Retail Property - Due Diligence
Commercial Real Estate
We’ve discussed retail property, which is one of the primary commercial real estate property types and thus an important part of any diversification or asset allocation strategy. In our earlier overview, we reviewed how this sector can be somewhat cyclical and is influenced by the state of the economy, especially such indicators as employment growth and consumer confidence levels. Valuation remains a property-specific matter, though, and in this article we’re going to drill down into some of the key aspects of due diligence on retail properties and some of the key factors driving their valuation.
As with any property, the physical state of the retail center must be assessed to evaluate deferred maintenance items that can materially affect the operation and value of a property. Depending on whether the property is of the triple net lease variety (and thus whether the tenants might be responsible for some of the building maintenance), a prospective retail property owner should evaluate the plant’s foundation, roof, heating and air conditioning systems, electrical, plumbing, elevators, and the building’s “envelope” (the windows and walls). Expected future repairs or improvements should be analyzed with an anticipated timeline and the associated costs, in order both to better negotiate the purchase price of the property and to perform appropriate financial planning for the investment.
An inquiry more specific to retail property concerns the quality of the tenants that occupy the shopping center. Investors generally hope to see some “credit” tenants -- stores that are part of a large national chain with access to public credit markets. The more prominent of these will have an investment-grade credit rating from a major rating agency, which rating can be anywhere from “BBB” to “A.” Retail properties that are dominated by “noncredit” tenants would be deemed of a somewhat lesser quality property type, perhaps as Class B or Class C.
We discussed in our retail property overview how leases in this sector can be of relatively long duration, since stores need to have some time to get their businesses established. Investors should review not only the current rent roll but also the various lease terms of the tenants, and get an understanding of the timing of any upcoming renewals. The market rent rates of similar properties in the area should be studied in order to assess whether the leases coming up for renewal currently have lower (or higher) rents than other similarly situated properties. Some centers may offer a “value-add” opportunity if the current rentals are perceived to have been mismanaged and the rent roll might be increased with a changed tenant mix or other repositioning of the property.
Factors affecting the general marketability of a retail property include the property location and nearby traffic flow; the area’s population demographics; and local household incomes and buying patterns. The average number of people driving (or walking) past the center on any given day is a key metric in evaluating a retail center. Convenience of access can also be an issue; if in a heavy traffic area, are there exit ramps or turn lanes that ease the approach to the center’s parking lot (and is the parking lot of sufficient size)? It is also important to understand the local population (and whether it is growing), and to know the average local age and income level. This is key in understanding the center’s customer base and in assessing whether the center’s existing retailers are an appropriate “fit” for that population.
The success of the center may also depend on the local competitive environment. If similar retail businesses operate nearby, they may operate to “cannibalize” the sales of the stores in the shopping center if the total market capacity is becoming saturated. It is also essential that the center not have an internal mix of businesses that might unnecessarily compete with each other. Fashionable new entrants can also disrupt the center’s business; if an older, smaller grocery store anchors a shopping center and a shiny new Whole Foods store opens nearby, then the older grocery store tenant could become competitively obsolete and the center’s overall sales may drop off correspondingly.
The above discussion represents only a partial survey of the various factors to be assessed when evaluating a retail property. At Realty Mogul, we try to do a review of a retail property’s tenants, location, market demographics and other attributes of the property. We include much of this information in the listing for a property, and each investor is advised to do his or her own due diligence in order to better understand a property’s risk profile.