Mark E. Zalatoris, president and chief executive officer of Inland, standing outside at the Algonquin Commons in Algonquin, Ill.

Inland Real Estate's necessity-based portfolio stands up

By Charles Keenan

At a time when shopping center REITs face potential vacancies as retailers struggle, Inland Real Estate Corporation (NYSE: IRC) seems to rest assured its portfolio will stand up to adversity.

Inland, headquartered in the Chicago suburb of Oak Brook, Ill., has steadily built a defensive portfolio of shopping centers in the Midwest, filled with grocery store anchors and other nondiscretionary retailers, offering moderate growth and steady income streams. While in boom times Inland's strategy has drawn criticism for lack of aggressiveness, its conservative bent hardly gets a complaint from investors today.

"We consciously assembled this necessity-based portfolio that was criticized at certain times for not being exciting," says Mark E. Zalatoris, president and chief executive officer of Inland. "But in these times, it looks pretty attractive."

Inland focuses on shopping center properties located in busy suburban and city centers in 11 states, with the bulk situated in the Chicago and Minneapolis metropolitan areas. It has assembled over the years a portfolio of $1.7 billion in assets, staying away from speculative development on the fringes of suburban expansion, instead sticking to areas with dependable rents and high incomes of customers.

Much of the recession-resistant portfolio is built upon supermarkets: Inland targets the number one and two grocers in its market and 45 percent of the company's portfolio is anchored with grocery chains, those that typically have leases of 20 to 25 years on average. Meanwhile, the REIT's Midwest focus also means less volatility of property prices when compared with the East and West coasts. "You might not get the fast ramp ups in values, but you don't get the fast declines either," Zalatoris says.

Zalatoris, a 23-year company veteran who became CEO in April, characterizes the company's investment style as "sure and steady." Funds from operations (FFO) per share in 2007 increased 7.5 percent over 2006 to $1.43. Modest growth remains in the outlook: FFO per share guidance for this year is in the $1.46 to $1.49 range, due in part to interest expense savings and big boosts in expiring rents that have countered some big-box vacancies, according to research by BMO Capital Markets.

Algonquin Commons in Algonquin, Ill.

The bigger story is Inland's dividend payouts. It is one of only seven companies in the entire REIT industry to pay monthly dividends, which have increased 13 times over the last 12 years, up to an annual rate of 98 cents in 2007. With dividends reinvested, Inland's steady performance shines brighter. For the five years ended May 31, Inland averaged an annual total return of 17.6 percent, versus 15.6 percent for all shopping center REITs in the FTSE NAREIT Equity REIT Index.

A Shopper's Market

Before Inland's creation as a REIT in 1994, executives saw an opportunity: lots of open-air shopping centers that were undervalued. "When we were contemplating going into retail as a property sub-type, we had looked at the type of investors that Inland has traditionally courted," Zalatoris says. "They are investors that want stability. They want a certain yield. This is an income product with a component of growth, not the other way around."

Inland acquires, owns and operates various shopping center types: community, neighborhood, power, life-style and single tenant. Its portfolio had 146 properties in mid-June, totaling more than 14 million square feet of retail space. National retailers represent 70 percent of the portfolio, including grocery chains such as Supervalu and Dominick's Finer Foods, a subsidiary of Safeway. Other retailers include Kmart, Kohl's, PetSmart, Office Depot and TJX Cos., the owner of TJ Maxx.

The shopping centers are mainly located in infill locations, where incomes are relatively high and population is dense. At its locations, the average annual income of residents within three miles was $84,500 in 2007, tops among its peer group, according to data compiled by Inland from Green Street Advisors and market research firm Claritas. That figure outpaces second-ranked Federal Realty Investment Trust (NYSE: FRT), whose average is $69,400. Meanwhile, Inland's population within a three-mile radius was 91,000, ranking it third among seven retail-focused REITs, behind Kimco Realty Corp. (NYSE: KIM) and Federal Realty.

"Shopping centers in infill locations are generally decent places for investors during uncertain economic times," says Paul Adornato, an analyst with BMO Capital Markets.

By concentrating most of the portfolio geographically, Inland can offer tenants a variety of rent levels and locations. "The difference for us as a property owner is we have clustered within the submarkets," says D. Scott Carr, president of property management. "In these major metro areas in our submarkets we offer a variety of retail centers, so we can cover the full spectrum of retailers looking to come into a specific submarket."

The Energy of Empty Space

High among investors' concerns is how much retail bankruptcies will plague REITs going forward. While Inland's portfolio is defensive, it is not immune to retailer woes: bankruptcy filings by Wickes Furniture Inc. and Linens 'n Things Inc. have affected Inland, but the company is working quickly to re-lease the sites.

		Humble Beginnings While Inland Real Estate Corporation the REIT dates back to 1994, the full story dates back 40 years prior to that. It all started out with a group of school teachers turned real estate moguls. Daniel L. Goodwin, Island Group's chairman and chief executive officer, and three other fellow school teachers were devoting an increasing amount of time to managing their growing portfolio of apartments in the late 1960s. At first, they tapped family and friends as their first investors. The partners started with two apartments, then four, then moved onto bigger buildings and apartment buildings. They formed the Inland Real Estate Group in 1968 to handle the ventures. Goodwin and the other three principals—Robert H. Baum, G. Joseph Cosenza and Robert D. Parks—soon quit their day jobs to devote themselves full time to the fast growing business, where they structured a series of syndicated limited partnerships, raising money from investors and buying apartments. As the investor base grew, the group formed multiple property partnerships, allowing them include other types of real estate in the vehicles, such as retail sites, offices, mini-storage units and industrial buildings. Inland later used public partnerships to organize assets in 1985. In the early 1990s, investor demand for REIT approach to real estate investment led to creation of Inland Real Estate Corp. under the sponsor's wing. The REIT's focus at the outset was on the metropolitan areas of Chicago and Minneapolis, keeping its market within a 400 mile radius. The REIT became independently self-managed by 2000, and started trading publicly in 2004. It is the only REIT originally sponsored by the Inland Group of companies that is publicly listed today, and is independent of its former sponsor.

By mid-June, one of its five former Wickes spaces had been re-leased to Sports Authority and Inland was in advanced lease negotiations with national retailers for at least two other locations. While two of its three Linens 'n Things stores will close, those locations are adjacent to popular shopping malls, the company said. On the good side, the opening of these sites allows Inland to mark rents to market. That is what happened when Kmart went through bankruptcy six years ago, freeing up sites for Inland.

"In the long run we see this as an opportunity," Carr says. "That is what our history has shown. If you look at our same store growth over the years, our largest increases were driven by capitalizing on these types of opportunities. I like to call it the upside of the downturn."

Adornato calls the bankruptcies a double-edged sword. "Obviously, any interruption in the rental income stream is a negative," he says. "But in the end, if they are able to re-lease at rents higher than current, that's a positive. The question is, ‘How long is the down time [the lapse between] and how much will they have to spend to get the tenant in the new space?'"

To be sure, the uncertainty over the health of retailers has weighed on all retail REIT stocks. Inland's modest growth and Midwest concentration has led its stock to trade at a discount relative to its peers, according to BMO Capital Markets.

Growth going forward will also be limited due to the tough market for acquisitions, with good prices still hard to come by, executives note. Capitalization rates for shopping centers have nudged back above 7 percent this year, but are still below the company's historically weighted average of 8.7 percent. In light of these market conditions, the company does not expect to acquire properties for its own portfolio in the current year. Instead, the REIT intends to fous this year on acquiring $100 million to $150 million worth of assets through its IREX joint venture.

Yet Zalatoris says the market will move toward an equilibrium as holders will be forced to sell to pay off maturing debt. "There is still a disconnect between what sellers think they can get for their property and what buyers think is an appropriate return," Zalatoris says. "Now is not the best time to buy, but I think it will improve in the near future."

Diversifying Income

A brighter spot for Inland this year is fee generation through a series of joint ventures Inland has undertaken. Those efforts from the last few years are paying off, with fee income rising in 2007 to $4.4 million, up 77 percent from the previous year.

One joint venture is with the New York State Teachers' Retirement System, which gave Inland a mandate to invest $400 million. So far, it has invested $320 million of the proceeds, generating annual income of $2 million in fees for property management, leasing and acquisition.

"In essence we are asset managing for that third party investor," says Brett A. Brown, chief financial officer. "The real difference is the permanent investment we have in the asset-based JV. We are co-investing alongside with them. We are acquiring assets, managing them for that investor, and we are also earning a return on the amount we invested."

Inland also has developed another business of buying assets on behalf of investors looking to take advantage of 1031 tax-deferred exchanges, where investors swap like-kind assets without paying capital gains. The REIT created a joint venture with Inland Real Estate Exchange Corp. (IREX), an affiliate of its former sponsor, the Inland Real Estate Group, a separate, privately held enterprise also based in Oakbrook, Ill.

In the joint venture, each company contributes expertise. The REIT finds assets to purchase, puts up the capital, and provides asset management skills. IREX handles the sale of equity interests in the property in 1031 investors who are looking for a tax-free vehicle. These assets typically provide capitalization rates Inland itself would turn down, but are still acceptable to 1031 investors. For acquisitions, Inland roughly charges 5 percent of the value of the property and splits half the proceeds with IREX. The REIT also earns annual fees for managing the properties.

Business is brisk, with the REIT rolling over $150 million worth of property to 1031 investors in 2007 alone. "It is a very efficient use of capital," Zalatoris says. "Equity interests get placed with investors in a few months, we get our money back, and we use it to buy another property and roll it two or three times in one year."

Meanwhile, Inland has teamed up with developers in another joint venture to help round out its portfolio while minimizing risk. Inland relies on five different developers to build new sites. Developers source the sites and secure big-box retailers, while Inland handles financing, leasing and property management. "We recognize the need to include some development component to our company's activity," Zalatoris says. "But we weren't really willing to invest in infrastructure and carry that kind of overhead, especially when times slow down like now."