This month, Massey Knakal partner James Nelson discusses the state of the retail investment markets with John Usdan of Midwood Investment & Development, which owns 120 properties in 12 states and is currently working on four development projects; Friedland Properties’ William Friedland, who is quarter-backing several projects, including the redevelopment of the former Bank of New York site on 63rd and Madison; Linfield Capital’s Mark Chan and Johnny McCarthy of Trevi Retail which buys properties and operates 17 primarily retail properties in Manhattan.
MOD: Please just give us some background on your company, and what you’re currently working on.
JOHN USDAN: Midwood Investment & Development is currently working on four development projects. The first one is a 82-unit rental on Broadway inSouth Williamsburgat theMarcy Avenuetrain station that will have about 40,000 feet of retail space. We have another rental project at 7th andUnionin Park Slope that will have 28 very high-end apartments with about 11,000 feet of retail space. We’re building a 60,000 square foot, three-story retail building at the corner of 15th andWalnut StreetinPhiladelphiathat’s designed by Vincent Jay. We have another project which is a renovation at the corner ofSeventh Streetand H in Downtown Washington, which is right across from theVerizonCenterin Metro station, which is the second busiest train station in D.C., that we’re leasing to a variety of food and retail firms. It’s about 30,000 feet of retail and office space.
MOD: What’s the total size of your portfolio?
JOHN USDAN: Well, our portfolio has around 120 properties in 11 or 12 states.
MOD: Great. William?
WILLIAM FRIEDLAND: Friedland Properties’ main project right now is a redevelopment of the former Bank of New York site at the Southwest corner of63rd Streetand Madison Avenue. It’s in a landmark district, so we’re trying to work through the Landmarks process to redevelop it from its original use as a bank in 1922. And so there are a lot of challenges to make it work for, for a retailer. We’ve been working on that for nine months now. And we probably have another year or two.
MOD: Okay. How many square feet will you end up with there?
WILLIAM FRIEDLAND: We don’t know. (laughter) It depends on the Landmarks process. But we’re hoping for at least 20,000 feet of rentable space.
MOD: Okay, great. And some of your other holdings include the retail at the Apthorp?
WILLIAM FRIEDLAND: Ah, yes. We’re a retail focused company, mostly inNew York City, mostly inManhattan, with a small amount in the boroughs and some things in the tri-state region. But the vast majority of what we do is inManhattan.
MOD: Great. Johnny?
JOHNNY MCCARTHY: Trevi Retail buys properties and operates them. We own 17 properties inManhattan. Our focus is retail in or aroundNew York City.
MOD: Great. For those of you who are out in the market trying to lease retail space, can you tell us what the appetite is like out there from retail tenants and where are rents today as opposed to, say, six months or a year ago?
WILLIAM FRIEDLAND: Things are very strong. Rents are up. And more importantly, I would say, velocity is up. So it’s not just a question of the rents. But if a deal falls through you have a backup, and in some cases a backup to a backup. And that certainly wasn’t true several years ago. I think in the higher end areas prices are as high or higher than they were in 2007. And in the secondary areas, I would say things are coming back strongly and maybe at those levels or approaching those levels.
MOD: Does anyone else want to comment on that? What is the difference in rent growth between side streets and Main andMain?
JOHN USDAN: I think that there is a flight to quality. Unique locations have tremendous pricing power while the tertiary locations don’t. Our better quality space is seeing a lot of rent growth and a lot of demand, with often two or three tenants competing for one space. And a lot of the markets that I think we’re all working in there’s a real shortage of space. And that’s a good thing for landlords.
MOD: Are the prime locations today only for national tenants as flagship stores? Do you think these are loss leaders for them? When a tenant pays three thousand dollars a foot to rent onFifth Avenue, is that a profitable endeavor, or is it really just about the advertising and notoriety that they get out of that space?
JOHNNY MCCARTHY: When I worked for a national retailer, we had a location inTimes Square. The location was a little bit of a money loser, but we looked at how much it would have cost to put a billboard up in Times Square and how much foot traffic it generated. It led to millions of dollars to the bottom line. So maybe in the four walls of the store it may or may not be profitable, although I think they’re starting to become more profitable over time. I don’t think any retailer is really looking to open up a store that really is truly a net loser for the company. So I think ultimately they have to be profitable for stores to, or companies to step foot inNew York Cityand open up these kinds of stores.
MOD: Okay. Are retailers having a challenge today competing against Amazon and other online retailers? Is this a trend that continues? Or is that really not applicable toNew York City?
WILLIAM FRIEDLAND: I think there are a lot of reasons to shop. And only some of them are getting the lowest price or being able to do it at 3:00 in the morning. Clearly, the internet has affected some areas in some stores, but Amazon has now been around for over ten years, and we’ve all just been talking about how the retail is driving, and seems like there’s enough room for everything.
MOD: What are typical lease terms today — free rent, build-out, increases? What kind of term are tenants looking for?
JOHN USDAN: It really depends on the type of tenant and the size of the space. If it’s a renewal soft goods retailer, they will come to us and say, we would like a ten-year lease, with the right to terminate after five years. We’ll say no. And they’ll say, okay, we still want the store. Typically in our space they get a minimal amount of free rent to build their store, and we do not contribute anything.
MOD: William, do you bring in partners? Do you syndicate?
WILLIAM FRIEDLAND: It’s mostly just our family. We try to keep it simple internally. And it’s the way we’ve been doing it for decades.
JOHN USDAN: Same…
MOD: Have any of you ever thought about raising a fund?
JOHN USDAN: We’ve thought about it. We’ve never done it. Because in order to raise money you’re, you’re staking your reputation. And to me, the most, the thing that I have of most value is my reputation. So I never wanted to put it at risk by making promises that I may not be able to keep. Luckily, I’ve never gotten over the hurdle of raising money.
MOD: Mark, can you talk about pricing today, deal flow, and what you’re seeing out there?
WILLIAM FRIEDLAND: Prices are off the charts. I’m sure everybody here would agree. Cap rates are — unimaginably, I would say, are continuing to compress. And it’s hard to see it stopping.
MOD: Even with the, the interest rate uptick?
WILLIAM FRIEDLAND: That’s been very, very recent, but certainly I don’t think it has deterred any sellers. And I don’t think it’ll really deter any buyers. It hasn’t been drastic enough yet to really impact the economics of it yet.
MOD: So if credit retail today is selling in the four cap range, how can cap rates continue to compress?
JOHN USDAN: There’s an inverse correlation to cap rates in the market. So, the stronger the market is, the lower the cap rates become. And in, particularly in areas — I don’t know about Johnny or William — but we’re seeing rent growth that is just breathtaking, that I’ve never seen before in some of the areas in the city. And people are paying based on that future growth. So there’s almost no cap rate, that if you think you’re buying a property and the rent’s a hundred dollars a foot, and tomorrow they’re going to be $300 a foot, that you wouldn’t pay for it. There’s obviously a lot of froth to the market. But there are some areas of the city where there’s so much residential development taking place in concentrated areas that it really is driving rent growth.
MOD: How do you project where the rents are going? For example you look at the comps onSixth Avenuein the Village, and they’re $200 to $250 a foot. Then I hear someone’s asking $500 a foot. How do you establish rents when you are trying to set the high water mark?
WILLIAM FRIEDLAND: Well, you can’t comp it, right?
WILLIAM FRIEDLAND: That’s the difference, I would say, between an investor and an appraiser or a bank lending officer. The investor has to take that leap of faith that there’s continued demand that the retailers would find value, even at a higher number, and presumably make money at that higher number. It is also knowing the market. If I have a space down the street and I had four offers for it, then when something comes available across the street, I know the market and do not have to rely on comp info from the past.
MOD: Johnny, when Trevi buys, are you looking for long-term or short term leases? Would you describe Trevi as a core or a value-add type investor?
JOHNNY MCCARTHY: We look for a balanced portfolio. So we try to mix it up with a little bit of a value add and a little bit of core. Ultimately we’re, looking for return. So if it’s a deal that doesn’t look attractive on the front side but it does get their eventually; that’s great for us.
MOD: A good example of that was a building you purchased onEast 13th Street with a two-level restaurant paying $80 a foot and barely making ends meet. And then you brought in a star restauranteur, and who paid double the rent.
JOHNNY MCCARTHY: That was a good example of what William was saying: if you know the market you can do quite well. We knew there were a lot of restaurants that were looking and were going to be aggressive right on that street.
MOD: What qualities do you look for in a retail tenant? Would you rather take a higher rent from a tenant with no credit or a lower rent from a national?
JOHNNY MCCARTHY: I think it’s a balancing act higher rent, versus the credit. We consider if the tenant can actually afford to pay the rent. Do they have some type of balance sheet? Or is it just somebody’s first restaurant where you could probably expect to get the space back? Ultimately we like to have a balance of credit throughout the portfolio.
MARK CHAN: One additional point is we try to look for a meaningful security deposit. If we have a local tenant that is a well known entrepreneur who we’d like to be supportive of at the right rent level or with the right security, it gives us further comfort.
JOHN USDAN: If we have a dozen other properties within a two or three-block radius, we will be looking at our tenant mix as well. And it doesn’t come down to the highest rent. But typically, it’s the tenant’s concept and what we think, whether that concept is aligned with who the customer is in the market and who we think has the ability to generate the highest level of sales that, obviously they have to be well qualified but that’s the, that’s the basis. We recently had a situation inPhiladelphiawhere we had two competing apparel tenants. And both excellent merchants. But we took one over the other because we felt that their customer was more aligned to who the customer is shopping onWalnut Street, and the other one who was more risk of the other tenant. Even though we felt that both of the tenants could pay the rent.
MOD: What is the most important metric when you buy? Is it the in-place cap rate? Is it an IRR? Or is it price per square foot? What type of holding period do you have?
JOHNNY MCCARTHY: It’s ultimately the IRR. We’re looking for return. We look at it as a ten-year horizon. But ultimately, that can be adjusted for the property. Dollars per square foot, and going in cap rate are just, factors to check our math for the most part. But cap rate’s can be misleading. ‘Cause you may have what you believe to be under market rents, so you go in at a really low cap rate, but you know once the tenant rolls you’re going to be in pretty good shape.
WILLIAM FRIEDLAND: I would say most of our calculations are back of the envelope. But what we would look for is the eventual cap rate. So of course a going in cap rate can be very misleading. One broker once told me, all cap rates are misleading, because everybody lies on the numbers. But you want to have an idea of, of what the property will be making when the magic happens or whatever it is that you’re doing or hoping for happens. So, that’s what we would look at.
JOHN USDAN: None of… I take none of those three metrics that you just described into account. What we’re really looking at is what is happening in an area; how are the demographics changing; and are there people moving into an area who are better educated at higher income levels? Because at the end of the day, retail rents are directly correlated to the amount of disposable income that is in an area. So we are really looking at both established areas and areas that are developing to see who we think the eventual customer would be; what their education level is; and what their ability is to make money into the future. Because we know that if that’s what’s taking place, our rents are going to grow faster than the rate of inflation. And as a generational family owner, you have to own real estate, in my view, you’re going to own it for the periods of time that we do, that is positioned to benefit from those types of demographics.
MOD: So is your holding period forever?
JOHN USDAN: Nothing is forever. But we’re not sellers unless we feel that something has changed in an area or there’s a problem that’s intrinsic to the real estate that we don’t have a solution for. But otherwise, as long as I’m around, we’ll own it.
MOD: William — same thing for you?
WILLIAM FRIEDLAND: Absolutely, for everything.
JOHNNY MCCARTHY: We’re the same way. We’re looking forever.
MARK CHAN: Ten years or more.
MOD: So what is the metric for you that you buy on?
MARK CHAN: Retail really is about scarcity value for ground floor space. We look for areas where scarcity value is at a premium, where there’s a ten-plus year momentum on that street, whether it’s anchored by a few global players that have established that high street order already. Areas that don’t have a tremendous amount of vacancy over different periods of the cycle, really. And so if you think about scarcity value, that’s really what drives our thinking (when) we look for high street retail corridors that we think will stand the test of time. That translates to rent growth that, as mentioned, is typically above inflation over the same period of time, ten-plus years.
MOD: No one says they’re buying on cap rates but how do we compare it to the rest of the world. Mark, I think you have a very interesting perspective because you invest in different markets, namelyLondonandHong Kong.
MARK CHAN: Sure. We, we focus on the relative cap rates between those three markets. And if you look at it over the last five years, just to take a period of time,New Yorkhas the highest cap rate of the three. And I’m simply talking about high street retail. So I’m not talking about malls or secondary or tertiary retail locations. If you look at the high streets as a band,New Yorkis trading at mid fours. Londontoday is trading in mid threes. There’s transactions sub three inLondon. Hong Kongis anywhere from 1 1/2 to 2 1/2 percent these days, on a roughly apples to apples to apples comparison.
MOD: And is that fee, or are those leaseholds?
MARK CHAN: Those are primarily freeholds inLondon. There are some leaseholds that will trade typically 25 to 50 basis points higher. There’s a lot of variation off of that. Part of that is driven by the tax codes in the three countries which I won’t get into in detail. But if I can just make the point that, different tax implications of entry and exit, it implicates the cap rate. The one other factor that implicates the cap rate in these three cities is just the expectation of rent growth. The rent growth is the highest inHong Kong. Therefore, they have the lowest and the shortest lease term of typically two years. And so the landlords have the ability to really raise rents well above three percent. It’s just a different structural environment. This conversation’s not about comparing which is better. They’re usually in their own universe. It’s just that the global capital flow now is looking at it on a relative basis.
MOD: John, do you prefer to buy straight retail or mixed use? You mentioned that you’re now doing development. Is that what you’re shifting towards these days?
JOHN USDAN: We have a portfolio with a lot of diverse assets that happens to have a tremendous amount of air rights. So we made a decision as a company that they were too valuable to let sit there. And that we had to develop a capability to take advantage of what we had and build residential. We also feel that the same metrics that underpin the rent growth in our retail portfolio underpin the, the rental housing market. And that owning rental housing in some of these markets where you have rapid change will lead to growth in rents much faster than the rate of inflation. So we think that it’s aligned and a good thing to own.
MOD: Johnny and William — are you looking at mixed use, residential above, office? What’s your feelings on other asset classes?
WILLIAM FRIEDLAND: Since we’re in a four-cap world sometimes it can be more profitable to develop, particularly if you have taxpayers or lower buildings to begin. And it also is a little bit of a diversification out of the concentration of retail. So we’re, we’re just finishing up our second major apartment building right now and planning our third rented right now.
JOHNNY MCCARTHY: Our portfolio reflects that we own a bunch of apartments, but retail is ultimately the driver.
MOD: Let’s talk a little bit about the debt market, what type of lenders and terms are you seeing out there today?
JOHN USDAN: We’re seeing a tremendous amount of debt, both on the construction and the permanent side. It just depends on what rate you want to pay. But if you want to borrow twenty-year, fixed-rate money, you certainly can. It’s available.
MOD: So is it mostly CMBS and the life companies?
JOHN USDAN: We prefer to deal with portfolio lenders. So we have relationships with life companies and banks.
WILLIAM FRIEDLAND: I think everybody’s in the mix. For several years CMBS was totally uncompetitive and out of it. That’s no longer the case. The life companies are certainly in the mix. And the traditional banks seem to be pretty busy as well. So everybody seems to be doing okay. I think there’s a wide variety of money available. It just depends on what you’re looking for.
MOD: Johnny, what kind of leverage do you typically look for?
JOHNNY MCCARTHY: Sixty percent. Nothing too aggressive. But there’s a long list of bankers that are willing to do stuff all across the spectrum. There’s pretty good debt market which probably is driving some of the cap rates.
MOD: Mark, if you’re looking to put out foreign capital, do they want to leverage?
MARK CHAN: It really depends. I think the debt markets are so friendly these day that it’s hard not to.
MOD: What are the emerging markets or are you going to stick toManhattan?
WILLIAM FRIEDLAND: I think we’re going to stick to our knitting. We have some properties outside ofManhattan, but there’s, ultimately there’s nothing like owning inManhattan.
MOD: Johnny, is that for you as well?
JOHNNY MCCARTHY: Oh, for the time being, yes. We knowManhattanwell so that’s what we’re going to stick to. Later we may go outside of that.
MOD: What would it take for you to go outsideManhattan? I mean, it seems like there is a lot of, you know, institutional capital now — looking at Downtown Brooklyn. I mean, at what point is that market ripe enough that you would consider making a move out there
JOHNNY MCCARTHY: It’s a good question. I think for the moment we’re going to stick to what we know. You know,Brooklynis close but really far away. It’s a good way of putting it.
MOD: Finally did anyone else want to say anything about Vornado’s $707 million-dollar purchase on Fifth Avenue for North of $10,000 a square foot. Was that a bargain? I heard that it’s actually not a global record as the Ralph Lauren headquarters went for $25,000 a foot in Japan.
MARK CHAN: Yes, it did.
MOD: So maybe we’re still a bargain. If Fifth Avenue, if retail rents are really $3,000 a foot, why wouldn’t that retail not be worth thirty, forty, fifty thousand dollars a foot?
JOHN USDAN: I agree, although I do think there is a limit. We had a meeting with a very high-profile tenant that has a presence onFifth Avenuedoing tremendous volumes but they don’t think that the rents are justified at this point.