Documeent title on one or two. investments: The art of the science. Function over form. July 2015 TIAA-CREF Asset Management

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1 July 2015 TIAA-CREF Asset Management Documeent title on one or two Shopping lines Gustan for retail Book property 24pt investments: The art of the science Martha Peyton, Ph.D. Managing Director Thomas Park Senior Director Retail property investments are available in many formats and analysts have devoted lots of ink to constructing definitions. Despite these efforts, there is considerable overlap in format definitions as many properties have size and physical characteristics that cross definitional lines. In our approach to selecting retail property investments, we focus on the characteristics of the center and the characteristics of the trade area in combination with the competitiveness of the property rather than on format definitions. This process offers insight into which of the seemingly obsolete two-anchor regional malls is really a super performer, which power center is really an extension of the upscale lifestyle center across the street, and which outlet center is really a blockbuster mix of off-price, full-price and entertainment offerings. The report that follows describes the criteria we use to evaluate retail property investments and its applicability across format types. TIAA has multiple decades of experience in the retail sector starting with our first retail property purchase in 1947 and our first commercial mortgage loan in This loan was secured by Country Club Plaza in Kansas City, MO, which many real estate professionals consider to be the first mall in the United States. Our long involvement in the retail sector has given us an appreciation of the industry s ebbs and flows and its continuous adaptation to shoppers needs, wants and preferences. This treasure trove of experience and property level detail, in turn, has shaped our investment philosophy and analytical methodology as is described in this white paper. Function over form Institutional investors typically target specific buckets of retail property for their portfolio. In the U.S., regional and super-regional malls, neighborhood centers, community centers, and power centers are some of the usual identifiers. However, shopping center formats can be defined more elaborately as shown in the shopping center types defined by the International Council of Shopping Centers (ICSC).

2 ICSC Shopping Center Definitions Center type Typical size # in US Description Strip/Convenience < 30,000 sq. ft. 68,390 Attached row of stores which provide a narrow mix of goods and services to a very limited trade area Neighborhood centers 30, ,000 32,422 Collection of convenience-oriented stores which provide for the daily living needs of the immediate area; at least one anchor tenant Community centers 125, ,000 9,642 Collection of general merchandise and convenience stores selling a wider range of apparel and soft goods; two or more anchors Power centers 250, ,000 2,249 Collection of three or more "category dominant" retailers with only a few small tenants Lifestyle centers 150, , Upscale national-chain specialty stores with dining and entertainment in an outdoor setting Regional centers 400, , Collection of stores selling variety of goods comparable to those of a small city CBD (general merchandise, apparel, services). Super-regional centers 800,000 and larger 632 A more extensive collection of stores selling goods comparable to a major metro CBD; anchored by three or more department stores Fashion/Specialty center 80, ,000 N/A Higher-end fashion-oriented tenants with no dominant stores Outlet centers 50, , Retailers' and manufacturers' outlet stores selling brand name merchandise at a discount Theme/Festival centers 80, , Anchored by restaurants and entertainment tenants and oriented toward leisure and tourist shoppers Airport retail 75, , Consolidation of retail stores located within a commercial airport Source: ICSC and NCREIF. An investor s first step in making allocation decisions might be to examine investment returns of shopping center types as reported by NCREIF. As shown in the table below, NCREIF total return results point to the mall sector as outperforming over the last twenty years. But, how does an investor reconcile the ICSC s eleven shopping center definitions with NCREIF s six performance buckets? Are the lifestyle centers defined by the ICSC as malls or as community centers? Is a power center with a grocer still a power center? Does it really matter? Average annual returns* 1 Yr 3 Yr 5 Yr 10 Yr 20 Yr NPI 12.7% 11.5% 12.8% 8.4% 9.7% Retail Community centers 12.3% 11.5% 12.1% 8.1% 10.0% Neighborhood centers 14.0% 12.3% 12.4% 8.2% 10.4% Fashion/Specialty centers 12.5% 10.7% 11.2% 8.9% Not Avail. Power centers 10.6% 11.0% 11.6% 6.6% Not Avail. Regional centers 14.9% 14.0% 14.2% 10.1% 10.5% Super regional centers 15.0% 15.6% 16.0% 11.1% 10.8% Single tenant 11.5% 15.4% 13.6% 8.9% 10.6% * Average annual returns for the periods ended March 31, NCREIF members also own outlet centers and festival centers but there is insufficient historic return data. 2

3 As investment managers of retail properties in most of the ICSC categories, we are coming to believe that the answer is no for several reasons. For one, the size overlap across the ICSC s definitions weakens the usefulness of size as a delineator. Secondly, tenant mix has also become less useful because tenant mix is becoming more and more eclectic. For example, gourmet grocers and big boxes are being added to malls; department stores and off-price retailers are found in lifestyle centers; new outlet centers contain full-price, off-price and outlet stores. Because of the blurring in categories, our analysis of prospective retail property investments applies a holistic analytic framework to all retail property categories. This framework focuses on trade area demographics, the competitive environment and the property s competitive strengths as indicated by the tenant mix and sales. Trade area analysis Chico s FAS Inc. is a cultivator of brands serving the lifestyle needs of fashion-savvy women 35 years and older While each of our brands has a distinct customer base, the overall portfolio caters to a broad age and economic demographic with customers ages from 35 and older and household incomes ranging from $50,000 to well over $100, Retailers target a specific demographic profile with their stores and brands. A shopping center s trade area demographics are therefore especially important because they define the customers that the property serves and the types of stores that are best suited for the center. In addition, the demographics of those customers are indicative of trade area residents prospects for enjoying growth in income and wealth that can fuel retail spending given the outlook for the U.S. economy. Trade areas are often initially estimated as concentric rings around a property with larger size properties requiring wider rings but subsequently customized to account for the location of competitive centers, the local road network, physical and psychological barriers such as rivers and interstates along with retailers data on where their customers live. Obviously, we look for sufficient population density to support shopping centers of various sizes. Larger centers can require 250,000 residents in a trade area to be viable whereas only 25,000 residents may be necessary for a small neighborhood center. But, density alone is not enough; a high level of aggregate income and discretionary spending power are necessary to support centers with a more upscale tenant mix. One indication of affluence is provided by the average and median household income of trade area households. The presence of higher income households i.e., those earning over $100,000 per year is another useful indicator. Source of income is also important as the dependability and growth prospects for local incomes influence a center s long-term prospects. We assess this by examining the economic composition of the larger metro area what are the key industries, who are the major employers, how has metro area employment grown both in aggregate but also relative to the overall U.S. average. Metropolitan areas are the relevant geography for examining economic composition because they capture commuting patterns in the wider region. We have an investment bias in favor of larger metros i.e., those with populations of one million and more and especially those with relatively stronger historical employment growth and future growth prospects. These size and employment growth characteristics support greater spending potential and enhance a property s selling liquidity. Shop til you drop After examining a center s trade area demographics and the economic growth prospects of the larger metro area, our analysis focuses on the property s current competitive position and the projected durability of that position within the larger market. A property s competitive position can only be grasped by evaluating its competitive strengths and weaknesses vis-à-vis the competition. This requires approaching the trade area in the shoes of a typical customer with money to spend. Customer shopping decisions are based on an amalgam of factors including travel time and ease of access, availability of adequate parking or public transportation, physical attractiveness of a property, safety perceptions, and perhaps most importantly, selection of retailers. Customers will compare these characteristics for all venues within a certain travel time distance. While current and historical sales productivity for individual centers demonstrate customer preferences, they alone are not enough to support and justify long-term investment decisions. Beyond tenant sales metrics, investors need to assess whether customer preferences as indicated by tenant s sales productivity are sustainable. This is a judgment that is more art than science. 1 Chico FAS, Inc Annual Report. 3

4 To formulate our judgment, our analysis attempts to construct a typical customer s view of the competitive landscape. It requires on-the-ground inspection of the trade area s various retail venues and involves a lot of driving and a lot of walking. The dispersion of retailers across a trade area s venues is particularly telling. We note, for example, whether a target property is fully leased and whether it offers a variety of today s most sought-after retailers. For larger centers, not only is critical mass important, but the strength and uniqueness of those retailers are major factors influencing a center s drawing power. Centers with a collection of exclusives i.e., having a large national tenant s only store in a metropolitan area often have the strongest drawing power. For smaller centers, a metro area s top grocer often has a large loyal local customer base which provides sufficient customers for the dry cleaners, takeout restaurants and local services that lease the adjoining small shop space. Our assessment must also take into account the evolution in retailer prospects, shopper preferences and store prototypes. Within the grocery industry, for example, grocers with the second and third highest market share in a particular metro market have been most vulnerable to competition from Wegmans, Whole Foods and gourmet niche grocers. Apparel retailers can stumble from fashion missteps as well as over expansion. The changing nature of shopping due to digital apps has affected optimal store sizing. For example, Best Buy s prototype has shrunk significantly since it no longer needs to stock a full array of its inventory in each store. Conversely, Restoration Hardware is replacing multiple smaller legacy stores in a metro market with a single 25,000-60,000 square foot Gallery which can display a larger amount of their merchandise along with furniture, lighting, textiles, bathware and the like. Knowledge of who s hot and who s not, along with their optimal store sizes, can be crucial in identifying properties with stronger competitive positions from those that are weaker. Beyond retail shops, restaurants and entertainment are becoming increasingly important features of successful shopping centers. A mix of leading retailers along with a collection of sit-down restaurants and high traffic generators like cinemas help facilitate a sense of place where people can shop, dine, entertain or be entertained. Eater-tainment features, in turn, increase both the number and length of shoppers visits along with enhancing customer traffic during evening and other non-peak hours. The proof is in the (sales) pudding After the on-the-ground inspection validates the competitiveness of a retail property, we examine the strength of its individual shop sales and total inline sales. But how does one define strong sales? We evaluate sales performance of key in-line retailers against company averages based both on total sales volume and on a per square foot basis as stores that are weak performers within their chains are vulnerable to closing. Sales also need to be put into regional context as shopping center sales volumes and productivity are typically highest on the East and West Coasts. We also maintain a proprietary database of tenant sales in selected top retail centers across the country which allows us to evaluate sales relative to a national peer set. Occupancy cost ratios tenant sales as a percentage of rent and contributions to center operating expenses are a key indicator of store profitability. All of this data provide an indication of the strength of the in-line tenant lineup and helps flag underperforming stores. Successful retailers tend to demonstrate a herding mentality. Retailers such as Apple, Banana Republic, Michael Kors, J. Crew, Sephora, Pottery Barn, and Williams Sonoma cater predominantly to affluent shoppers and are able to draw higher-income shoppers and visitors from an extended area. The sales performance of these key retailers, in turn, influences the site location decisions of other retailers who cater to a similar demographic and those looking to take advantage of key retailers drawing power. Top shopping centers offer a variety of hot retailers; such centers are emblematic of the axiom that success breeds success as news of strong sales is common knowledge in the retail community. In addition, long-term growth of total in-line sales is important for several reasons. Firstly, sales growth demonstrates that the property manager and owner are keeping the mix of retailers fresh and up to date with new retail concepts and changing shopper preferences. Given the constant evolution of the retail industry, older, less productive stores need to be culled and replaced with newer, higher productivity concepts on a regular basis. Secondly, sales growth demonstrates that a property is capturing a share of the growth in consumer spending, or in many cases, capturing market share from competitors. 4

5 Shopping for retail property investments: The art of the science Washington DC area malls and household incomes 2015 Median Household Income (Esri) by Block Groups $150,001 to $200,000 $100,001 to $150,000 $50,000 to $100,000 $0 to $50,000 5

6 Digital Impacts On-the-ground research will show the evolution of physical space in response to changing population density and the adjustment of retail markets as retailing becomes increasingly digital. Walking tours illustrate the very limited construction of new retail centers in recent years as well as the boom in renovation activity. Closer inspection shows the concentration of renovation activity in the best properties which typically comes at the expense of weaker properties. The winners and the losers in the daily competition for customer dollars is clearly visible from a market tour. OMNI channel retailing Our preferred retailers have also demonstrated their ability to prosper in the increasingly digitalized environment of today s retailing. The most successful retailers have well-functioning websites, smartphone apps, personalized communication with customers, and seamless integration of inventory across physical stores and digital venues. Strong omni-channel retailing capabilities are now crucial for long-term success in the retail industry. There are also benefits at the store level as companies like Williams Sonoma have found that the multi-channel customers spend four to five times more than single channel shoppers. 2 Enticing shoppers to visit a nearby store though programs like Reserve in Store and Hold at Store provides significant cross-selling opportunities which boosts overall sales. Having a seamless inventory system minimizes sales loss that occurs by having insufficient product on the shelves. Media Internet Mailer/Print Social media Customer Loyalty programs Store Targeted s Mobile/Tablet 6

7 Concluding comments Retail property investment analysis contains both quantitative and qualitative elements. The quantitative piece includes analysis of demographics and tenant sales trends. Sales volumes, sales productivity, occupancy cost ratios and other hard data are crucial pieces of the analytical puzzle. But there is also detective work which is more qualitative. It involves the legwork required to shop the competition and handicap the market based on store mix, ingress and egress, circulation patterns and overall aesthetics. The definitions of various retail venues do not play a big part in this analysis. Centers in any category can be attractive investment opportunities or not. The key is in the detective work, which is far from elementary... 1 Chico s FAS, Inc. 10-K for the year ended January 31, Williams Sonoma, Inc Investor Presentation. This material is prepared by and represents the views of Martha Peyton, and Thomas Park and does not necessarily represent the views of TIAA-CREF, its affiliates, or other TIAA-CREF Asset Management staff. These views are presented for informational purposes only and may change in response to changing economic and market conditions. This material should not be regarded as financial advice, or as a recommendation or an offer to buy or sell any product or service to which this information may relate. Certain products and services may not be available to all entities or persons. Past performance is not indicative of future results. Please note real estate investments are subject to various risks, including fluctuations in property values, higher expenses or lower income than expected, and potential environmental problems and liability. Investment, insurance and annuity products are not FDIC insured, are not bank guaranteed, are not bank deposits, are not insured by any federal government agency, are not a condition to any banking service or activity, and may lose value. TIAA-CREF Asset Management provides investment advice and portfolio management services to the TIAA-CREF group of companies through the following entities: Teachers Advisors, Inc., TIAA-CREF Investment Management, LLC, and Teachers Insurance and Annuity Association of America (TIAA ). Teachers Advisors, Inc., is a registered investment advisor and wholly owned subsidiary of Teachers Insurance and Annuity Association of America (TIAA). Past performance is no guarantee of future results. It is not possible to invest in an index. Performance for indices does not reflect investment fees or transactions costs Teachers Insurance and Annuity Association of America-College Retirement Equities Fund (TIAA-CREF), 730 Third Avenue, New York, NY C