CASH FLOW CONNECTIONS Interview with Hunter Thompson and Concordia Realty’s Michael Flight
Hunter Thompson is a fantastically knowledgeable interviewer! I first heard him on the Tom Woods Show and then started listening to his podcasts. I subscribe to the Cash Flow Connections podcast and have learned something new from almost every show I have heard. Hunter gets some really experience guests who are experts in the asset classes they discuss. Hunter is Managing Principal for Cash Flow Connections which is headquartered in Los Angeles California. Cash Flow Connections assists investors who are seeking passive cash flow focused real estate investments across multiple-geographic locations. CFC provides low-risk real estate opportunities that provide a reliable source of monthly income for investors. Hunter is the author of “Rest Easy Real Estate” a short eBook that summarizes the low-risk cash flow focused investment philosophy.
Below is the list of the questions Hunter emailed so that we could be prepared for our call:
• Please tell us more about your background. What was the first deal you ever did?
My first experience in real estate was mowing the lawn and fixing things at a 2 flat my parents owned. I was in grade school when I started. During college my older brother and I went to a nothing down seminar. I ended up rehabbing apartments for a local investor, “Colonel Becker” while finishing up college. Then started working as a commercial real estate broker out of college. Also, my brother and I bought a 3 flat in 1986. We did everything wrong with that deal but ended up coming out OK.
• How and when did you get into the retail investing space?
I got into retail real estate as a commercial broker. I saw that you could do multiple deals with retailers expanding into the market versus doing 1 deal with an office or industrial tenant. From there I was recruited to work for a large syndicator who owned about 250 shopping centers nationwide. I ended up doing leasing and redevelopment in the midwest for them. Three of my co-workers from NPA ended up at other institutions and became either clients or partners. In 1989 the economy was headed into recession; real estate was hard hit because of the S&L crisis and changing of tax shelter laws. I started Concordia Realty with my partner, Cory Andrews to manage, lease and purchase shopping centers. We did work-outs for banks, insurance companies and REITs. In 1990 we also started a relationship with Sarakreek, a publicly traded Dutch pension fund consortium. John Mannix was the US Managing Director and Jeff Gwin, my friend from the NPA days, was the Director of Retail Investments. Sarakreek morphed into Merchant Equity and they were our main equity partners from 1996 through 2015. With Merchant Equity we did deals with Westbrook Partners, Soros Funds, SageCrest Hedge Funds and Hampshire Companies among others. Jeff tragically passed away in late 2015.
• What are the types of opportunities you are investing in?
We look for value add retail or high cap rate low price per square foot anchored shopping centers in tertiary markets.
That said, grocery-anchored neighborhood centers have remained above water in the tumultuous retail environment, as have pharmacy-anchored centers and those filled with more service- and food-oriented tenants.
How many tenants?
The shopping centers usually have 4 to 40 tenants. We have managed enclosed malls that had up to 65 tenants
• Why types of tenants?
Depending on the demographics of the area, we always like supermarkets. With the caveat that the grocer should be a leader in the market. So if it is a working-class neighborhood we like discount grocers like Save A Lot, Save Mart, Aldi. We like Kroger or the world’s largest grocer Walmart. You pay a lot for the Walmart but we have seen some ground lease deals where end up getting a competitive caprate. We really like T.J. Maxx and Marshalls which are both part of the same company we like dollar stores especially Dollar Tree which seems to have a broader appeal from low to middle income and even upper middle income. We don’t mind lower incomes as long as there is a lot of density. I like Old Navy and they’re looking to expand so much that they’ve added additional real estate committee meetings this year. We like Walgreens and CVS. Surprisingly, CVS has pulled much
further ahead than Walgreens which would not have been the case 10 years ago. I blame Illinois Senator Dick Durbin for a lot of the damage done to Walgreens. Because of his bullying them over the Boots Alliance reverse merger. Now a lot of good people have lost their jobs and Walgreens has lost its edge. I am rooting for them to get it back.
Many discounters like Ross, TJ X and dollar stores are further protected against Amazon and online because purchases are made with cash and debit cards. The average household income for Ross customers is $63,000 a year, according to the off-price sector report by retail strategy firm Coresight Research. Amazon shoppers’ average household income is $85,000. Recent studies have shown, Millennials have the strongest affinity of any age group to off-price retailers.
A lot of people are doing health clubs. I believe they are good for filling space but they don’t really add anything to your tenant mix. People go to the shopping center take up a bunch of parking work out and then leave. And I worry that a lot of the guys who are driven by franchise model might be over expanding.
Ulta is a fantastic story of going from a few stores in the mid-1990s to now the largest beauty supply company in the United States. We think they do a fantastic job and have a deal started with them right now with more in the future. Any kind a beauty supply store is usually a reliable tenant and from middle income demographics all the way down to low income.
Right now restaurants are the rage in retail, but they also have some of the highest failure rates. And they also require the landlord to put in higher TI dollars to secure the tenant. As an example, I was involved with the ground up development of eight convenience type of shopping center is about 35 or 40,000 square feet. 60% of the tenants were fast casual restaurant. My partner said, we should hold this deal and I said we have an offer at a 6.5 cap rate. We should sell this deal and run away like our hair is on fire because all these restaurants will be popping out within the next 3 to 5 years. And sure enough while we were in contract during the buyers due diligence period Baja Fresh went dark.
• Value-add strategy?
We employ and have executed multiple value add strategies. Ideally if you can find them is taking under-managed shopping centers and improving the tenant mix with higher volume retailers which will pay higher rents. A grocery/drug store anchored deal we are currently underwriting has been owned by a family for the last 45 years. Many of the tenants are in at very low rents and some are not paying net charges. We will make some changes to the tenancies and also update the leases to full triple net.
We also just underwrote a power center deal with a grocer as our joint venture partner. They are already located in the center and want to own their store. Since power centers are out of favor right now we would be buying the deal at a 9 cap and then selling the outparcels for 6.5-7.5 caps and a freestanding 70,000 sf LA fitness for a 7-7.75 cap. You arbitrage buying wholesale and selling the pieces retail.
We have executed a lot of deals where we relocate or terminate tenants in a portion of the shopping center to make room for a larger tenant. Many times it was assembling the spaces, dealing with environmental issues, demolishing the buildings and turning over a pad for a ground lease. The
most extreme form of this was the 550,000 sf Southgate Mall in Milwaukee WI. We built a new cinema in the rear, relocated Walgreens to an outparcel, emptied the tenants from the mall, knocked it down, flipped it to JDN so they could build a Walmart supercenter.
On some of our most recent deals we are researching the feasibility of repositioning a portion of the shopping center to self storage, We don’t know enough about the self storage market to know what makes sense so we are looking for a quality operator to partner with for evaluating some of those deals.
• Purchase price range?
$1 to $15 million. We will stretch to $25 million if we have an institutional equity partner and a business plan. Above $20 million you get into too much competition with institutions. Our sweet spot is $2.5 to $10 million because it eliminates some of the “one off” investors or mom & pop investors and is too small for institutional guys to profitably allocate their capital. They usually like to invest in $5 – $10 million slugs of equity.
• Cap rate?
We look for deals in the 7-10 cap range. We are more sensitive to the price per square foot. We look for deals $100 per square foot and below. Tertiary markets they might be as low as $40-$50 psf and a 9-11 cap rate. In metro areas if we can find a grocery anchored deal below $150 and has a path to increase value we like it. We prefer to stay below replacement cost or in some cases look at the land value for the deal. In certain situations where we are underwriting the deal as a redevelopment the cap rate might be exceptionally low. But in those cases we are buying by the pound and not for the current income.
• What markets?
Nationwide with a concentration on Indiana, Michigan, Ohio, Wisconsin, North/South Carolina, Nevada, Phoenix. We may be more active in Texas now that we have a potential partner in Austin. We also really like Tennessee but have not had the bandwidth to execute a strategy. We have operated extensively on the East Coast and are currently doing a deal in Vermont. Vermont is great because the socialists don’t allow anything to be built.
• What are some of the important underwriting rules of thumb you are using to underwrite your deals right now?
With retail everything is driven by location. Rent is about 10% of a retailers total expenses. If a retailer cannot do sales volume you cannot give away Then we look at the tenants, especially the anchor tenants. Going back to price per square foot and a discoverable path to increasing the returns.
• There has obviously been a significant amount of changes that have taken place in the industry since you started. Over the last 5-10 years, what notable changes have taken place in the industry in terms of industry standards, interest in investing in the sector, etc.?
I really like history and biography. Retail has constantly evolved and will continue to evolve. For example, you had the General Store out in the hinterlands and Sears and Montgomery Wards started selling everything by catalog (even houses). That was the killer app of the 1890s. Then they started expanding with stores of their own because interaction sells more goods. Also, the big department stores sold everything. Then you get specialty shoe stores and chain stores. Department stores start expanding by building their own malls like Northland in suburban Detroit and Southdale Center in Minneapolis. With malls you had all this space between the department stores so you get a profusion of specialty stores. Specialty stores started eroding the market share of department stores. In the 1970s you also get discounters really expanding and even department stores start their discount divisions like Target. The malls don’t allow discounters so you get strip centers popping up and the 1980s the specialty stores turn into big box category killers. Many specialty stores in the late 1980s and early 1990s started as catalog merchants and now they are big stores. Retail is constantly evolving. I think retailers in the future will be doing smaller stores with more online selling.
• I think a lot of people when they think of retail, they are going to mention Toys R Us and they are going to mention Circuit City, and Radio Shack. I’m sure you have spent time contemplating, whether or not, this is the new face of retail, so what are your thoughts on those businesses closing up shops?
Retailer bankruptcies are not a new thing. There was no reason for Radio Shack to be in business for the last 20 years. Same with Sears. I don’t know what Eddie Lampert is doing, he should have closed all the Sears stores within 5 years of taking a controlling position and turned it into a REIT. Sears had and still has some great real estate. Unfortunately he doubled down with a loser like Kmart and since no one had a reason to go to Sears for the last 20 years he took down the malls where they were located. JCPenney and Kohls are also probably not long for this world. In fact JCPenny’s new strategy is going after an older woman shopping. I guess they were not awake during college marketing class that you want a growing customer base, not a dying customer base. Plus old people don’t shop as much as families and 20-50 year olds.
Toys R Us is a special case. They were bought by private equity, loaded up with debt and did not have any money left over to invest in CapX or better employee service strategies. Amazon did not kill Toys R Us: Walmart and Target have been growing toy sales and selling space mostly at the expense of Toys R Us. Toys R Us should have taken a page from Best Buy and not only went wide with product offerings but also upped their game on service and installations.
• Did you have any properties which were renting to those tenants? How did those challenges get resolved?
Retailer bankruptcies are not a new thing. We have probably dealt with at least 10-15 retailer BKs throughout the years. On one Circuit City deal we removed the plug (the tower entrance that was their design criteria) and split the space leasing it to Office Depot and Dollar Tree. We may not have the Office Depot much longer but they are in at a lower rate since they put most of their own TI into the space. Dollar Tree does insanely well in that location. We still sporadically get checks from the Circuit City resolution trust for some expenses owed. We were also able to take advantage of the Circuit City BK when our partner Merchant Equity becoming a stalking horse bidder in the bankruptcy court and buying a ground lease in the middle of a Simon Properties power center. That deal was a gutsy move in 2009. Initially there were not a lot of high paying tenants because of the recession. Dollar Tree saved us with some cash flow and then tenants started expanding like crazy again. We were able to lease the remainder of the space to HH Gregg, give them a lot of TI for a high rent and then sell the deal for a great price. Unfortunately for the buyer, HH Gregg went into BK a few years after that.
• Since 2007, the percentage of retail sales which took place online has gone from about 5% to about 13%. Based on those numbers, the vast majority of retail sales are taking place in brick and mortar stores, but how are you mitigating the ecommerce risk?
We know that retail will continue to be a combination of online and physical sales. So we look at tenants that a) have a successful dual strategy or b) are not affected too much by the internet. Those tenants would have more service components or be more difficult to sell online or cater to customers that are not online
• Are you seeing that the retail market is pricing the ecommerce threat into the market? Is it over compensating for it? Have you seen cap rate expansion taking place while other asset classes have become quite overheated?
We believe things are on sale right now in the retail sector. Cap rates have been widening so I hope the media keeps up the steady drum beat of doom and gloom. Also the market in some areas got pretty frothy in 2017 so the widening of bid and ask is actually a good thing. There are certain areas like Las Vegas and California that are way overpriced. I see deals in Las Vegas anchored by a tattoo parlor and smoke shop priced at $250 per square foot. That is crazy California money driving up the prices. The Chicago and New York metro areas are way too expensive vis a vis the property tax risk and regulatory risk.
• What are your thoughts on the grocer-anchored shopping center play? Is that still valid, or is that priced into the market as well?
We like grocery anchored centers. There are some quality centers out there with good retailers like Kroger, Hy-Vee, Publix, Albertsons, HEB, Save-A-Lot and Aldi that can be found for a good price. They are in smaller markets. There are also a few local grocers in bigger markets we like. We just did a deal for a 70,000 square foot Tony’s Fresh Market in a Chicago suburb. Tony’s is the strongest independent in that market doing sales per square foot much higher than the nationals. You also get Amazon credit with Whole Foods but the cap rates are crazy. Trader Joe’s is another excellent grocer, we have not done any because they are pretty pricey. Wegman’s is my favorite grocer to shop along with the local ethnic grocers. My two favorite ethnic stores are Los Altos Ranch Mart a hispanic grocer in the Phoenix area and H-Mart a Korean/Asian grocer.
• What are some of the other tenants, or types of retail tenants, that you really like? If you have a good mix for tenants base, that would be greatly appreciated.
Again it depends on the shopping center. For a grocery deal we like a mix of service tenants like dry cleaners, mobile phone guy, sandwich shop and QSR. Coffee is good too. We really like a pharmacy too with that mix CVS, Rite Aid Walgreens. If grocery will let us we think Dollar Stores are pretty complimentary. Auto parts guys and pharmacy
For a community center or one with fashion we really like TJ X, Burlington one of your shoe guys like Shoe Carnival, DSW and will try to add a grocery component if it needs one.
• What are the main differences, and who do you prefer between: dollar general, dollar tree, or family dollar?
Dollar Tree is my first preference because they appeal to a much wider spectrum of shopping and they will pay a higher rent than the other two. Dollar General is the top dog and right now probably the strongest. I don’t think they are quite as good in urban markets as Family Dollar. Then Family Dollar appeals more to a low end shopper and probably pays the lowest in rent. I’ve taken my kids to about 44 or 45 states and they always know were in a less than great neighborhood because they will point out the Family Dollar.
• What is the typical lease period for these tenants and what are the typical terms of those leases?
A typical lease period for an anchor store can be 10 to 25 years with a string of 5 year options. You need a longer initial period to amortize the costs of building for the tenant. We do not allow the options to exceed the primary term. So 10 year lease would be 2 x 5 year option. With specialty chain stores the typical lease period is 5 years with a 5 year option. Sometimes we get them to commit to a 10 year deal with a termination option based on sales volume. If it is a good center we make the termination mutual. Also, if they have the right to terminate they need to pay the unamortized costs of the TI and brokerage fees. A typical local tenant is 3-5 years. We don’t give them options unless they are really special and unique.
• NN or NNN?
Triple Net or NNN is how we structure our leases. To remember NNN use the acronym TIM Taxes, Insurance and Maintenance. A net lease with one single that is where the tenant pays for property taxes a double net lease is when they pay for property taxes and either insurance or maintenance. Triple net lease they pay for everything related to operating their store. for example, the typical tenant in a strip center will pay for their pro rata share of property taxes, property insurance including liability and building insurance and they will also pay for the insurance for the contents of their store and liability insurance for the interior if anything happens in their store. Additionally, they are responsible for maintaining everything inside their store including toilets and we usually make the tenets purchase an HVAC maintenance contract. On a ground lease the tenant is responsible for everything.
• Do you like to get a mix of local, regional, and national brands, or do you stick to one group?
It really depends on the situation, but most the time we look for some sort of national anchor tenant because that is what the lenders are looking for. We have looked at and purchased smaller centers with all local tenant if we saw a strategy for upgrading the tenant mix. For example, we passed on a deal in Phoenix that hit everything we were looking for in terms of the center needing a little work, local tenants that were paying gross leases and the opportunity to add a national coffee chain and some chain fast casual restaurants. The problem is that the owner did a 10 year lease with the local hot dog guy a month before we started looking at it on the end-cap the shopping center. The most visible place, that we would look to put the national tenant to change the vibe of the shopping center. What he did with that tenant, eliminated $100-150 per square foot of value on the exit for us.
• What do you typically see in terms of expense ratios in the properties you are looking at?
We actually look at recovery ratio so there are some expenses that you will not be recovering like partnership expenses and income tax preparation. But important factor is with the triple net leases how much the expenses were allowed to be capped or unpaid by tenets. Most anchor tenants and national chains are going to Common area expense increases by 2 to 5%. In those situations we carve out on controllable expenses like Carmen and her utilities snow plowing insurance etc. It also keeps the landlord/property manager sharp because if you have two shopping centers across the street from one another and you can reduce the cost are the common area you might be able to get a slightly higher rent or have that is the deciding factor between the centers. A big way for us to add immediate value is change the parking lot lights to LED and many utilities will assist with paying for the replacements. Tenants see a reduction in expenses or don’t notice the increases in landscaping or other better maintenance.
• When you are conducting due diligence on these retail centers what are some of the things you look out for?
We actually look At the access to the property, visibility, we always want to see anchor tenant sales numbers. With the sales to rent ratio you can tell if they are doing a enough volume to stay at the shopping center. We always asked for an aging report and common area/property tax reconciliation reports to compare the numbers from the broker pro forma to what they were are actually collecting in reimbursements. Of course we want to see the ages of the roofs in certain situations we will have our inspector take or samples of the roofs. Another big thing is environmental. Shopping centers are known for issues with dry cleaners gas stations if a tenant like Sears or Kmart had a tire battery in Idaho or TBA you could have a problem with leaking underground storage tanks or the hydraulic fluid leaking into The soil from the older style floor jacks. You could have a brand new shopping center in an urban area that was built on a manufacturing site so you need to be careful of that shopping center is built before 1974 probably have some sort of asbestos issue. Important thing to look for is a thorough analysis of the leases. Are there cotenancy closet which means that if one or more anchor tenants close to the tenant rents go to some sort of percentage rent only or do they have the right to terminate their lease. If you have a week anchor tenant and they blow out on you you’re shopping center could end up in 100% vacant within a year or two. You also want to check what type of exclusive use closet they have granted to the tenants. If they have granted too many broad exclusive use clauses to local tenants it could prohibit you from upgrading the tendency of the shopping center morni.
• What are some of the questions you ask tenants when conducting tenant interviews?
How is the shopping center? What do they like about the location? What are somethings they would suggest for improvement? At a shopping center that has primarily chain stores the store managers may not know a lot. In those cases we have contacts with the real estate representatives if we know them and ask how the store does. Are same store sales increasing for this location. Do they know the store manager and should we speak with them.
• Are you typically able to talk to the tenants without the property manager there?
I will usually go in and shop the stores. But if we have a contract we would do it with the property manager or owner of the property if they insist. Retail tenants are never shy about complaining. They complain about the weather if it is too hot, too cold, too sunny everyone is going to the beach too snowy. But most times they have very valid criticism of things current ownership is doing wrong. The worst things we have seen is non-sophisticated owners doing any kind of construction in late October through December. A deal we were doing a few years back the owners were office guys and they reconfigured the parking lot in December through January. They lost 20% of their tenants and especially the restaurant tenants.
• What are the typical tenant improvements/sq. ft. in the markets that you are looking at?
It really depends on the retailer, market and condition of the space. If it is a newer white box and a great center we try to keep it minimal. If you need the tenant it may go to $30.00 psf. We try not to put too much money into locals. We have been working with 2 hot tenants that are around 10,000 to 12,000 per square foot and one wants slightly above a shell and $70.00 psf and the other one wants their white box which is about $30.00 then they want $70.00 allowance to build out and fixture. The other issue that factors into this decision is what is the investment strategy? Are we looking at selling or refinancing in the near future? Then you may want to take more risk on build-outs for tenants and boost the rents. If it is a long term hold and cash flowing we would prefer to give the tenant free rent to minimize the risk.
• What is something that you wished you had done earlier in your career, or learned earlier?
I wish that I had done a tour as an acquisitions guy. I know everything from the operations side but should have done more underwriting in my career. Conversely, I see a lot of acquisitions or money guys with no operating, leasing or property management experience. They don’t have a feel for tenant mix, achievable tenant rent rates or realistic expenses.
• Tell the listeners know how they can learn more about your firm and what you do.
They can contact me through our website at www.concordiarealty.com
