Today we’re interviewing James Chung, he is the Executive Managing Director and Managing Principal for the Western US for Cushman & Wakefield’s Retail platform. He has been with the company for 15 years and has worked with over 30 national tenants and over 9 million sf of retail across the Bay Area in Silicon Valley. Some of his clients are: AT&T, Chase Bank, Adidas, In&Out Burger, and Sur La Table. He not only helps national tenants find space to lease, but he also lists retail properties for lease. James has served as State Director for ICSC, which is the largest Retail organization within the industry, and he is also very involved with other organizations such as ULI.

First I wanted to hear his thoughts on the future of retail real estate and where it is going, he said that it’s all speculative and that there has definitely been a national softening in retail, as well as a gradual shift in the types of transactions that are happening in the retail front: whether that is downsizing, or right-sizing, some have been creatively repurposing outside of retail. Sometimes people are allergic to change, and that uncertainty makes people worried, but retail is going through a metamorphosis. Things are becoming more efficient, the supply and fulfillment side of the business is becoming even more important (which is connecting the e-commerce side of a business with their brick and mortar stores), but while that was once seen as adversarial, he believes it can work in harmony with retail, and the sky is the limit!

Tips for Listing Retail Properties for Lease and What to Charge Tenants per Square Foot
First you need to understand the health of the shopping center, and one way to do that is to understand the health ratio of the tenants. The health ratio is the relationship between gross sales and total occupancy cost. Then go through the health ratio tenant by tenant, and understand if the rent they’re paying is equitable to their sales performance. The challenge with pricing is that geography will often dictate pricing. However, you can have an asset next door to you charging half the rent! Part of that reason is co-tenancy, part of it is how updated the center is, part of it is who anchors the center, as well as how accessible the center is. There are a lot of variables that will dictate the market rent (or at least the asking rent), and oftentimes geography doesn’t dictate that number. Retail is not commoditized in the way where we can say “By virtue of being on this block or that block, your rent should be X”, it’s like when you are getting comps for a home, the price/sf in that area gives you an indication, but it is within 10 to 20 to 30% of where things could be, depending on the home itself. And in retail especially, block-by-block can change dramatically. Other things to look at are how to optimize the merchandising strategy for the center, and what he means by that is: are the tenants in place at highest and best use for the positions that they are in the shopping center? When digging into that exercise, he takes a much higher level look at lease expiration dates, who’s lease is coming up and when, who is healthy or not, where we could reposition tenants, and that sometimes means moving them around in the center to optimize the opportunity for the asset.

What is TI and How is it Negotiated? 
TI is Tenant Improvement Allowance, it is a funny item because there is no rule of thumb per se.
For ground up development what ends up happening is that you will have a certain delivery condition that you will provide to the tenant, and then you’ll earmark cash for the tenant to ultimately finish the space. What that means is that it’s a good idea to deliver the space in a shell condition (which may not include a restroom, or drywall, and will often have electricity, but not distributed) and the reason for that is that tenants are very specific in their build-outs and they will often end up ripping everything out to their own specs, so we should save all that money, earmark that cash, and give that to the tenant for their build out.
For existing spaces it all depends on the financial position of the owner: is the owner in a place where they have cash? Can they underwrite those dollars to the tenant? Are they willing to write that check to the tenant? There is obviously a risk if the tenant does not succeed (the cost of capital), and the financial position of the landlord is also important. When you work with institutional landlords, there’s a lot of cash earmarked, but when you’re working with a local private owner who may not be able to write a huge check, there’s often a push and a pull as it relates to the base rent (and therefore TI), so a lot of times that capital is amortized at a money factor, and underwritten like a loan. The capital improvements in the space are depreciable, not the TI, the TI is amortized at a money factor like any other kind of loan. Often times when negotiating a lease with large institutional banks for example, their cost of capital is cheaper than anyone else’s, so they don’t want any TI. They would rather pay a lower base rent and deal with everything themselves. On the other hand, restaurants and fitness centers require the most TI, and it’s challenging because when you’re dealing with these types transactions you’re providing $50 to $100/sf in TI over 5,000-80,000 sf. That’s a very large check, and those checks are typically not used to finance the deal, they’re typically given after the tenants receive their certificate of occupancy and all the liens have been released, but it’s really not intended to be used to finance the project.

What are Good Types of Tenants to Have in Your Center?
It depends on the opportunity, if it’s a neighborhood shopping center, the most coveted asset class would be a grocery anchored shopping center. One of the most desirable investment opportunities for people, especially in the Bay Area are grocery-anchored centers in the retail space. If you’re in any neighborhood, if there is a strong national grocery tenant who is the hub of the center – that is typically the most desirable. Besides that, there are lots of asset classes like malls, lifestyle centers, outlet malls, and so many different types of shopping centers, but if he had to pick one, he would probably say grocery anchored.

From a Real Estate Investor’s Perspective, What Should We be Looking for When Purchasing a Retail Property?
Geography is one, there is always demand for all asset classes in places like the Bay Area where the fundamentals and the demographics are sound, and you have a lot of reasons that will survive the flow of business cycles. But when you get into the fundamentals of a shopping center, it really is driven by your purpose. Is your purpose to value-add, reposition, create the lift, create the value and enjoy that, or sell it? Or is your purpose to have fixed and safe income, where you have a lot of good credit in your center and you’ll be able to enjoy it for whatever a typical hold period time is? Depending on what you’re looking for will dictate the type of opportunities you’ll be asking, but as it relates to the quality of the investment, it’s going to be credit-based, and dependent on the value of the signature on the leases.

How Can We Make Money in Retail When the Cap Rates Are so Low in This Market, and What Should We Look For in a Deal?
Low cap rates are actually not necessarily a bad thing if the income on the property is under market. Even if you’re paying 3.5% cap on a deal but the rent is 50% of what it should be, that’s when market intelligence comes into play, and understanding how things are being underwritten. There is currently a compression in cap rates just by virtue of geography and being in Silicon Valley, but there still are great opportunities out there, you just may not find them listed openly. It’s about understanding how to unlock the value in whatever asset you’re looking at because there are many ways to skin the cat, and oftentimes people are looking at it very one-dimensionally, when in fact there may be multiple ways to create value.

What Are Some of the Ways to Create Value?
Understanding the latitude of the land that you are on is one of them, so that maybe retail is not the highest and best use, maybe it’s a large enough parcel to build something. When you understand how high you can build, there is a considerable delta in what land value is for pure retail, and what land value is for high density residential, so there is potential for an entitlement play where maybe the retail on the property is X, but there is a strong multiple for repositioning it for high-density residential.

Lastly, even though you may be buying something at a low cap rate, maybe there is a 2-3 year carry, and you know that the value in three years can be at a 7% cap, even in today’s market rent. Or maybe there is a repositioning opportunity at a certain price, be it based on it being on X corner, which is one of the best in the Bay Area, and knowing that there’s a large tech tenant coming across the street, or that there are things happening down the road and public transportation is coming in. You have to understand the whole landscape in order to properly evaluate something because what may appear today, is not going to be what appears 2 years from now, and having that knowledge is power.

What Are the Top Things We Should Make Sure to Cover During the Due Diligence Process Before Closing on a Retail Property
You should see if there’s any history of hazardous materials in the property, or any current hazardous material because that can undermine anything you could ever want to do on the property. Make sure you’re doing a full circle around a property, and understanding all the latitude that you have with the opportunity. It’s hard to generalize because there are so many ways to buy a property, and sometimes you’re buying on a speculative basis where maybe it’s an empty property. Some of the things are:
– Understand if you’re buying on income
– What does that income really mean
– What the signature is really worth
– Who signs it
– Is the signer a shell entity that has a single purpose for this property and despite being a billion dollar company, the actual signature is not worth anything?
– Who has signed the LOI

Those are some things to check off during the process. But, depending on where you’re buying and how you’re buying will really dictate your due diligence process.

The only constant thing in life is change.

François de La Rochefoucauld