Curbside King: How David Lukes Cornered the Market for Unanchored Retail

On Oct. 1, David Lukes, CEO of Site Centers, spun off the firm’s  unanchored convenience portfolio into a new publicly traded real estate investment trust (REIT) called Curbline Properties. By bringing public money into a long-neglected sector of the retail space — unanchored convenience stores —  Lukes has institutionalized a sub-asset class that has seen its importance skyrocket in recent years, even as the business model bucks conventional wisdom.

Traditional retail investing rested on the notion that profitable shopping centers required large anchors to drive traffic. But today, smaller retail outlets with dedicated parking and repeat consumers who run quick errands have grown to more than 950 million square feet nationwide. Lukes sat down with Commercial Observer to discuss how he carved out a major niche in a growing asset class that is just now emerging as a powerhouse due to geolocation data.

This interview has been shortened for length and clarity 

Commercial Observer: You’ve become the first REIT to institutionalize the curbside retail space. How did it happen?

David Lukes: In the retail real estate space there are dozens of competitors, and you’re all competing for the same shareholders. While there are some differences in portfolios, in general, most people own a fruit salad: There’s some grocery, there’s some power, there’s some lifestyle, there’s some net-lease. The physical format of the shopping centers can vary widely, and everyone has a pretty wide range, and most of our peers in the group are exceptionally well managed, and it’s hard to compete. So to stand out, it helps to have something unique and different that happens to be an interesting business. Probably 20 years ago I became interested in a unique and underappreciated format in retail, which are unanchored strip centers, or convenience centers. 

Unanchored strips aren’t noteworthy. They tend to be simple shops or buildings right up the street. They’re not name-brand, large anchors, but they have strong credit. Think Starbucks or Chipotle. The challenge is no one has anchored at scale in the public market that format type, and there are reasons for that. I started making small investments in 2019 in that format. And to be honest, when COVID hit, there was more time to do homework, as there wasn’t a lot of deal-making going on. We did a deep dive to dissect these properties financially and look at returns for different pieces of our properties, and it confirmed the thesis that this asset class has more compelling financial returns and less risk than other formats in retail. And We decided in summer 2020 to become the dominant owner in the public markets. 

Over the next three years, we gradually scaled up. We subdivided pieces of existing properties, put them in one bucket, and announced we’d be spinning it off into a public company. That was the genesis. We had a thesis that the asset class had been around a long time but no one had the desire to scale in a small way. 

Tell us about your strategy and why it works?

If you’re a mom-and -pop investor or small fund with capital, you can make a bet because you have a hunch. But if you’re raising institutional capital from pension funds, insurance companies or public shareholders, there better be some math behind it. Starting in 2019, landlords started getting geolocation-scale phone data, and that changed the world for me. In the unanchored sales space, you don’t have a grocery store to point to sales volume or a movie theater to point to sales volume, or even a Target — you have small shops, and they don’t report sales. But with geolocation available, it gave a massive amount of information to landlords to decide which is a good property and what is a bad property and how to make investments using data science and math. That, to me, was the critical piece that said this deserved to be in the public markets and public shareholders can use this data. So when you combine the historic financial data and the geolocation data, we now have a pretty compelling thesis. 

What are the primary challenges with communicating the benefits of this new asset class to the investment community? Why didn’t people do it before?

One reason is there’s a massive amount of it. There’s 950 million square feet of this type of real estate in this country, and it’s 90 percent owned by local families. It’s an asset class that’s been around for a long time, but it hasn’t been done in the public market because you need a much more compelling initial theme, and you need the data to back it up. Without the geolocation data and without the five-year historical financial statements filed with the Securities & Exchange Commission, you didn’t have that. But since we had the financial data and we bought all the geolocation data, we found ourselves in the first-mover position to start the company. The challenge in becoming public is you have to be a certain size. It took us a couple years to get to a certain size to float in the public market with enough relevance and be able to cover the cost of being public. There are a couple of funds we compete with in buying this stuff, but no one else is public. 

What’s attractive to investors in terms of your metrics?

If you have an interesting idea, and you want to make a bet, one way to do that is you borrow a lot of money and put in very little equity and make a highly levered bet. Sometimes it works out well and sometimes it doesn’t. In public markets, if you’re running a publicly traded company, you need to have a good idea and a capital structure that supports growing that idea. The biggest benefit of announcing the spinoff and taking a year to complete the spinoff is we could sell off properties we owned that were large format and use that cash to pay off all our debt, all of our bonds, all our credit facilities, and seed Curbline with additional cash. If you think about new REITS, or IPOs, this is the first one that went public with no debt and $800 million of cash. 

Do you have the capacity to grow? 

We have $800 million in cash, which is one-third of our enterprise value, and we have no debt, so we can double the company before needing to go back to shareholders to raise more capital. That’s a very unique situation. If we’re starting with about $1.5 billion in real estate assets, our cash is now $800 million, so we’re already at $2.3 billion in enterprise value and our stock is trading higher, which shows that our investors are more enthusiastic than our underwriting value. And the $2.3 billion can double and we can be a $4.5 billion or $5 billion company without needing fresh equity. And that’s extremely rare in the public space.

In terms of these properties themselves, obviously retail has been impacted by recent evolution of technology. What type of changes do you see in the evolution of the U.S. economy that can benefit and threaten curbside retail? 

We’re a reflection of leases we sign with tenants, and the credit behind that: Will they pay rent, and will the rents go up? Inflation isn’t great for long-duration leases. If you have a 20-year lease with a grocery store, and it’s fixed at 6 percent, every time inflation is 2 percent you lose value. With small format convenience properties, the lease terms are shorter. Our weighted average lease term is six years, which means, as inflation grows, market rents are growing because replacement costs go up. Every time a tenant runs out of lease term, and we renegotiate a new lease, the rent is higher. If you look back five years, we’re averaging around 28 percent mark-to-market when a tenant expires. Normally, higher inflation is bad for real estate because it makes total asset value lower, but, ironically, it’s not bad for us, because if inflation stays at 3 percent, it means our market rents are growing and we’ll capture it every time a tenant becomes available. 

But other societal things could disrupt it. There are positives and negatives. When people go to malls, they are going shopping. You spend an hour and a half in the mall after parking. Consumers have done something else after shopping, and it’s called running errands. You run down to the bank or McDonald’s or the ATM. The convenience property business is not a shopping business; it’s a running errands business. Everything we sell is right on the street on major thoroughfares. And they’re not making more major roads, there’s no more land being created in mature markets.

When you buy curbside real estate in high-traffic areas, in high-income suburbs, they aren’t making it anymore. It’s a finite amount of material you can go after. The idea that development will break this thesis is pretty weak. There could be development in tertiary suburbs that are less dense, but it’s hard to imagine there will be a whole lot of development. I think inflation for us is pretty good, and the changes from COVID in the work environment have changed dramatically. You used to go to the mall on weekends. Well, now people are in the office three days per week and if you’re working from home two days per week, you’re proximate to curbline real estate twice as much as you used to be. I like being in the running errands business because I feel like society has changed, and as long as we have some flexibility in the work environment, in the suburbs, it feels like this business is catching a tailwind from that.

And what about the threats?

What usually happens in a recession is occupancy trails GDP. I have seen it time and time again throughout my career. And that will happen here, too. If we have a recession, we’ll lose the local pizza guy and other local tenants. About 70 percent of our tenants come from national high-credit names. Our list is Wells Fargo, AT&T, Fed Ex, Five Guys, Chick-fil-A, Starbucks, and those are not tenants that will close during a recession. But the other 30 percent are local shop tenants, and we will lose some of those. Part of our business thesis is that you accept the fact that you lose tenants in a recession, but the cost to lease them up again on the upswing is much less expensive, particularly compared to other types of real estate like office or regional malls that have a high capex [capital expenditures] load. The number of tenants looking for small 1,500-square-foot spaces is so vast that if you lose them in a recession, it’s probably 6 months to lease the space and you’re probably leasing higher than you were before.

Can you give us a real life example of this?

Capex is the cholesterol of shopping centers. If you lose a 100,000-square-foot Walmart, how many tenants will take that space? Zero. How many might take 100,000 square feet if you change it with a different loading dock? Maybe one. If you lose a 50,000-square-foot theater, or a 40,000-square-foot Best Buy, there might be three tenants to replace it. But the cost to subdivide the building is expensive. The cost to replace is expensive. But if you lose a nail salon, there are well over 200 tenants to take the exact same size space. It could be a restaurant, another nail salon, a dry cleaner or a Jersey Mike’s. The cost to backfill that ubiquitous size is so low the capex load in this type of retail format is one-fourth to one-third compared to what an anchored tenant or grocery property will have. And your returns are exceptionally different. We just generate more free cash flow that drops down to the bottom line than other formats because you’re using that to put capital back into the property to generate more income. That’s probably the most shocking statistic that I’ve heard from our investors. 

What was it like in 2020 to discover this public market investment advantage with curbside retail? 

It feels like the end of a long saga. Most people in the industry know this type of real estate can be very profitable, but no one had spent the time — and frankly I would not have spent time without a team of intelligent people around me. My two partners, my CFO and COO, the three of us spent time saying, ‘This thesis makes sense, but let’s see if it’s business. Is this anecdote a business plan? Can it be a business?’ That’s when we did the historical financial analysis, and when we uncovered how low the capex load was, the lightbulb went off.  But even then, we studied 30 properties, we can see what the capex load and rent growth has been, but could these 30 assets become 3,000? And then we had to figure out the addressable market and, shockingly, lots of industry followers didn’t have the information. We worked with ICSC and other data sources to see how much is out there, and then you see public information from third-party providers saying there’s 950 million square feet of unanchored strip. I don’t want all of that — there’s a lot of vape shops and tattoo parlors in that, so all of it isn’t for the public market. But even if you take the top 15 percent, it’s still 50 times larger than our current portfolio. 

What’s the upcoming competition like?

It’s almost exclusively local investors we’re competing against. Every now and then we run into another REIT, but this is a straight-buy play. We buy small assets, and the public companies buy larger assets. PIMCO just bought a big property in Orlando. The idea that we’re running into peers who are interested in what we’re buying is pretty low, and the benefit of dealing against local investors is they use debt and we don’t use debt, so we can close fast and there’s sometimes a tax advantage to selling to a public REIT. So right now we’re the obvious buyer, but that could change. Because we just highlighted financial data that didn’t exist last year, and now other investors can see that and it might bring more interest to the asset class, so that’s certainly a risk.

Brian Pascus can be reached at bpascus@commercialobserver.com