect data presented in the OM. At a 7.5% cap rate, that’s $1,333,333 overstatement in value.

Then what?

Absent any other issues, you would go back to the seller and point out the $100,000 per year overstatement. You then ask for a purchase price adjustment. You agree to a purchase price of $38,666,667 based upon the corrected $2.9 million NOI. The 7.5% cap rate stands.

However, quite often during the due diligence process, you are likely to uncover an upside. Perhaps a few tenants have rent caps that were treated as non-cumulative but should have been treated as cumulative. Maybe the seller and broker have used the same denominator for property insurance as CAM when there are a handful of big-box tenants that provide their property insurance and should be excluded from the denominator when allocating to other tenants; one of the many common findings.

Let’s say that the series of adjustments you have found will increase the NOI by $125,000 per year. Where buyers hurt themselves is that rather than going back to the seller with the $100,000 overstatement, the buyer does not because the NOI, after the overstatement adjustment and after the series of upsides giving the buyer an additional $125,000 for the first year, results in a revised NOI of $3,025,000. In those cases, buyers tell themselves that they are doing better than a 7.5% cap rate because they are getting a $40,333,333 asset for $40,000,000 when, in fact, they should be getting it for $38,666,667 by treating the adjustments separately.

Keep in mind that these are two separate and distinct issues. In the first example, the seller inadvertently misrepresented the NOI. There should be a purchase price adjustment based on the overstatement. Otherwise, the buyer would be giving away the upside it identified during due diligence if they net the upside against the overstatement. That is almost a $1.67 million swing in value by not treating the two issues separately.

Another common issue in the due diligence process is a disconnect between the acquisitions team’s assumptions and the property management/asset management teams not being fully aware of those assumptions.

Often during the due diligence process, you are likely to uncover an upside

This past year, we encountered a few instances where the new owner billed all tenants on leasable rather than the handful of tenants that were underwritten using the seller’s leased method. Retail leases commonly use the gross leasable area as a basis for rent and reimbursable calculations. However, some tenant leases require those calculations to be based on the pro-rata portion of the leased – instead of leasable – GLA. The tenant’s lease-required contribution can be substantially less or more depending on the method used to calculate those expenses. As the acquisitions team did not communicate that it had underwritten the cash flow using the lease-required “leased” method, the buyer applied the “leasable” approach used in its standard lease form. Essentially, because of this miscommunication, the buyer would be paying for revenue it would not receive.

When using the income approach to value a shopping center, many factors are considered when assigning the capitalization rate. These factors include the prevailing interest rates, the property’s condition, the asset class, the investment size, the quality and credit rating of the tenants, the reliability of the anchors, the comparable retail sales of the tenants in the center and the market, the perceived upside in rent growth, the property’s location, and external economic factors, such as employment in the primary trade area and the size and growth potential of the market.

However, once the cap rate has been agreed to between the buyer and the seller, the net operating income applied to that cap rate needs to be qualified to ensure the buyer does not pay more for the agreed valuation in the event the income is underestimated.

Related Articles

• Easily Identify and Access Closed and Vacant Anchors
• What Do CAM and Taxes Run at Open-Air Shopping Centers These Days?