Newbie question

Good morning everyone,

I'm new into the real estate space and I'm preparing for the interview season (EU here, completely different timeline).

I came across the following question in the IB section of the forum and I'm not sure about the correct answer, assuming we have two identical shopping centers (same location…etc), is it worth more the one with a big anchor grocery store or the one with 5/6 smaller stores?

I'd say that the latter is worth more since it should guarantee a higher average NOI and occupancy rate on average (I'm thinking the shopping center like a portfolio) on the other hand this may imply higher property management fee.

Is this answer that I'd have given reasonable?

Thanks in advice

Comments (7)

 
Most Helpful
Jan 8, 2021 - 6:18pm

So, this is a common type question to see how well someone really understands real estate, specifically the connection between tenants/leases and cap rate (valuation multiple) and its disconnect with the "physical features" (and even location details) of real estate. 

Essentially, the value of income real estate is a direct function of the net rents (called NOI) and the applicable cap rate. Your question omits if the set of tenants pays the same as the grocery anchor (if it really is "identical", than this becomes a super easy question, but in reality not likely the case, but wont change the answer).

That answer... the "big anchor grocery store" lease is way more valuable than a set of 5/6 smaller stores (under normal assumptions). The grocery store is likely a "credit" tenant and likely structures the lease like a long-term bond (20-30 year term, with renewal options) and they likely take 100% of opex and capex. The smaller stores are likely lesser credits (maybe mom/pops even), shorter leases more most likely (5-7 years at most), and opex may pass through while capex is left to landlord (that can vary). The net effect is the cap rate for single-tenant grocery story lease could be sub 5%, while a multi-tenant non-credit deal could be 7-8% (round number guesses, but not unreasonable).

If we are speaking in "COVID" times, the delta between the two grows even more. That cap rate falls for the grocery anchor (I mean, they are doing pretty well in essential world these days), and rises given any re-risk of small retailers today (I mean forget if any are restaurant/bars, all sorts of in-line tenants are closing). So the value of the grocery store goes up in COVID while the other falls (using basic assumptions). 

The "trick" of the question is understanding that credit of tenant sets valuation rate (cap rate) and thus value, making the big anchor grocery store the easy winner. If you want to rock an interviewer, add a point on how in the 5/6 tenant plaza, one tenant may have a "co-tenancy" clause letting them reduce rent or even terminate if another tenant goes vacant (common in malls between luxury brands). 

Hope this makes sense! 

 
Jan 11, 2021 - 5:24am

Interesting, and I follow the logic. But just to ask, when you would value shopping mall as a whole (ownership 1/1). Would you capitalize each lease separately (or by groups) or would you just use single cap rate and capitalize total NOI? 

 
Jan 11, 2021 - 9:06am

Generally, you should/could only split out units for valuation when they are legally separable (like a condo), otherwise it doesn't make much sense. Investors tend to think of multi-tenant real estate as a combined assets and the leases can "diversify" risks. Sometimes large anchors get split from the rest of the shopping center (the in-line tenants) to accomplish this, but it is usually split legally (doubt an appraiser would sign off otherwise). Part of the issue with retail in particular, is that tenant mix and vacancy can impact the other tenants, the rent asked on vacant units, and other factors. So if one store goes "dark" it could hurt the other stores and the thus ability to lease or renew. 

 
  • Associate 2 in RE - Comm
Jan 8, 2021 - 6:27pm

You are right to assume that with a bunch of smaller tenants you can charge higher rents than a grocer due to the smaller sqft of the shops, but that is only the numerator of the equation (NOI/CAP rate= value). This is actually a very relevant question that has been playing out over the past 8 months. In certain markets a center with a high quality grocer, such as Whole Foods (not sure who the European equivalent is), cap rates have held steady and certain markets had some compression. Cap rates however for retail with shop spaces have expanded, accelerating a trend that has been going on. 

To put it in numbers lets say the center is 40k sqft ( you can covert this to sq/meters if it makes more sense) and can either be all shops at an average rent of $52 sqft  per year or the grocer will pay $25 /sqft per year. In this example the grocer would have an NOI ( assuming NNN here) of $1MM and the center with the shops would have an NOI of $2.08MM. If the grocer was likely to trade at 5% cap rate and the shops traded for anything greater than a 10.4% cap rate, the center with the grocer would be worth more.

This is a long winded way to say that it depends on both the rents and the cap rates used. 

 
Jan 9, 2021 - 3:52am

Thank you both, immensely helpful answers!

You wereright, I was only thinking about the first part the equation omitting the second that defines the property value.

To sum up, even if the two had the same NOI the first shopping center would be more valuable since has a lower cap rate (as it's less risky due tenant's higher creditworthiness ) [Value = NOI/cap rate]. Am I correct?

Again thank you very much, well deserved +1 for both

Have a good day

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