Developers Diversified Realty (DDR)

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Anichya G

Thomas Gaffney

Developers Diversified Realty Corporation (NYSE: DDR) is a real estate investment trust that specializes in leasing shopping centers. The company makes money by charging its tenants a fixed rental rate in addition to taking a percentage of their overall revenues. Like most REITs, DDR is vulnerable to economic downturns. Tough economic conditions can lead tenants with expiring leases to choose not to renew or to renew at lower rental rates. Moreover, if the company's tenants make less money, it lowers the variable percentage of the DDR's revenue. The company's focus on "value retailers" like Wal-Mart Stores (WMT) however, provides it with a degree of insulation from downward economic cycles. During economic downturns, these companies tend to fair better than their midrange competitors because consumers tend to downgrade from premium and midrange offerings to less expensive options during periods of economic weakness. DDR's properties are also primarily off mall and have benefited over the last decade from a shift in consumer shopping preferences from mall locations to off-mall locations.

DDR is a pioneer amongst REITs in the use of joint ventures. DDR prefers using joint ventures in order to raise capital because it protects DDR from movements in capital markets. Thus, DDR partners itself with cash laden investors in order to undertake larger projects which DDR manages. This approach has allowed DDR to become one of the fastest growing REITS and allows the firm to collect management fees. DDR is involved in 10 partnerships totaling $3B in funding. These ventures account for a third of the DDR property portfolio. ^[1]

DDR believes in entering international investments through join ventures in order to benefit from the local knowledge of partners. In 2006, the company entered into a joint venture with Sonae Sonara, a Brazilian Real Estate firm. The partnership which managed $3.4 million square in Brazil at the end of Q1 2008, is the second largest real estate owner in the country and also has properties in Russia and Puerto Rico as well. DDR has further plans to grow its international properties to 25% of total square footage.

Financial/Operating Metrics

DDR has significantly increased square footage over the last year with an increase of 38.9M square feet. This is a result of its acquisition of Inland Real Estate. As a result revenues have grown quickly, but the added expenses involved in these new projects have prevented net income from growing in step.

Below are several metrics of operating performance for the company.

^[2]

Trends and Forces

DDR Gains from The Decline of the Traditional Enclosed Shopping Mall

Beginning in the 1990s shopping malls began to lose their appeal to consumers as they migrated to main-street shopping areas and lifesyle centers instead. To underscore this point, not one new indoor shopping mall will be built in America in 2008 compared to 5 in 2005. In 2002 19% of U.S. retail purchases were made in mall compared to 38% in 1995. ^[3] The term greyfield (after brownfields) is used to describe dying malls where annual sales per square foot have dropped to less than $150, or one-third the rate of sales at a successful mall. In a 2000 study, PricewaterhouseCoopers (PWC) found that 140 existing regional malls were already greyfields, while another 250 were headed in that direction. ^[4] DDR stands to gain from this trend as most of its properties are off-mall properties.

DDR Depends Heavily Upon a Few Major Corporate Tenants

DDR relies on major tenants making it vulnerable to changes in their demand for space. This may depend upon the business and financial condition of these tenants. The rental revenues received from Wal-Mart Stores (WMT), Mervyns, T.J. Maxx, PETsMART (PETM), Loews (LTR), Bed Bath & Beyond (BBBY) , and Circuit City Stores (CC) represented over 15% of DDR's annualized shopping center base rental revenues.^[5] DDR's dependence upon the financial health of these major retailers could adversely affect it in the event of the bankruptcy, insolvency or a significant downturn in the business of one of these tenants. DDR could also be adversely affected if any of these tenants decide not to renew their leases as they expire.

Changes in Interest Rates Affect Both the Health of the Real estate Market and the Costliness of DDR's Debt

As of December 31, 2007, the Company’s total debt consisted of $4.5 billion of fixed-rate debt and $1.1 billion of variable-rate debt, including $600 million of fixed-rate debt that had been effectively swapped to a variable rate. The variable and fixed debt had weighted average maturities of 3.9 and 4.1 years respectively. The average interest rate for fixed-rate was 5.1% and 5.3% for variable. ^[6] Thus, DDR's total debt exposed to interest rate fluctuations is $1.7B, a large sum compared to other REITS. A fluctuation in interest rates by 100 basis points would immediately increase DDR's costs by $17M.

DDR Offers Greater Stability through its Geographically Diverse Holdings

DDR has large presences across the United States, Brazil, Russia, and Puerto Rico. It is the second largest real estate owner in Brazil and plans to increase its international properties to 25% of total square footage. By doing this, DDR lowers its dependence upon the American economy and allows itself to profit from the rapid expansion of developing countries.

The Strength of the Retail Sector Affects Demand for DDR Properties

DDR's properties consist primarily of community shopping centers making the company’s performance dependent upon general economic conditions of the market for retail space. The market for retail space is affected by weakness in the economy on the national, regional and local scales. Trends such as Supermarket Consolidation, excess retail space in a number of markets and the increase in consumer purchases through catalogs and the Internet could all hurt demand for DDR properties.

Competition

DDR is at an advantage to many competitors because it is one of the nation’s largest owners and developers of shopping centers. The Company has established close relationships with several large retailers. DDR still faces competition from numerous developers and real estate companies both private and public. They compete with DDR in acquiring properties and leasing them to tenants.

The table below provides relevant competitive data of close competitors:

Market Share

In 2007 DDR's market share among global Retail REITs was just 5%. Market share is listed by Funds From Operations (FFO), a metric that takes into account earnings from existing properties but not cash from acquisitions or sales of assets. Globally there are 38 REITs focusing on retail properties producing an aggregate $10.0B in FFO.^[11][12]] Most of those were small companies, only 9 Retail REITs are listed in the Russell 1000.

2007 Data^[13][14]

• General Growth Properties (GGP) has ownership interests in and/or management responsibility across regional shopping malls totaling over 200 million square feet of retail space with 24,000 retail stores and anchor department stores, as well as theaters, sit-down restaurants, ice skating rinks, and other forms of family entertainment.^[15]

• Westfield Group ((WDC) is the largest retail property group is the world with a portfolio of 119 shopping centers across Australia, the U.S., New Zealand, and the United Kingdom, valued at $53.2 billion.^[16]

• Kimco Realty (KIM) is largest publicly traded owner and operator of neighborhood and community shopping centers in the U.S., with more than 1,519 properties comprising 180 million square feet of leasable space across 45 states, Puerto Rico, Canada, Mexico and Chile.^[17]

• Simon Property Group (SPG) develops and leases regional malls, shopping centers and strip malls. Simon Property Group owns or has an interest in over 379 properties comprising over 256 million square feet of gross leasable area across investments in the U.S., Europe, and Asia,^[18] making it the largest public U.S. real estate company.^[19] Simon Property Group's investments tend to be in large metropolitan areas with very high consumer traffic and are comprised of anchor department stores alongside smaller retailers.

Footnotes

1. ↑ Retail Traffic, August 1, 2005
2. ↑ DDR 2007 10K, Item 15, pg. F-4
3. ↑ [http://www.psfk.com/2008/01/the-decline-or-death-of-the-shopping-mall-in-america.html The Decline (or Death?) of the Shopping Mall in America, PSFK, January 4, 2008]
4. ↑ Malls: Death of an American Icon, July 24, 2003, CNN Money
5. ↑ DDR 2007 10K, Item 1A , pg.7
6. ↑ DDR 2007 10K, Item 7A , pg.130
7. ↑ DDR 2007 10K, Item 1 , pg.3
8. ↑ KIM 2007 10K, Item 1 , pg.4
9. ↑ WRI 2007 10K, Item 1, pg.2
10. ↑ FRT 2007 10K, Item 1 , pg.3
11. ↑ U.S. Global REITs
12. ↑ [2007 Company Annual Reports]
13. ↑ Datamonitor Industry Market Research: Global - Retail REIT's
14. ↑ [2007 Company Annual Reports]
15. ↑ VNO Company Site - About Us
16. ↑ Westfield Group company website - Company Profile
17. ↑ Kimco Company Website - About Kimco
18. ↑ Simon Property Group company website - About Us
19. ↑ Simon Property Group company website - About Us