Topics: Sprouts, redevelopment, negotiation

Transcript:

Chris Ressa:
Welcome to Retail Retold everyone. I’m your host Chris Ressa. Thanks for joining me today.

So I’m excited. We’re going to talk about a redevelopment that’s been in the works for a while and the lead store opening for that, which is Sprouts Farmers Market at College Plaza, our shopping center in Fort Myers, FL.

So redevelopment is a funny word. It means a lot of things to a lot of different people. For some, redevelopment is a change of use, right? Where you’re taking a retail box and turning it into self-storage, or you’re taking a former industrial site and turning it into a shopping center. For a lot of things that we do in retail real estate, redevelopment really means, and by the way, we do that, but for a lot of people in retail real estate, in particular us, redevelopment means that it’s still generally retail to retail at times. And I think it’s important to start with redevelopment because what really drives… redevelopment is highest and best use and it is funny how we determine the highest and best use.

So the highest and best use is really determined by the demand for that use in a market and the financial wherewithal to satisfy that demand. I think one of the things that happens when properties don’t get redeveloped, even if there’s demand, the financial wherewithal to… meet that demand doesn’t work. The economics don’t work. And so one of the most challenging things about redevelopment, and that’s why redevelopment’s so hard, is because you have a use step or a project that needs to morph, and then you have this, can I morph it and make money? Which is a hard thing.

Now, with a caveat, there are obviously redevelopments of properties that are great and we’re trying to make them better. And that happens all the time. What I would say is what makes headline news are the ones that like go from challenging to exciting. So highest and best use, right? What makes the highest and best use. There’s a lot of things you could, you know, I’ve seen so many highest and best use sites. It’s something we will do when we’re looking at something, you know, real estate developers for a long time have like gut feeling on what should be there. You go talk to the community, but you know, really digging into the data to get to a highest and best use is super helpful. And if you’ve never gotten a highest and best use study, I think it’s a pretty helpful tool. It’s not a Bible, but it’s a helpful tool. Oftentimes they don’t necessarily consider the economics to a developer. They just start looking at, you know, macro numbers in a trade area and comparing that to other trade areas and what’s successful for those uses.

Let’s step back, we’re in retail. So we talk a lot about micro uses all the time. A soft goods retailer or a food and beverage retailer or a sporting goods retailer or home improvement retailer. That’s not what I’m talking about by use. What I’m talking about by use is the zone. Zoning, right? Is it zoned for commercial or retail? Is it zoned for industrial? Right? Is it multifamily? That’s the start. That’s what’s typically driving in the highest and best use study.

So we have this property in Fort Myers, Florida. We’ve owned for a very long time and the property was one where we hadn’t put a lot of capital into it. And it was a cash-flowing property. And because of the low rents of the property, it was hard to justify spending significant dollars. Now, the property was anchored, a smaller property, to give everybody some context. Let me give you the exact square footage here. Don’t know it off the top of my head, but hold tight. The property is anchored by a call center. It’s an 85,000-square-foot property. The property is anchored by a call center. So… Um, you know, from a retail perspective, hard to drive small shop rents if the anchors are call center, but it was always pretty decently occupied. And, we always had good renewals. And, you know, we kept it at it as is. When I say good renewals, I meant we always had, you know, good retention on tenants. And they’re certainly driving rent growth.

However, the market around us, Fort Myers, Florida, Southern Florida, West Coast, but Southern Florida, starting to get really hot. Markets getting tighter, very little retail vacancy, but super desirable from a tenant perspective. Now we have COVID and the call center calls us and says, “hey, we’re up in a few years, we’ve had a good relationship, you’ve been a good landlord. We’re giving you a heads-up. We probably are looking to downsize. It’s a call center. We’re gonna do some things remotely.”

Here’s the thing that was a challenge, but one thing that made the property great. HCA, one of the largest healthcare systems in the United States, is the tenant on the lease for the anchor. So it’s a call center, so from a use perspective, it doesn’t really drive the rest of the center. From a credit perspective, it’s super compelling. So taking them off the lease always made it hard because we had some opportunities in the past. But… it was challenging because we were offered trading down in credit. So this was the opportunity though like we’re going to have to really force ourselves to look at potentially redeveloping if they wanted a downsize and they were giving us the time.

So we decided we went to market the box and we had some ideas on what we thought it should be. We thought it could be a specialty grocer. There’s two grocery stores in the market and there were full-service grocery stores and they were, you know, doing really well and those centers were driving for small shop rents more than double what we were achieving. So for the first step we have some time, we’re just gonna see what the demand is. So we go to market and we’re trying to figure out what the split of this would be if we downsize it. Turns out we get an opportunity with the grocery store, but they don’t want us to downsize the call center. They want the whole space. So we’re trying to see how real they are. Keep in mind, by the way, that the call center is a full-service lease. We’re not an office landlord. So it was operationally, it was different than all our properties because it was a full-service grocery list where we were doing the cleaning inside the space and all these things. So, we get this grocery store. Now we have great credit timing. And we all know that adding a grocer will definitely elevate the… the creditworthiness of shop tenants that we procure and potentially the rents. So as we get a letter of intent from the grocer, you know, now we have to talk to HCA.

So HCA, we went to them and sold our loan and we said, listen, I know you want a downsize, but you’d be interested in buying out of your lease completely. We might have an interest in that. And they came back and they said, depending on the number, yes. So now we’re, and what you have to do in these scenarios, we’re negotiating both deals simultaneously. Because you have to understand the economics of both. One without the other you can’t really do.

And so we started negotiating. We kind of got to an understanding of what it would be to turnkey Sprouts and what that rent would be for a turnkey. And then, and we’ve got a 15-year term, and then what it would be on a buy-off from HCA. Now it’s only four years left, not that significant, but something to offset some costs, because we know there’s costs. We’re in the middle of COVID, construction costs are rising. And so we end up… signing a termination contingent on us, signing a lease with Sprouts. And a lot of tenants wouldn’t want to do that, but the office tenant didn’t have HCA, didn’t make anything loose, so they agreed to sign a termination contingent on us with Sprouts. And we had a window of time where we had to get the Sprouts done or then my termination went away. We were able to get that done. But one of the things that also happened was, you know, the, there was a lot of deferred maintenance at the property and you know we were patching things not replacing things at times.

Remember it was low rents, and it was hard to invest significant capital. So we ended up getting to a place where we were like alright we’re going to redo the whole center. So what does redo mean? Redo meant we were going to redo the entire facade of the balance of the center on top of the turnkey for the sprouts. And then we were going to start to, bring in new tenants to push rents. Now pushing the rents meant we were going to have to invest more dollars because some of the spaces were in tough condition. We have to really renovate those spaces to get them leased up. So we’re talking about a significant spend.

Significant in an already income-producing asset that we have to go and get an accretive incremental return, right? And so when I say incremental return, it’s a number that we look at all the time. It’s the return on the new equity that we’re putting into the property. So if you have a tenant, let’s say who pays $20 a foot in rent. and they’ll renew for 22 or you have another tenant that’ll pay $30 in rent but it’ll cost you $80. The way you might look at that, one metric you might use is what’s your unlevered incremental return on cost? So in the example you could get 22 on the renewal as is but you get 30 on the new tenant. Well, that’s a spread of $8, so eight, that’s your numerator. And then, but the new 10s can cost you 80. So I’m gonna get an extra $8 in rent. For the pleasure of that, I get to spend $80. 80 is the denominator, eight divided by 80. I get a 10% incremental return. So we’re looking at, there’ll be 10% of the new money going into the deal. Now, those weren’t the returns here, but that, that I’m talking about, it’s a more complicated pro forma. We were, you know, we were trying to solve to what we felt was a creative incremental return on cost to do this, because this is now going to turn into, you know, an $8 million-ish, you know, $9 million-ish, you know, depending on what happens with star shows. renovation. So we want to make sure we’re going to spend that.

We have to be able, you know, just let’s say if you’re going to do an eight million dollar renovation, you wanted to make 10. Well, you need to find an extra $800,000 if that lies in that property. Again, those weren’t, those aren’t exact numbers, but I’m giving it our own context. And so the way we, the way we kind of got there was, you know, We had some spread on the sprouts from HCA, but we also, we realized we were significantly under market on the balance of the shopping center and the small shop space. So, you know, we did a huge market study on market rents, in particular, at the centers really close to us that would be akin to us, those grocery centers, what were they getting in small shop rent? And they were full.

So, we ended up moving forward with this Sprouts HCA termination and new signing and committing the dollars to the property. And Sprouts ended up opening a couple of weeks ago. It looks great. You can go on our social media, DLC, social media, go on my LinkedIn. You can see what the new Sprouts looks like. And The balance of the facade is continuing now and should be done relatively soon. So that’s the story of Sprouts.

But something I will say that is something to keep in mind is, you know, it’s because we made a big bet here, right? If we don’t lease up the rest of the small shop at, you know, some rents, if our thesis in bringing in a grocer, remodeled on the center, coupled with the market fundamentals, doesn’t drive rent growth. Those are the three things that are the base foundation, right? Bringing in a, you know, a highly productive, hot grocer, long-term basis, remodel the center, and the market fundamentals, you know, demand in the market for space is high, low vacancy. you know, so far as, you know, growing. Those are the three foundations, you know, the non-monetary but the foundational pillars of the investment thesis. So, if you’re right, you should be able to, you know, get some small shop. If you’re wrong, you know, it’s a big miss.

You know, we have done this a lot all over the country. So we’re pretty, you know, pretty compelled by the opportunity. But along the way, you know, the small shop leasing, you know, the words getting out, we’re doing press releases about what’s going on. The small shop leasing was a little slow. And you know, it’s a lesson I learned a long time ago about commercial real estate. And that’s the best marketing. There’s a lot you can do in marketing. The best marketing commercial real estate is construction of your property. The intrigue of things happening drives tenant demand, or what I should say is tenant intrigue. And tenant intrigue can lead to tenant demand. And so, you know, we signed the lease and then you gotta go through the permit process, there’s a long time coming.

And the small shop, we’re going out to market and you’re showing a vision, a dream, what’s on paper. And, you know, a lot of people have leased vacant dirt. That’s often easier pre-lease than a redevelopment because vacant dirt, there’s no history, no existing product, people in their mind, they see what’s been there forever. And they’re like, I gotta, I gotta really see the changes. The rendering on paper isn’t enough. And so just as we suspect at the moment we start construction, we start getting new small shop leases and we’ve signed a bunch.

And so it’s a little insight at the end, like the best marketing you can do at your property is construction. And it doesn’t always have to be a remodel. It could be just the construction of a new tenant. People are interested, oh there’s action going on here. People want to be at this property. That’s interesting. What’s going on here? Let me reach out to the landlord. Let me find out. Let me get more information. Like I said, vacant piece of dirt never been developed. There’s a growing market, you’re trying to catch up to the market. That’s a sales pitch for new development often. And like I said, that’s actually often easier because there’s no history. So anyway, that’s how Sprouts opened at. College Plaza in Fort Myers Florida. You should check it out on our social. You should check it out if you’re ever in Fort Myers. I’m excited about this redevelopment. It’s cool taking a non-Grocery Income Center and making it a Grocery Income Center. And yeah, remember some of that tidbit on construction about being a marketing weapon. All right everyone, thanks for listening. That’s the show today. Catch up soon. Looking forward to everyone listening next week.

Thanks so much.