Quarterly Commentary

Happy New Year! Last year I took a break from writing a quarterly commentary. The year started with a bad case of writer’s block/getting older and I decided to take a break. That seemed to help, and I will be churning out 4 editions this year.

Heck, maybe I don’t need to write at all with the emergence of the new AI technology called Chat GPT; it can write the commentary for me. In fact, two paragraphs were written by it. Can you guess which one? Learn more about Chat GPT here.)

2022 was a truly transformative year for Shannon Waltchack with changes in leadership, in corporate structure, and in the crystallization of the values that guide the company.

Structurally, we transitioned from a partner-led firm to a management team-led firm directed by Andrew Patterson, our President, who continues to amaze me with his command of details and ability to get us all pointed in the right direction. This is the right model at the right time for us to continue to scale up our growth. I’m really proud of Andrew, as he’s earned every bit of this role.

Helping us grow in a smart way, we’ve contracted with David King, a Certified EOS Implementer. His insightful contributions are proving invaluable as we move forward. If you’re not familiar with EOS, it’s a process-oriented way to run a company. This has really helped us define who we are, what we want to become, and how to get there. If your business is ready to take the next step, I highly recommend it.

WHO ARE WE?

Starting in late 2021, the new management team began the task of updating our core values, mission statement, and our goals. As an outcome of these discussions…

Our Core Values are:

Grounded in Gratitude
Fully aware that our current and future success is anchored in the trust that others have placed in us.

Engaged in Innovation
Constantly searching for better tools and methods to lead our craft.

Relentlessly Driven
To exceed expectations in all aspects of our craft.

Invested in Integrity
Dedicated to the moral and professional principles upon which our company was founded, keeping our word even when it hurts.

We took some time to develop a fresh Mission Statement. We found the common link in each service we provide.

Simply stated, we help people.

Our team is fundamentally committed to help people in 5 ways:

1. We help people maximize value.
2. We help people build wealth.
3. We help people see the future.
4. We help people cultivate relationships.
5. We help people make great decisions.

If we are daily helping our clients, investors and tenants, we are confident that we’ll always have enough business. And how much business are we hoping to achieve?

Our primary goal is to have $1 billion in assets under management within 9 years. We currently have $514,000,000 under management.

STRATEGY UPDATE

We continue to doggedly pursue unanchored, conveniently located retail centers across the country with service-focused tenants. Fund I is 95% occupied and has produced a 13.09% cash-on-cash, property level since inception. Fund II is 98.8% occupied (absolutely astonishing) and has produced an 11% cash-on-cash return since inception.

In 2022 we bought $38mm of unanchored shopping centers from Texas to Indiana.

The greater real estate investment marketplace is now coming around to our view that these small centers are the “filet” of the retail real estate market.

Reading through some REIT analyst calls proves that Wall Street is paying attention to this space.

David Lukes, the CEO of SITE Centers had an interesting perspective on his 2022 3rd quarter call:

“Going forward, we remain encouraged by the unique opportunities in the convenience sub-sector…. Future acquisitions would allow us to continue to grow our portfolio of properties with strong credit and low recurring CapEx located at high traffic intersections within wealthy suburban communities. Because the cash flow growth profile and risk adjusted IRRs of this property type are elevated with rents accelerating with inflation, we will continue as we have in prior years to utilize retained cash flow and proceeds from recycling fully stabilized assets into this sub asset class when the right opportunities arise.”

He goes on to point out that one of the greatest attributes of this niche is that, in an inflationary market, these centers are structured to keep pace with inflation:

“The thing to remember is when we’re buying convenience assets, about a third of the rent roll matures with no options in the next five years. So even though the cap rates are moving up marginally, the market rents are also moving up faster than anticipated. So I think the unlevered IRRs are the ones that are growing a little bit faster than going in cap rate.”

MARKET THOUGHTS

As mentioned earlier, our portfolio is as full as it’s ever been. Rentals rates continue to rise and there’s no hint of things slowing down. Yet, interest rates are as high as they’ve been in 11 years, liquidity is being pulled out of the market and PMI readings have been negative since November. What gives?

A few things can explain the discrepancy.

First, the moves by the Federal Reserve haven’t fully hit the ‘real economy’ yet.

Second, SW’s out-of-state portfolio can be found in places where the population growth rate is higher than the national average- places like Florida, Virginia, Texas and even Wisconsin. A rapidly growing population can cushion an otherwise declining economy.

Finally, within the retail real estate industry, a lack of supply also serves as a tailwind for our portfolio. In spite of worries about inflation, interest rates, and a looming recession, the retail industry grew in 2022 thanks to consumers and retailers who remained resilient. Tenants signed leases for 193 million square feet of retail space. Net absorption reached its greatest levels in six years as a result of retailers only closing 20 million square feet of retail space, the lowest amount since the Great Financial Crisis. With a 9.2% rise in overall retail sales, Americans spent $683 billion more than they did in 2021. As a result of rising demand for premium space and a dearth of new retail deliveries, the vacancy rate decreased to 4.2%.

In 2023, trends to watch include retailers continuing to shrink the size of the stores, diminishing consumer demand, and core retail remaining attractive. According to the U.S. National Retail Forecast, the vacancy rate should remain stable, although net absorption in the mall segment will continue to decline, development will stabilize, and rents will rise.

On the acquisition side, things have been difficult. Interest rates grew 2.5 times in just six months, significantly affecting the amount a buyer can pay for an income stream. Therefore, owners are only selling at this moment if they have to. We must hunt harder to find a deal that can work. Time will help this some, but we expect this year to be a difficult buying stretch. Nevertheless, we have a goal of buying $33 million in real estate this year. We’ve got some work to do!

CLOSING THOUGHTS

As I reflect on our founding in July of 2005, I am truly amazed at how much change we have experienced. It’s hard to fathom that we now employ 35 people with plans to hire 3 more this year. We’ve come a long way from our first days on Linden Avenue with only Len, Andrew and yours truly. And we couldn’t have done any of it without our investors, who are the gasoline in our tank. We thank you.

In 2022 we also said goodbye to our retiring partner Tim Blair. Tim contributed to our firm in countless ways but none more pronounced than spearheading our fund business. Through his hard work and vision, he made our business more durable and scalable. Thank you, Tim!

I’ll close with a request, please take the time to read this this letter from Howard Marks. It was the very best investment piece I read last year. In his letter, he offers his thoughts on when and how to time investment exits. You’ll find some contrary thoughts and challenging ideas that might make you a better investor. This is a discussion you won’t hear on CNBC.

I wish you all the best in 2023!