Lessons Learned in Shopping Center Development

Looking back at the last 40 DEVELOPMENT IS AT the heart of Regency Centers’ heritage. Since the years, a noted shopping center company was founded in 1963 we have developed approximately $3.5 billion of developer finds many lessons. commercial properties. Over the years we experienced many hard-earned lessons learned. No matter what any future savant may assert, there will always be cycles in the economy and real estate, and it is during market peaks that even the best and most experienced developers let their guards down and lapses occur. Then, the recessions and difficult times will surely follow and the most valuable lessons are repeated and business judgments and principles are hopefully honed. Regency’s HAP STEIN president, Brian Smith, has frequently said

104 ZELL/LURIE REAL ESTATE CENTER that mistakes are more often made in good to pay large inducements to those stores times rather than during downturns. made the mall space too formidable. Our less-than-favorable views on office development were influenced by the wild PRE-IPO, 1963-1993 swings in the operating fundamentals caused by economic cycles and lack of My parents, Joan and Martin Stein, constraints to new supply other than the started Regency’s predecessor company availability of capital. Even if capital were to develop the first major regional mall plentiful, shopping center and mall devel- in Jacksonville, Florida. In the ensuing opments were not viable without anchor thirty years the company developed a tenants, whereas all that an adventure- number of projects throughout Florida. some developer would need to build an These included various property types: office building was an undisciplined bank multi-family, suburban and downtown willing to provide a construction loan. office buildings, regional malls, and com- Moreover, due to sizable lease commis- munity and neighborhood shopping sions, tenant improvements and free rent, centers. Over time, grocery-anchored we found that less than 70 percent of community and neighborhood shopping Net Operating Income (NOI) from office centers became the most appealing prop- buildings was available for debt service or erty sector to the company. We liked the equity distribution. This compares with significant daily traffic that the super- over 90 percent of shopping center NOI, market anchors generated and long-term where there were typically lower tenant twenty-year leases. We found the daily and building improvements and leasing necessity and convenience-oriented ten- commissions in relation to rent. ant mix to be recession-resistant. Given In addition to being attracted to gro- Florida’s growth and Publix’s increasing cery-anchored shopping centers, there are dominance, there seemed to be plentiful many lessons learned from our first thirty future development opportunities. Most years in business. Perhaps the most critical important of all, our shopping centers is that shopping centers that are anchored performed well. In contrast, the playing by market leaders have much higher odds field for mall development was severely of both performing well in good times and restricted by competition from the major enduring the downturns. It also became developers like Simon, DeBartolo, GGP, evident during the recession in 1990 and Macerich, and CBL. Their relationships 1991, when capital went on strike, that with department stores and willingness financing developments and our com-

REVIEW 105 pany with permanent long-term capital, has to be fed. Do fewer deals, do them including substantial equity, was critical better, and don’t be afraid to say “no.” to surviving economic and financial crises • An anchor relationship can obscure and taking advantage of the opportunities reality and an anchor lease doesn’t that are usually only available in times of guarantee success or achieving 95 per- stress. One of my memories is hearing the cent leased. late Peter Knox, a founder of Merry Land • Stay away from fringe areas and sec- Properties, an early apartment REIT, talk ondary locations. about the risk of too much debt. He said, • Maintain careful underwriting. Don’t “Leverage is like salt. A little will make bank on future population growth your dinner taste better. Too much will or build too much speculative space. ruin the whole meal.” Build based on existing rooftops, cur- Regency’s current senior execu- rent rents, and reasonable absorption. tives, including Brian Smith and Bruce • Avoid buying land as a competi- Johnson, Regency’s chief financial officer, tive advantage in excess of near-term who have been my partners for more than requirements. twelve and thirty years respectively, all • When the market was good, we were lived through similar experiences in the too lenient on tenant credit. When the early 1990s, whether it was with Regency market was falling we tried to hold out or other fine shopping center companies for higher rents too long. Leases signed like Trammell Crow. Brian’s notes from in early months of a downturn turned a 1990 Crow partners meeting captured out to be our best ones. ten of the critical development “mistakes • Maintain hiring standards. The tough- made” and “lessons learned” that still ring er the market, the greater the need for true today: the best people. • Years of success and flawed confidence • During good times don’t overstaff and that the “music” of a good market lose focus on overhead. While it is easy won’t stop combine to lull a company to staff up, it is hard to cut back. into believing this time it’s different and, ultimately, into complacency. • Be extra careful doing deals at the BUILDING A NATIONAL height of the market and when the COMPANY, 1993-2008 markets become frenzied. • Be wary when the company culture lion- With the benefit of these lessons, a sharp- izes growth and the development beast ened focus on grocery-anchored shopping

106 ZELL/LURIE REAL ESTATE CENTER centers and a keen recognition of the criti- 95 percent occupancy within about a cal value of substantial equity for the com- year of anchor opening. The unleveraged pany’s long-term survival and growth, our return on $1.4 billion of invested capital company went public in 1993 as a REIT. was 10.4 percent, creating almost $700 Within six years of the IPO, we made million of value at a profit margin of two major acquisitions and a merger that nearly 50 percent. expanded our portfolio to a national scope. In spite of the fact that, by 2005, we Also, the purchases of Branch (operating were becoming concerned that the strong in Atlanta and the Southeast), Midland (in tailwinds in the economy and the housing the Midwest), and especially Pacific Retail boom might be peaking, and could even Trust (in the Western United States) ulti- change directions to become headwinds in mately enabled us to have a development the next few years, it is now obvious that presence in virtually every major market. we did not adequately moderate our devel- By 2000, we could reasonably claim that opment program. We did not appreciate we were the leading national owner, oper- how difficult it would be to substantially ator and developer of shopping centers. slow a $500 million development program During the next nine years we developed at the sign of darkening economic clouds. 174 shopping centers at a cost of more And, unfortunately, the disciplines from than $2.6 billion. With twenty-nine cen- the lessons previously learned were not ters anchored by Publix, twenty-two by more forcefully applied. Kroger, thirteen by Safeway, and twelve With the benefit of hindsight it is now by Target, the company established itself apparent that five blinders distorted our as one of the leading national shopping judgment. These were: center developers. • Our track record by all accounts was As Table I shows, the developments impressive, and we perhaps began to that Regency started between 2000 and take that success for granted. 2004 were successful by every measure. • Realized profits from development sales On average the shopping centers achieved totaled more than $250 million for the

Table I: Development performance 2000-2004

# of Net NOI Yield Underwritten Average Estimated Total Estimated Profit Margin Project Development Yield Months Value at 7% Net Value Costs to Project Cap Rate Creation Completion(1) 103 $1,415,934 10.4% 10.4% 25.0 $2,101,696 $685,762 48%

(1) From closing on land. Construction was typically 12 months.

REVIEW 107 period 2000-2008 and had expanded to The story wasn’t nearly as pretty 20 percent of Funds from Operations for the twenty-nine projects where we (FFO, which is the primary earnings strayed from our proven strategy. While metric for REITs). We had created a the majority of these projects enjoyed machine that was responsible for a large the benefits of a number one anchor in percentage of our reported earnings. a premier location, a good portion of the • Regency’s partnerships with institu- leasing challenges that we faced in these tions were the primary acquirers of centers can be attributed to a housing many of our developments, which bust and a recession that were much worse mitigated the funding risk but not the than most anticipated. Still, the adverse development risk. impacts would have been mitigated had • The need to productively employ the we relied on our experience and instincts large amount of overhead devoted sole- to say “no” more often. A number of these ly to development. deals involved developing for our anchor • Almost all developments were anchored tenant customers in “greenfield” areas or by best-in-class operators like Target, secondary markets with the “promise” of Publix, Kroger, and Safeway, which a significant amount of projected future gave us great comfort. As we were housing growth. Many were large com- reminded, having the best operators is munity centers, which were slated to be only one of the necessary ingredients of contributed to a fund that was created a successful development. with institutional partners to buy an 80 Before examining the results of devel- percent interest in our larger format cen- opments that deviated from our standards, ters. One particularly large development it is important to note, as Table II shows, was our first—and last—lifestyle center that even late in the cycle, where we fully development. Since the decisions to go “stuck to our knitting,” our forty-two forward were made at the height of the developments performed pretty well. The market, too often we ended up paying too average time to 95 percent leased was less much for the land and building too much than two years from anchor opening, and space. As graphically illustrated in Table the average return on invested capital was II, the results were long lease-up times and nearly 9 percent. Although these returns poor returns on capital. The bottom line were less than the 2000-2004 develop- is that, until these centers are 95 percent ments, the profit margins were still in the leased, we will have lost nearly a quarter 30 percent range, and more than $150 of the $850 million of estimated value million of estimated value was created. that was created by the successful proj-

108 ZELL/LURIE REAL ESTATE CENTER Table II: Development performance 2005-2008

2005-2008 # of Net NOI Yield Underwritten Average Estimated Estimated Profit Margin Starts Projects Development Yield Months Total Value at Net Value Costs to Project 7% Cap Rate Creation Completion(1) Met Criteria 42 $572,201 8.9% 9.5% 31.9 $728,932 $156,732 27% Below Regency 29 $641,735 4.9% 9.1% 53.1 $445,383 ($196,352) (31%) Standards Totals 71 $1,213,936 6.8% 9.3% 40.6 $1,174,315 ($39,620) (3%)

(1) From closing on land. Contruction was typically 12 months. ects developed between 2000 and 2008. • A focus on growing NOI, recurring Additionally, the cost basis of the 500-acre earnings and NAV—rather than non- land bank was written down by more than recurring earnings that can be distorted $100 million, or more than 50 percent. by profits from development sales—is Having relived the class of hard knocks a better way to grow intrinsic value during the worst recession and financial over the long term. crises since the Depression, I am hopeful • In that vein, developing core shopping that the most important lessons have been centers that meet Regency’s invest- reinforced and now become permanently ment criteria is preferable to merchant engrained in management’s psyche and development. Believing that a third- our principles and strategies. Building party buyer may want to own a shop- on Brian’s notes from the Crow partners ping center that might not be up to meeting twenty years ago, my “10 Lessons Regency’s standards for core assets can Learned 2.0” are: be “fool’s gold.” • The perception and reality of a strong • Be extremely cautious when developing balance sheet and reliable access to larger community shopping centers. capital matter a lot and are critical to They are much more complicated and weathering and profiting from future more things can go wrong, including recessions and financial storms that store closings and the adverse impact will surely be encountered. from opening covenants. They also • Infill shopping centers with domi- take longer to entitle, develop and nant anchors, especially supermarkets, lease, which exposes the developer to a that are located in protected trade higher degree of market risk. areas with high purchasing power in • Always, always be thinking about what Regency’s target markets perform bet- can go wrong: think scared, negotiate ter regardless of the economic cycle. assuming the worst will happen, and This also applies to developments. think of the consequences. Anchor

REVIEW 109 tenant commitments that are not iron- erty sales, all of which further strength- clad are worthless. ened an already stolid balance sheet. • Don’t develop lifestyle projects, period, • Intensifying the focus on restoring or mixed use developments, which can occupancy in the operating portfolio be even more complicated than com- to 95 percent from 92.5 percent and munity centers, without a partner pos- achieving 95 percent in those develop- sessing substantial office or apartment ments still under way. By attaining expertise and deep pockets. this goal an additional $35 million of • Build the amount of space based on NOI will be harvested, thus creating an demonstrated tenant demand, not the estimated $500 million in incremental size of the site. value. Almost a third of this NOI and • Do fewer deals, and do them better value will come when we achieve 95 with talented professionals and atten- percent occupancy from 80 percent in tion to the details. Make sure there is as the developments. much focus and incentives on making • Using recurring FFO as the primary the existing projects successful rather earnings metric rather than FFO. Since than the next new one. recurring FFO excludes transaction • Don’t forget Lessons Learned 1.0. profits, it is more closely tied to sustain- ing growth in NOI and, in turn, NAV per share. In my view, the size and vola- APPLYING tility of transaction profits can distract LESSONS LEARNED from the focus on growth in recurring earnings, which is a more reliable way Armed with Lessons Learned 2.0, we to build intrinsic value over the long have attempted during the last two years term. to make the most of the difficult times • Substantially slowing new develop- to position the company for the future, ment activity, focusing instead on the including moderating and sharpening the best opportunities that fully met our focus of the development program. These underwriting and investment criteria. significant measures included: In addition, the amount of space being • Raising more than a billion dollars of constructed at a number of develop- capital through a combination of two ments was cut back through phasing. common stock offerings that totaled • Completing four developments and nearly $600 million, mortgage and redevelopments that will serve as the unsecured debt financings, and prop- model for future value-add investments.

110 ZELL/LURIE REAL ESTATE CENTER The strong openings in 2010 by the You might ask “Should REITs be in two Publix’s, Safeway, and Giant stores the development business?” The question are evidence of strong anchor sponsor- seems more than appropriate given our ship. Both the pace of leasing and the view that REIT investors will be pleased level of rents exceeded expectations, with a future compound total annual demonstrating that the right amount return of 8 percent to 10 percent using of shop space was built and proving the low levels of leverage. This means that attractiveness of the infill trade areas in REITs need to sustain long-term growth target metro areas. in earnings of 5 percent annually in addi- • Reducing the size of Regency’s overall tion to paying dividends in the 4 percent work force by 30 percent. The major- to 5 percent range. This compares with ity of these painful cuts were related just three years ago when the unrealistic to development. Even after eliminating and unsustainable expectation was for a these positions, the development team total shareholder return of 12 percent to still has the capabilities to manage our 15 percent and an 8 percent to 10 percent existing developments and create new growth rate in earnings with higher lever- ones that meet our more stringent crite- age levels. ria. Our conclusion is that companies like • Instituting a more focused and team- AMB, AvalonBay, Boston Properties, oriented approach in each of our target ProLogis, and Regency, which can aug- markets. This means that the function- ment reliable growth in NOI and NAV al organization structure with separate from a high-quality portfolio with a prop- development and operations groups was erly managed and sized development pro- replaced by regional and market teams gram, should be able to offer superior long- responsible for all aspects of the busi- term growth in shareholder value. The first ness. reason is that development enables compa- • Establishing a high priority on mean- nies with those capabilities the capacity to ingfully reducing the land bank by “manufacture” high-quality properties that converting the parcels to developments most probably could not be purchased on that meet Regency’s standards or to cash a third-party basis. Also, these develop- through sales. ments can be “manufactured” at returns that are accretive to the cost of acquiring comparable properties, the cost of capital THE FUTURE OF and NAV. The profitable returns should DEVELOPMENT translate into higher growth rates of per

REVIEW 111 share recurring FFO and NAV. Further, pelling use of capital. The four develop- the value-added skills are transferable to ments and redevelopments that we opened redevelopments to improve assets within last year, for example, share these ideal the operating portfolio. Finally, there is no attributes and furthered our relationships better way to service key customers than to with Publix, Safeway, Giant and other provide for their expansion needs through retail customers that expanded into the development. centers. Each asset is a quality shopping What does this mean for retail devel- center that would be extremely hard and opers? Creating new shopping centers in expensive to replace through acquisition. target markets with dominant anchors and Figure 1 shows how we can manu- demonstrated demand for shop space and facture high-quality shopping centers at reinforcing through redevelopment the much higher returns than by acquisition. competitive advantage of existing centers The weighted average return for the four at attractive risk adjusted returns and mar- is projected to be 9.5 percent. This results gins remains and should always be a com- in a projected internal rate of return in

Figure 1: Returns on developments vs. acquisitions 11.00%

10.40% 10.50% 10.23% 9.89% 10.06% 9.88% 10.00% 9.72% 9.59% 9.40% 9.56% 9.50% 9.24% 9.29% 9.09% 9.00% 9.00% 8.70% 8.41% 8.50% 8.11%

IRR 8.00% 7.81% 7.51% 7.50%

7.00%

6.50%

6.00% 6.00% 6.25% 6.50% 6.75% 7.00% 7.25% 7.50% 7.75% 8.00% Mkt Cap (Dev @ 200 bps over) Acq IRR Dev IRR

Assumes development initial returns are 200 bps higher than acquisitions. For example, on a typical acquisition with a 6.5 percent initial return, the initial return for a comparable development would be 200 bps higher, or 8.5 percent, and the IRR would be 9.4 percent, compared to 8.11 percent for the acquisition.

112 ZELL/LURIE REAL ESTATE CENTER excess of 10 percent that is meaningfully Furthermore, we have no appetite to grow higher than an IRR of slightly above 8 the development engine and the associated percent from buying the centers at a overhead back up to the $500 million level 6.5 percent cap rate, if they ever became of annual starts at the peak. We are all too available. The projected IRR for develop- familiar with how that story ends. We do ments in the figure does incorporate a full plan to capitalize on our unique combina- allocation of development overhead. The tion of a long-standing development track returns from these developments are also record, in-house development expertise, well in excess of Green Street Advisors’ presence in key markets and close relation- most recent estimate of Regency’s cost of ships with the leading anchor tenants and capital of 6.3 percent. local development partners to win more By building on the successful profiles than our fair share of developments that of the four developments and redevelop- we will want to pursue. In addition, there ments that opened last year, we want to are ample value-add redevelopment oppor- reach $150 million to $200 million of tunities within the existing portfolio. As a annual development/redevelopment starts result we are comfortable that $150 million over the next several years. Given our to $200 million a year in development and abundant caution toward “greenfield” sites, redevelopment starts represents a man- the mandate to align the amount of shop ageable and attainable level of value-add space with demonstrated demand, and investments for our market and regional preference for more difficult infill devel- teams. Over a five-year period the future opments in major markets, we anticipate development program should enhance the that the opportunity set for developments portfolio through the addition of $750 that meet our more rigorous criteria will million to $1 billion of outstanding shop- be much more modest than the last cycle. ping centers.

Table III: Development contribution to earnings model 2.5% same property 2.5% same property NOI growth - NOI growth - Development at Base No development $150m per year (1)

NOT $400.000 $410,000 $413,000 FFO(2) $220,000 $230,000 $233,000 FFP Growth Rate 4.5% 5.9%

(1) $150 million per year of developments at 9 percent returns funded by selling an equal amount of assets at 7 percent cap rate generates a net gain of 2 percent, or $3 million of additional NOI (2) FFP is based on $5.7 billion of assets, 40 percent leverage, interest at 6 percent and G&A of $45 million FFP = NOI - ($135 million interest - $45 million G&A)

REVIEW 113 The hypothetical model below (Table III) shows how $150 million of development at returns on capital of 9 percent can increase the annual per share growth in FFO by 25 percent or more for a company with assets in the $5.5 billion range. It has been our experience that growth in recurring FFO translates into a roughly equiva- lent growth in NAV. In our view, building recurring earnings and being able to then increase dividends together with growing NAV is a proven recipe for compounding shareholder value. As a result of the potential for meaning- ful future contributions to recurring earnings and NAV and the enhancements to the quality of the portfolio, development will remain an integral component of our strategy in the future. Along with own- ing and investing in high-quality grocery- anchored shopping centers, maintaining a strong balance sheet, and engaging a top- flight management team, development will continue to play a prominent role in our distinctive approach to creating shareholder value.

114 ZELL/LURIE REAL ESTATE CENTER