2022 REIT Leadership Series–Stuart Tanz, ROIC

Well, the first quarter of the year was a very strong quarter across the whole strip center sector, not only ROIC. Part of that was obviously continuing to come out of the pandemic in terms of tenant demand. That's what's really been driving a lot of the performance in the strip center sector or in the retail sector. I think that most of that tenant demand is being driven really two ways. Number one is supply. There's been virtually no supply across all markets since coming out of the credit crisis, and as we have come out of COVID, or as we began to get out of COVID and demand began to pick up from the tenant perspective, the facts are that because there's been no supply, that tenant demand became very robust and, more importantly, continues to be very, very strong. So tenant demand is what's driving really a lot of this outperformance in the first quarter. Whether you're looking at same-store NOI growth, releasing spreads, occupancy, even some of the underlying issues that everyone is beginning to deal with like higher interest rates, the first quarter of the year was very, very strong. It's a bit frustrating as I sit here today with the overall performance last year of the sector and with such a strong first quarter, seeing how the stocks have sold off since we announced earnings. And then more importantly, most of the REITs out there during the quarter and coming into the year who had a much lower cost of capital had the ability to issue equity, primarily through their ATMs, and have begun to grow their businesses and grow their companies like ROIC. That's been very rewarding because for the first time in, let's call it two years or three years, most of us coming out of the pandemic have balance sheets that are quite strong in terms of capacity, and a lot of us have been growing the company over the last six months. That's been very rewarding from the standpoint that by growing the company, you have the ability to grow earnings, and by growing earnings, you grow dividends. That's been more rewarding. You've had fundamentals very strong, external growth strong, internal growth strong, and all of that really bodes well as we move through 2022, subject to some of the constrictions of the market that none of us control and that we have seen more recently. But most of the companies are in a pretty good place right now, and I think as we move through the balance of the year, tenant demand continues to be very strong. If that continues, although we've seen the discretionary spending side of retailing begin to unwind a bit, certainly the sector that we focus on, which is primarily all grocery- and drug-anchored shopping centers, that's what we're continuing to see a lot of momentum in terms of looking at where things hopefully continue to go as we move through the balance of the year.

Well, certainly everyone stopped when COVID hit in terms of their own growth plans. And then, as everyone knows, in 2020, in the heart of the height of COVID, approximately 19,000 or close to 20,000 tenants went into bankruptcy. So as things recovered quite quickly, what that has done is it's given the ability to tenants who were even in bankruptcy, but certainly tenants who were very good operators, to build a better balance sheet. In a lot of cases, we capitalized their balance sheets. So from that perspective, that's really what has driven this growth. It's really a catch-up of all of those moving pieces as we went through the pandemic. E-commerce obviously got the benefit of all of that, and we saw penetration levels move to historically high places or to levels that no one had anticipated. As an example, grocery store penetration before COVID was only, let's call it 2 or 3 percent. That moved as high as 17 or 18 percent at the height of the pandemic. Today, that's come back down to approximately 7 or 8 percent. But what we've seen through the pandemic from an e-commerce standpoint is really two things. One, that the tenants themselves, across the whole spectrum of retail, have realized that they have to embrace the e-commerce side of their business. So capital has gone more so into building their e-commerce platforms than in some cases their stores themselves. There's been a shift of capital towards the e-commerce side. So as the e-commerce side began to pick up, the primary focus there was obviously pick-up and delivery or click and collect, which is the physical aspects of ordering online and then going into the shopping center and either picking up the goods or having the goods delivered to your car, or direct delivery. But what we've seen which has been interesting is that a lot of growth that occurred during the latter part of getting out of COVID has now begun to really tail off, and in some cases, penetration levels have actually moved further down to levels that are still a lot higher than they were before the pandemic, but levels that people realize that e-commerce, although a very important platform, still has a way to go in terms of penetration. I think people are wanting to get in their car and actually get out of their houses, and that's what's driving a lot of this penetration back down. They're also realizing that delivery and pickup can be as profitable as just having a customer walk inside the store. So e-commerce is going to continue to evolve, penetration is going to continue to get higher. However, the customer right now is really wanting to get off the computer and into the physical real estate, and long term, that omnichannel connection can only help the underlying retail industry versus hurting it.

Well, inflation is good for our business because a number of our leases are tied to that index as it relates to increases, the CPI escalators. Those escalators are typically in a lot of leases and are done annually. What that is doing is really generating a couple of changes in the market right now. One is that retailers are trying to capture a lot more term in their current leases. They realize that if they don't capture more term and if their leases do come up or expire within the next couple of years and they don't have that additional term, they're going to end up paying a lot more in rent because of the inflationary pressures. The second thing is that that's also hurting the cost of goods in terms of the way they operate. So a lot of this inflation is being passed on to the customer, and the retailer is having to look at their margins. In some cases, their margins are getting a bit worse because they're having to deal with this inflationary pressure. So even though their sales have gone up, their margins are getting squeezed. So in a lot of cases, it's benefiting retailers but not to the extent you might think. The interesting thing that came out of ICSC in terms of being on the ground last week in a number of meetings I had with retailers, the grocery stores and drugstores, is really two things. The two most important items that continue to impact the industry are labor and the supply chain. Labor is continuing to have a big impact in terms of hiring and store counts and even growth, because if you can't hire, you can't open up another location. And then the supply chain is also a big issue. A number of retailers are having to pre-order their FF&E right now. They need lead times now as much as almost 18 months in some cases, even longer, because the supply chain issues are not giving them the ability to get stores open. So those two things are having a big impact across the whole sector. But the interesting news of all for me coming out of ICSC last week was that the grocery stores and drugstores are the ones that are benefiting right now from this inflationary pressure in that the consumer is basically cutting back on discretionary spending, and the ability to shift those dollars to more important things like food and drug is what's going on. Sales at grocery stores and drugstores post-pandemic and in the environment we're currently in are still quite elevated at, let's call it 4 or 5 percent per year. That has now doubled overnight because most of the demographics, the lower-income demographics, are having to really reallocate spending dollars, and that reallocation is going to the grocery store and the drugstore. So their sales have picked up tremendously. Interest rates are going to have an impact across the board because that's the cost of capital in terms of doing business, and when interest rates go up, the consumer will pull back in terms of spending. We haven't seen that much of an impact yet; we expect to see more of that at the lower demographic levels. But the other item with higher interest rates is that because that cost of capital has gone up, I'm expecting valuations to also rise. Not as much in the sector we're in, which is the grocery-drug anchored sector, but certainly in the more big-box sector, you're going to see some movement in valuation because the cost of that capital has gone up, and that's going to have an effect, there's no question about it.

Well, luckily we swapped all of our debt and we staggered our debts so that we really don't have any impact until next year, late next year. But there are a couple of swaps that are unwinding, and we certainly made the decision to float. It's not a large sum of dollars, but it's going to basically bring our cost of debt capital actually less than the swap, but it's going to be floating, so we'll keep an eye on that in terms of how interest rates might impact that segment of our debt long term. But right now, I think most people are sitting on the sidelines watching what is going to happen. But more importantly, most companies in most REITs today, given what we went through in '08 and '09, have really focused on the balance sheet, and I would tell you that most REITs' balance sheets are in very good shape in terms of weathering this interest rate storm, as you might say.

Yeah, I mean, I've been at this for three decades now. Before ROIC, I built a company called Pan Pacific Retail Properties, and that was one of the most successful strip center companies in the late '90s and up until the credit crisis. I got lucky; I sold the company to Kimco in October of 2006. And the one thing that I realized and lessons learned from that transaction are really lessons learned today in watching what's going on in the overall market today. I've been through seven recessions over the last 30 years. I've owned this product type all the way through these recessions, and the one thing that taught me early on was that this is where you want to be when things get soft. People have to eat, people need their drugs, they're still going to get their hair done, they're still going to get their nails done, they need medical attention. This product type really holds up well, and it's the most defensive part of the retail sector when times get tough. But more importantly, the lessons learned coming out of the credit crisis, or before the credit crisis in terms of selling, were really lessons based around the tenant balance sheets, tenants' occupancy costs as it relates to sales, and more importantly rents. And the fact that are we getting to a point where rents have been climbing as they have over the last 10 years, will tenants have the ability, if we go into recession, to continue paying these higher rents that most tenants today are paying because we've been on such a long expansion here economically?

Yeah, the underlying theme in buying assets today for us, as it's always been, is really two things. Number one is the NOI profile of the asset. You want to buy older assets where preferably private sellers have been more focused on cash flow versus what I would call increase in tenants' rents. What we have found in the past are good assets to buy because these families tend to focus again on cash flow versus on higher rents. So we tend to try to find assets that are owned by families where the mark-to-market of those rents is quite good, and that more importantly, looking out the next three or five years, you're going to build some strong NOI growth. That's the underlying theme of what we look at, along with many other aspects of a shopping center, but the underlying theme is always NOI growth. The situation now, and yes we have been quite active on external growth, is that you really, given what's going on in the macro picture which is slowly getting to more of the local picture, is that really to be patient and to continue watching risk as best you can. Patience is the virtue that very few of us have in this business, but it's something that you really got to take into consideration as you look over the next 60 to 90 to 120 days because the market is moving and it's changing pretty quickly. You've got the dynamics in the capital markets, you've got the dynamics in the private markets, and then more importantly, the debt markets have basically blown out. So to me, that could provide some opportunities. So the key here is being patient, but that doesn't mean you stop. If the right transaction comes along and if the NOI profile looks strong, then it's certainly worth looking at as a potential acquisition. On the disposition side, it's the same sort of focus where you look at NOI, and if there's very little NOI growth in an asset, then it's time to sell. Luckily, the market for selling assets is still quite robust. You do have institutional capital, you do have some private capital, preferably 1031s. That tool has shrunk considerably, but it's still there, it's still active, so it's still an opportunity to get out there and turn our capital, as we say. But the reality is that now's the time to be more patient in terms of buying and selling because there's no real indication how far and how deep this market could go as it relates to the environment we're currently in.

Correct, correct.

Well, I think it's both. ESG is now a very big part of the public market and is getting, as you've seen with the most recent SEC comments, a lot of investors have been paying a lot of attention to this aspect of every company, especially in the public markets, and eventually will be the private as well. It is a very important tool to have at your disposal in terms of your tenant communication and the tenant leases. We just got awarded another award for being a leader in our green leases, and that's because we've taken upon ourselves to educate our tenants and, more importantly, show them why it's important that they engage with us on all aspects of ESG. ESG is a complicated, time-consuming, capital-intensive process. It's become more strong and will become even more so as we continue to move through '22 and '23. Investors are paying a lot of attention to this, and so are portfolio managers because for them to go out and get capital from investors, the investors are requiring that they now undertake and almost have their own in-house ESG evaluation on a company-by-company basis. So it's become a big part of the public markets, and it's going to get bigger as we move through time. It's a process, depending on which part of ESG you're looking at, that again requires a lot of interaction across all aspects of your company. It's also a lot of interaction with your tenants and, more importantly, interaction with investors in terms of what you're doing. When I say that, the key there is setting benchmarks and making sure those benchmarks are attainable in terms of meeting the objectives that you're setting out over a one-, three-, five-year period. That's really the key here. Capital, I mean, you are beginning to spend a lot of capital; you don't get much return on that capital day one, but what you do get is some real efficiency at the property level, and that efficiency over time will certainly be helpful for your tenant base. But more importantly, it's really creating this baseline and then working from there in terms of every aspect of ESG. We were one of the first public companies to actually tie these benchmarks to compensation. I think that ISF and some of the large investors out there have now begun to focus on how important this is, and that if you make it part of your long-term compensation, that really aligns investors as it relates to your ESG program. We were sort of one of the first ones who created this within our long-term compensation plans, and we believe, as every company is now beginning to adopt this, that that will align investors in a pretty big way in terms of meeting these benchmarks.

Well, I guess for us, we're so highly occupied, it's not easy. We have the highest occupancy you can see in the retail sector, and given the fact our average center is, let's call it 250,000 square feet, it's not easy to find a lot of space. However, what we're finding in terms of fulfillment is that the grocery stores and drugstores started this process a couple of years ago where they began carving out primarily the front part of the store and then refrigerated that part of the store for primarily their e-commerce platform. As e-commerce has continued to grow, what we've seen across the board in all aspects of retail is that a number of retailers are beginning to take less storage, which is inventory control, and create more fulfillment in the back of the store. What that is going to do is drive a change in prototypes going forward. A lot of new prototypes are basically the store, the retail component of the store or the sales component, and then the rest is fulfillment. There's very little room left for what I would call inventory management, and now of course with technology, you can have real-time inventory management. But what we're finding is that fulfillment is very active; it has to be more local in nature in terms of delivery and/or pickup. A lot of the stores are utilizing the back end, and then more importantly, newer prototypes are primarily almost all fulfillment from an inventory perspective or from a store layout perspective. I'm anticipating prototypes moving around as it relates to fulfillment. There are other companies that have created space either within malls to do nothing but fulfillment or are taking space even in shopping centers to provide nothing but fulfillment, in other words, there'll be no retail area in these locations as well. So the fulfillment story is still in the very early stages. We are continuing to see fulfillment sort of changing real-time depending on the market and location of the asset and its customer base. But on the ground, certainly the prototypes, both new and some of the existing prototypes, are beginning to actually change as it relates to having a much bigger component of fulfillment than what we've seen in the past.

Correct. At one point, when you look at industrial rents, as you probably know, if you look at certain markets and certain submarkets within those markets, what you find is industrial rents are beginning to almost get up to retail rents. So at some point, it's almost worth repositioning part of the center and looking at creating nothing but fulfillment versus pure retail. That's the other thing out there that developers and owners of shopping centers are beginning to think about and look at in terms of the overall layout of the physical real estate.

The answer is we've looked at it over the years. It's complicated. Under the current rules, there's what we call bad income, and there are certain rules under the current structure of a REIT where you are limited to the amount of bad income that you can have, which is income that has been generated from a business versus from the real estate. So a lot of REITs looking at the game of owning and operating versus just owning come to the conclusion quite quickly that you really got to stay much more focused on owning versus operating. However, there have been a number of REITs, mall REITs, that have been very active in buying these retailers. For me, the reason why there are really a couple of reasons why they're focused on owning these retailers: one obviously is space. They would rather keep a retailer, restructure the balance sheet of the retailer. A lot of these retailers are very still very good operators; it's just that whether it's private equity or other sources of capital have leveraged the balance sheets, and what these REITs have done is come in and fix these balance sheets and continue to have these tenants operate and pay rent. So a lot of this, in my view, is about sustainability of the current tenant and the ability for them to continue to lease space and operate. The other thing we've seen in terms of this opportunity is the fact that if things go well and they have the ability to restructure the balance sheet of these retailers and the retail continues to do well, then it gives them the ability to exit and make some money, but more importantly, it gives them the ability to help grow the companies, and the growth of those companies are going to obviously come to their assets first because they own these retailers. So it's almost like getting a first right to fill space that you didn't have beforehand. So it's a combination of tenant retention, fixing balance sheets of good operators, and having the ability at that point then to exit and fill that space with the growth of that retailer. That gives them the ability to do these types of investments and may make it make sense for everyone.

Correct, especially in metro markets where there is no space available, and the only way you can fulfill or get closer to fulfillment of these retailers is to pay these higher rents for industrial. There's no other way of doing it because it gets you closer to the customer in terms of delivery times. So we've seen this explosion of industrial rents in these very dense metro markets across the country.

Yes, correct, without a question. That's what we're seeing.

Yeah, Joe, thank you for your time, and certainly call if you have any questions. At some point, let's try to get together on my next trip to New York.

That would be great. I mean, I've followed the REIT conference for years and years. A lot of my relationships are out there. I speak at every year at these conferences, and it's very well done. You guys do an amazing job, I will tell you. You should be really proud of putting this series together and what you've been able to accomplish over the years.

Great. Have a great day, and thank you very much.