Background

Established and newer companies both public and private, often seek growth through acquisitions, which are accretive to earnings, reduce costs, strengthen credit, and increase market share. Acquisitions for CRE and private equity firms can include property portfolios, which are typically held for a period, and then sold once target returns are achieved. Acquisition opportunities can also be unexpected or time sensitive, for which firms may be unprepared to assess, making outsourcing of this function critical, yet cost effective.

At Townhouse (“THP”), our advisory services are designed to foster sound investment decisions by clients. Key insights derive from THP’s in-depth CRE industry experience combined with incisive analyses, which use data analytics to hasten the due diligence process. THP’s integral role in some of the largest CRE industry transactions has honed our approach, and benefits clients.

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Challenge

Our client was a major New York based commercial real estate owner, manager, developer, with a portfolio of mostly office and multi-family properties. A public retail REIT was exploring taking the company private, and preferred a relationship driven transaction with a single buyer. The client was offered an exclusive opportunity to acquire the company on an off-market basis, along with its large retail portfolio. However, the client had finite experience evaluating, owning, and operating malls, and large shopping centers. Further, the shifting retail environment magnified the transaction risk, and warranted greater scrutiny. The retail properties were concentrated in the northeast, mostly within densely populated, supply constrained, growth markets, with strong demographic profiles. Many assets were situated on infill sites with excess land, offering expansion, development, or mixed-use redevelopment potential, estimated at over $1.0 billion. Additional upside derived from retenanting vacant anchors, contract rent escalations, and mark-to-market lease renewals.

THP was uniquely positioned to advise on the acquisition, being familiar with the client’s platform and methods. The client was focused at the corporate level, and relied on THP to assess the real estate. The client’s strategy involved keeping the high-quality, flagship, and core assets, while divesting of lesser, non-strategic properties in secondary markets, to attain superior risk-adjusted returns. THP’s in-depth experience evaluating trophy malls, and national retail portfolios was critical to enable the client to gauge whether to proceed. The exercise was severely time constrained, and compounded by having incomplete info. This required THP to perform market research to support assumptions, a strength given the extent of our resources, industry contacts, and business network alliance. The due diligence investigation required absolute confidentiality, given only top executives of the seller and our client were aware of the potential sale.

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What we did

An internal task force was assembled to evaluate the top 25 assets our client planned to retain. The complex assignment highlighted the following in our analysis:

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• Re-constructed and evaluated seller projections in the absence of source documentation.
• Formulated and stress tested assumptions for future rents, leasing absorption, expense recoveries, inflation, and capitalization rates.
• Devised independent cash flow projections for a hypothetical 5-year hold, and estimated IRRs based on future disposition of properties.
• Incorporated upside potential from development of outparcel sites, and re-leasing of vacant big box and anchor tenant spaces.
• Conducted extensive market research from a wide range of sources to achieve consensus for estimates.
• Compiled demographic information to view trends, and potential impacts on cash flows.
• Identified issues of concern, including tax re-assessments, unfunded obligations, and new competition.
• Examined tenant composition, concentrations, and retailers at risk for bankruptcy or liquidation, with a focus on major tenants due to the sheer volume of ~1,400 tenants.
• Compared limited tenant sales data, and health ratios with peer data.
• Investigated potential benefit of sites located within Opportunity Zones.

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How it worked

The retail sector continues to undergo fundamental change, with stores closing, chains liquidating, and demand shifting online. Some retailers that were thriving only recently, face diminished prospects for continuing to operate. Successful merchants have adapted by melding the physical and digital realms, while retail center owners seek more unique tenants to woo traffic. This dynamic requires caution for those investing in retail assets, and when forecasting related returns. The client lacked retail expertise, and hence focused on acquiring and holding the 25 best assets, preferring stable cash flows with more modest income and value growth potential. Most of these properties were grocer and/or discount retail anchored. Higher returns, although speculative, were projected for the portfolio assets with value-add upside potential. This derived from adding square footage, re-developing or re-tenanting big-box/anchor vacancies, and developing excess land for mixed-uses such as hotel, office, or multi-family.

At acquisition, the client planned to retain the top 25 properties, and sell the remaining assets concurrently. Those with value-add upside were to be sold at a premium to then current market values, based on their future development potential. This approach would reduce the acquisition basis of the 25 assets to be kept. However, THP’s rigorous analysis concluded the seller’s projections were too aggressive, and could not be met. The client entered into negotiations but was unable to reach agreement with the seller. The retail assets were deemed overpriced, and if acquired would depress target returns. THP provided realistic yet impartial projections, which ultimately prevented the client from overpaying for the acquisition, recalling the adage “you make your money when you buy, and not when you sell”.

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