Neighborhood and Community Centers (NCC) are Recession ... · 11/6/2018 · institutions are...

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Neighborhood and Community Centers (NCC) are

Recession‐Resistant

Dr. Randall Zisler

Zisler Capital Associates, LLC

November 15, 2018

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Dr. Randall Zisler

Zisler Capital Associates provides independent research, consulting, expert witness and

capital placement services to high net worth and institutional clients.

Randy holds an undergraduate degree, two of his three master degrees (architecture and

planning) and his Ph.D. from Princeton University (economics and planning), where he was a

professor and taught economics and finance. He also received a master degree in civil

engineering from The Catholic University of America. He has lectured at Harvard, Yale, and

other universities.

He has written over 100 papers spanning a wide range of topics in finance and economics;

some of these papers are frequently cited.

He was executive director and head of real estate research at Goldman Sachs & Co. and

managing director and head of real estate research (CMBS) at Nomura Securities

International, partner at Pension Consulting Alliance (an advisory firm to large pension funds)

and managing director and co‐head of investment banking at Jones Lang LaSalle. He has

been an expert witness to corporations and governments.

Randy has served many ultra‐high net worth individuals. He was chief investment officer to

Merv Griffin, the entertainer, entrepreneur and real estate investor.

He has consummated over $5 billion of equity and debt transactions (public and private), and

has advised investors that include GM, IBM, CALPERS, CALSTRS, Marvin Davis, Guggenheim.

Government of Singapore Sovereign Fund, Morgan Stanley, Deutsche Bank, and Rockefeller

Development.

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Contents

A. Abstract

B. What are the stylized facts (SF)?

C. A closer look at the stylized facts SF 1. The goods and services sold at NCC and malls differ in fundamental ways,

and these differences affect risk.

SF 2. Neither a rise in interest rates nor widening credit spreads will necessarily increase NCC cap rates or cap rates for other retail concepts.

SF 3. Mall tenant sales are more volatile and are more prone to negative

growth than are NCC sales, especially during recessions. SF 4. The less volatile NCC sector specializes in consumer nondurables, is less

volatile and, hence, presents less downside risk. SF 5. The price and income elasticities of demand indicate that NCC services

are necessities and goods sold at malls are more volatile luxuries. SF 6. Consumer durable (mall) sales per square foot are growing faster than

nondurable sales (NCC) per square foot because the price of durables, which is also income elastic, has declined faster in relation to the price of nondurables and, as a result of this price effect, durable demand has grown relative to nondurables.

SF 7. The nondurable price deflator is rising while the durable price deflator is

falling, which has important positive implications for the long term demand for NCC space.

SF 8. Our short‐term (two‐year) forecast, which assumes no recession before

2020, indicates stable consumer durable and nondurable sales growth. However, when a recession occurs, NCC and nondurable sales will perform better than mall and durable sales.

D. Conclusions

4 5 8 13 20 24 27 31 32 38 44

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Neighborhood and Community Centers (NCC) are

Recession‐Resistant

A. Abstract

The market has failed to price neighborhood and community centers (NCC) efficiently.

Malls enjoy an institutionally driven, not always deserved, premium and investors, since the Crash,

have unjustly penalized NCC (to their detriment). There exists a dichotomy between NCC’s strong

operational performance and its investment perception.

NCC is much more recession resistant than malls, and we explore in this report scientific, evidence‐

based reasons why this is the case

NCC presents an arbitrage opportunity that the discerning institutional investor can systematically

exploit with great profit.1

Investors do not realize that NCC sales are much less volatile than mall sales, especially during

recessions. NCC is a relative safe haven during times of economic turmoil.

NCC is qualitatively different from malls not only with respect to the goods and services they sell, but

also with regard to whether these goods are either necessities (NCC) or luxuries (mall).

We report that the pre‐tax demand for NCC tenant services is highly inelastic with respect to price.

Hence, NCC goods and services are termed necessities. By contrast, the demand for mall goods is

much more elastic with respect to price; this high elasticity contributes to the greater volatility of

malls sales. The income elasticities of demand are inelastic for NCC but very elastic for malls, which

implies that NCC demand is less sensitive to changes in household disposable income over the

business cycle.

We show that if there is little substitution between NCC labor and NCC floor space in the production

of retail services, then the income elastic demand for these services and the difficulty of substituting

retail labor for NCC space will drive the demand for NCC space. This insight supports the conclusion

that the operational demand for NCC space should be robust long term. The investment thesis is that

institutions are discovering NCC. They will reallocate capital to NCC, which will lead to lower cap rates

(or higher property prices), the introduction of institutional quality asset management, and the

consolidation of the NCC sector, all to the profit of first‐mover institutional investors.

1 Institutional investors who favor malls complain that NCC, which are smaller centers than malls, need more due diligence, which burdens the capital placement effort. Firms, such as Baceline, are efficient in acquiring and underwriting these centers and delivering exceptional risk‐adjusted returns. We believe that there are two biases that have impeded the flow of institutional capital into the NCC sector: The gateway bias and the large property bias. These biases reflect an intense pressure to place significant amounts of capital in a relatively short time span; larger properties accommodate this need, possible at the expense of lower risk‐adjusted return.

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B. What are the stylized facts?

This paper compares and contrasts the historical operational performance (e.g., rental growth and

other property performance metrics) and investment performance (e.g., cap rates and total returns)

of NCC and malls and presents findings as a series of stylized facts.

Section C, “A Closer Look at the Stylized Facts”, presents technical analysis.

Stylized Fact 1: The goods and services sold at NCC and malls differ in fundamental ways, and these

differences affect risk.

Consumer spending consists of consumer durables (CD), consumer nondurables (CN) and consumer

services (CS). The government reports data for these categories. However these data do not fully or

accurately reflect the goods and services actually sold in malls and especially in NCC. NCC goods and

services include most CN categories as well as some services. These services, such as health services,

which NCC tenants increasingly provide, are affecting the growth of overall CS, which itself is

commanding an increasing share of household expenditures. These services, which, in addition to

health care, include as well other personal services, will be a powerful economic force driving the

demand for NCC.

Stylized Fact 2. Neither a rise in interest rates nor widening credit spreads will necessarily increase

NCC cap rates or cap rates for other retail concepts.

Unexpected changes in interest rates and credit spreads are risks that affect all properties; these

changes often create performance volatility. Should NCC investors be concerned about these risks?

No. The cap rate is the sum of the risk free rate, the credit spread, less the expected growth of net

operating income (NOI). The relationship between retail (or retail sub‐group) cap rates and interest

rates or credit spreads is neither simple nor is it stable over time. Other factors can swamp the impact

of interest rate shocks on cap rates. Macroeconomic factors explain some of the variation in cap

rates. However, much of the variation in cap rates is attributable to regional or urban factors. The

retail sub‐categories include anchored and unanchored centers, malls, drug stores, and single tenant

properties. The interest rate impact on cap rates is not the same for all five retail categories. Mall

cap rates are much more sensitive to interest rate and credit shocks than are NCC cap rates.

We believe that the NCC market is inefficient, lacking extensive institutional trading and research. (This is

an opportunity for the astute investor.) Malls, single tenant, and drug store trading is much more

efficient. These property classes enjoy a veritable army of brokers and investors. Such is not the case

with NCC. Nevertheless, NCC’s liquidity is comparable to that of malls and other major property classes.

This characteristic contributes to the significant opportunity that NCC presents well‐capitalized

institutional investors. The inefficiency of the NCC market actually leads to wide cap rates, which

protects NCC from interest rate and credit shocks. An inflow of institutional capital will reduce NCC

cap rates and the market will become more efficient. Until that time, NCC will be a compelling

opportunity.

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Stylized Fact 3: Mall tenant sales are more volatile and are more prone to negative growth than are

NCC sales, especially during recessions.

NCC is recession resistant. Sales volatility is an important differentiator between NCC and malls.

During the Crash, mall sales growth dipped below a negative ten percent; meanwhile, NCC volatility

was minor.

Stylized Fact 4: The less volatile NCC sector specializes in consumer nondurables, is less volatile and,

hence, presents less downside risk.

While the growth rate of nondurables was negative during the Crash, durables were far more negative

not only during the Crash. While nondurables are closely associated with NCC, NCC tenants focus on a

subset of consumer nondurables and a limited number of consumer services as defined by the

government.

Malls are the riskiest of the retail concepts, followed by single tenant and drug stores. NCC is the least

risky of the five retail categories, which include anchored and unanchored NCC, malls, drug stores, and

single tenant retail properties.

Stylized Fact 5: NCC, unlike malls, specialize in necessities.

The price and income elasticities of demand for NCC and mall services and goods are parameters that

define and differentiate NCC from malls. They measure the sensitivity of demand to changes in factors

that can include income or price. We use consumer nondurables as a proxy for NCC services and goods.

The NCC income elasticity of demand is inelastic, which indicates that NCC specialize in necessities. By

contrast, a mall’s more durable goods and services have an income elasticity of demand that is very

elastic; we term such goods and services as being luxuries. The demand for luxuries is more volatile.

The price elasticities of demand indicate that the demand for NCC goods and services is almost perfectly

inelastic, which indicates that NCC demand is not price sensitive. However, the demand for mall services

and goods is sensitive, which is another source of volatility.

The price and income elasticities differentiate NCC and malls and help us understand why mall

expenditures are more volatile than NCC expenditures, especially during recessions.

Stylized Fact 6: Even when expressed as sales per square foot, malls sales, which are mostly

durables, are more volatile than NCC sales, especially during recessions.

The growth rate of economy‐wide, not necessarily in‐mall, durables sales per square foot has

been more rapid than the growth of non‐durables sales. However, durables per square foot

are more volatile, especially during a recession, than nondurables per square foot.

Stylized Fact 7: The nondurable price deflator is rising while the durable price deflator is falling,

which has important positive implications for the long term demand for NCC space.

A little recognized, but essential, stylized fact that fundamentally affects the long term evolution of

NCC is the divergence of the nondurable and durable price deflators. The nondurable deflator is

rising but the durable price deflator continues to fall. We believe that this divergence reflects deep

fundamentals that will affect the demand for economy‐wide services and will drive the demand for

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and pricing of NCC inventory. Unlike the high productivity computer sector, the service sector exhibits

lower productivity and rising average cost. NCC services reflect this observation. The demand for NCC

services is income and price inelastic. As incomes rise, NCC‐related expenditures will rise and

comprise an increasing share of consumer expenditures. To the degree that the ratio of NCC retail

workers to NCC space is not very responsive to changes in rents or retail worker wages, then the

underlying NCC service fundamentals will support strong long term demand for NCC properties.

Stylized fact 8: Our short‐term (two‐year) forecast, which assumes no recession before 2020,

indicates stable consumer durable and nondurable sales growth.

The two‐year forecast for the growth in consumer nondurables is 2.9% and the growth in consumer

durable sales is 5.8%. Owing to the low elasticity of substitution between NCC labor and space, the

impact on NCC investment performance should be favorable and enduring. Our forecast assumes no

recession before 2020.

Looking beyond two years, we can say with confidence that whenever, not if, a recession occurs, NCC

and nondurables will perform better than malls during the downturn. The demand for NCC services is

income inelastic and consumer service expenditures, especially on health, will increase as a share of

total expenditures. Since the ratio of NCC retail workers to NCC space is relatively inelastic and the

long term growth in demand for NCC retail services will likely be robust, the demand for NCC will be

strong. The sustained demand for NCC space will increase the value of NCC properties (and lower

NCC cap rates). These properties, especially in infill locations with rising household income, will

appreciate.

In other words, as in the classic tale of the tortoise and the hare, non‐durables will become more

dominant and win the day in the long term.

A Postscript

Now add institutional capital to strong operation performance. With the inflow of institutional

capital will come professional management and risk assessment. The new owners will consolidate the

NCC sector and drive down cap rates.

Early investors will be richly rewarded.

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C. A Closer Look at the Stylized Facts

This section presents analysis and numerous exhibits that support each stylized fact.2

Stylized fact 1: The goods and services sold at NCC and malls differ in fundamental ways, and

these differences affect risk.

The US Government collects retail sales data. However, the attribution of sales to malls and NCC is

not straightforward and requires some adjustment to the government sales data.

Exhibit 1 describes the goods and services frequently found in typical NCC and malls. NCC specializes

in services whereas malls specialize more in goods. Still, there is some overlap between NCC and

malls. For example, NCC may have a tenant that sells some clothes, either as the primary business or

as one of many items and services, but clothing sales are not typical. Similarly, most malls have

limited and full service restaurants. NCC also has tenants that provide limited service dining.

Exhibit 33. Goods and sales for NCC and malls

NCC Mall

Medical: Emergency care, dentists, etc.

Personal care: Beauty, barbers, nails

Gyms and athletic facilities

Beer, wine and liquor stores

Pharmacies and drug stores

Limited service eating places and take‐out

Full service restaurants

Grocery stores

Financial services: Insurance, banking

Offices

Education: Tutoring

Shipping and mail

Dry cleaning

Department stores

Furniture and home furnishings

Clothing stores

Book stores

Electronics and appliance stores

Sporting goods,

Hobby and musical instruments

Toys

Shoe stores

Source: Zisler Capital Associates

Two‐thirds of the Baceline portfolio, as shown in Exhibit 2, consists of five of these NCC tenant groups.

These groups consist of restaurants, beauty and spa, medical and financial services.

The increasing presence of office is consistent with in‐process secular changes in the nature of NCC.

NCC, often embedded within clusters of housing, is more generally a deliver point for all kinds of

2 Busy and less technically inclined readers may ignore this section without losing the thread of the analysis.

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services, not just traditional retail. As such, NCC will evolve and become even more essential in the

economic ecology of urban areas.

Exhibit 2. Five tenant categories account for 67% of Baceline leasable area.

Source: Baceline

The government defines consumer sales as consisting of three sales categories: Consumer durables

(CD), consumer nondurables (CN), and consumer services (CS), as shown in Exhibit 3. Note that CS

has grown since 1959 much faster than either CN or CD. Services, especially health, expressed as a

share of total consumer expenditures, are growing.

This trend, which is practically immutable, has profound implications not only for macroeconomic

performance. It affects NCC in ways that investors should welcome. We are already seeing some of

these in process changes as NCC owners increasingly emphasis on financial services, medical,

education, and offices.

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Exhibit 3. Consumer services is the fastest growing consumer spending sector and this growth is profoundly affecting NCC.

Source: U.S. Bureau of Economic Analysis

NCC overlaps mostly with CN but includes some services that the government classifies as CS.

Exhibit 4 describes some of the components of CN, CD, and CS. Highlighted in red are some of the

goods and services that we associate with NCC. Note that NCC goods and services include most CN

categories as well as some services provided by CS. These CS services, which are found increasingly

in NCC, are affecting the growth of CS. Services will be a powerful force driving the demand for NCC.

Health care expenditures, a component of CS, are an important and rapidly expanding component of

CS but health care still constitutes less than 15% of most NCC, as exemplified by the Baceline

portfolio. This will change as the health sector looks for more efficient ways to deliver medical care.

We expect health care to command an every growing fraction of NCC leasable area. Health care

expenditures are an important reason why CS is increasing at a rate which not only exceeds the

growth of CN and CD, but exceeds the growth of household income and inflation.

If we add to CN the CS components highlighted in red and remove the non‐highlighted components

from CN, we would expect modified CN, or NCC expenditures, to grow at a significantly faster rate

than raw CN. This modified CN will comprise a growing and significant share of consumer after‐tax

0

2,000

4,000

6,000

8,000

10,000

12,000

2006 2008 2010 2012 2014 2016 2018

Components of consumer spending, $ billion

Services Nondurable Durables

‐20%

‐15%

‐10%

‐5%

0%

5%

10%

2006 2008 2010 2012 2014 2016 2018

Year‐over‐Year Change in Consumption, %

Services Nondurables Durables

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expenditures and NCC will be intimately linked. We will argue later that this ineluctable trend

benefits the demand for NCC but weakens the demand for malls as they are currently constituted.3

Later in this report we estimate the income and price elasticities of demand for NCC and malls and

report for NCC low elasticities. Low elasticities indicate that NCC sales are necessities.

In our econometric model, which we use to forecast as well as estimate elasticities, we use CN as a

proxy for the goods and services commonly sold by NCC tenants. We will create a more refined NCC

sales index that explicitly incorporates the contributions of certain consumer services within the CS

category, especially health care and financial services. However, we do not expect the conclusions

to change as a result.

Moving health care and financial services from CS to CN, for example, will only make the income and

price elasticities more inelastic, which will strengthen our findings even further. The demand for

health care, which is highly income inelastic, will in decades constitute a major share of disposable

income.

Exhibit 4. The components of consumer spending—NCC goods and services are highlighted in RED.

Source: U.S. Bureau of Economic Analysis

3 Malls must redefine their mission.

Consumer Nondurables Food and beverage Alcoholic beverages Pharmaceuticals Household supplies Personal care products Tobacco products Magazines, newspapers Clothing and footwear Gasoline and fuel oil Recreational items

Consumer Durables Motor vehicles Furnishings Household appliances Glassware and utensils Garden tools Sporting, recreation goods Books Musical instruments Jewelry Therapeutic appliances Luggage Telephone equipment

Consumer services Health care Veterinary Postal and delivery services Vocational training Legal services Accounting Personal care Rental of nonfarm housing Water supply and sanitation Electricity and natural gas Nursing homes Transportation services Public transportation Taxis Air transportation Theatres and parks Photo and audio processing Gambling Food services Nursery and schools Funeral and burial services

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Proper classification is essential. For example, department stores anchor malls, and traditionally the

purpose of an anchor was to attract customers who would frequent the in‐line stores. Department

stores sales have faltered and this decline has affected mall performance.

Exhibit 5 compares the rate of growth of department store sales with NCC sales (excluding health and

other CS‐related services). The department stores deal primarily in consumer durables. Services play

only a minor role. Since 2009, department store sales have declined in every year while NCC sales

have consistently grown; NCC and department store sales are dramatically negatively correlated.

Note that department sales growth is not only negative during this period, but it is more volatile than

NCC sales. While NCC sales slowed dramatically during 2009, it still grew, while department growth

plummeted. If department stores are a driver of mall sales, no wonder that many malls are in trouble

and in need of fundamental change.

Exhibit 5. The growth of department stores has been negative since the Crash while NCC tenant sales keep growing.

Data source: Zisler Capital Associates; U.S. Bureau of Economic Analysis

‐8%

‐6%

‐4%

‐2%

0%

2%

4%

6%

8%

2008 2009 2010 2011 2012 2013 2014 2015 2016

NCC

Retail Ind

ex and

dep

artm

ent store sales,

annu

al cha

nge %

NCC retail sales, annual change, % Department stores, annual change, %

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Stylized fact 2. Neither a rise in interest rates nor widening credit spreads will not

necessarily increase NCC cap rates or cap rates for other retail concepts.

Should retail investors be concerned about rising interest rates? Moreover, should NCC investors

be anxious? We think not. For those worried about market volatility, recessions and rising

interest rates, NCC may be the best defensive play, perhaps even a safe haven.

When the economy is overheated, which is good for NCC, the Federal Reserve typically increases

interest rates, as it is now doing. Assets, such as NCC, which have higher cap rates, tend to be

more resistant to interest rate increases. In that respect, NCC is not only a defensive play at the

bottom of the market, but it is defensive in an overheated economy as well.

In this section, we estimate the sensitivity of general retail cap rates as well as the cap rates of five

retail concepts (anchored centers, unanchored centers, malls, single tenant, and drug stores) to

changes in interest rates and credit spreads. When the economy slows, in most cases interest

rates decline but credit spreads widen. In a strong economy, the opposite often occurs.

What is a cap rate? The cap rate, defined below, is the ratio of net operating income (“NOI”) to

the property price; it is also the sum of the risk free rate (the Treasury yield) and the credit spread

minus the expected rate of growth of NOI, plus other variables. The credit spread reflects the risk

that the market assigns an asset. AAA‐rated bonds have tighter credit spreads (lower rated

default risk) than sub‐investment grade junk bonds. Properties with higher growth prospects—

greater NOI growth—tend to trade at higher multiples, or at lower cap rates.

CAP RATE = RISK FREE RATE + CREDIT SPREAD –RATE OF GROWTH OF NOI + other variables

That the cap rate is neither an interest rate nor highly correlated with interest rates (BB‐rates bond or

Treasury yields) does not mean that there is no relationship between cap rates and interest rates; the

relationship is masked by other contributing factors.

Exhibit 6. BBB‐bond yields and the overall retail cap rates is not simple.

Exhibit 7. The relationship between Treasury yields and retail cap rates is not linear.

Data source: Morningstar, Board of Governors of the Federal Reserve

3%

4%

5%

6%

7%

8%

9%

10%

5% 7% 9% 11%

BBB‐rated corporate yield, %

Retail cap rate, %

3%

4%

5%

6%

7%

8%

9%

10%

5% 7% 9% 11%

10‐yea

r Trea

sury yield, %

Retail cap rate, %

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In a hot market, despite a rising risk‐free rate, credit spreads could narrow and rental rates could

increase sufficiently to buoy expected NOI growth, thus offsetting the effect of rising interest rates.

Other factors can swamp the impact of interest rate. Thus, even if interest rates were to rise, we

might actually observe falling cap rates, especially in certain metropolitan NCC markets where cap

rates are still wide in relation to Treasuries. Non‐gateway cities are an example where cap rates are

sufficiently high. We know that this is the case because a simple scatter plot of cap rates and

Treasury yields appears almost random. The reason is that there are multiple factors at work, each

masking the effect of interest rate changes on cap rates. Some of the cap rate variance is due to the

national economy but a significant residual is due to MSA‐level factors that we can exploit in building

high performance NCC portfolios.

If cap rates always rose when interest rates increased, then one would expect to see a clear linear

pattern in a scatter of cap rates and either BBB‐rated or 10‐year Treasury yields. We see no such

pattern, especially with regard to BBB‐rated bonds.

If rising interest rates were a strong predictor of increasing cap rates, than we would expect a

significantly positive and steady correlation of cap rates with BBB‐rated corporate bond yields. We

do not see such a pattern. Exhibit 8 shows the 5‐year running correlation between the credit spread

and NOI growth oscillating between positive and negative. It should be consistently negative. As NOI

growth expectations turn negative, credit spreads tend to increase with rising fears of tenant and

owner default. Similarly, the running correlation between Treasury yields and NOI growth is not

stable for reasons we have discussed.

Exhibit 8. The correlation between the credit spread and NOI growth is not stable.

Exhibit 9. The correlation between NOI growth and the Treasury yield is not stable.

Data source: Morningstar, Board of Governors of the Federal Reserve, NCREIF

Overall NOI retail growth is volatile. Exhibit 10 shows the annual NOI growth at almost 7% during

the recovery; the crash was another story. NOI growth was almost a negative 4%. (The story for

NCC sales is quite different, as we shall discuss.)

‐1.0

‐0.8

‐0.6

‐0.4

‐0.2

0.0

0.2

0.4

0.6

0.8

1.0

1997 2001 2005 2009 2013 2017

Correlation of cred

it spread

and NOI growth

rate

‐1.0

‐0.8

‐0.6

‐0.4

‐0.2

0.0

0.2

0.4

0.6

0.8

1.0

1997 2001 2005 2009 2013 2017

Correlation of NOI growth rate an

d 10‐year

Trea

sury yield

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Frequently quoted cap rates usually hide more than they reveal. For example, cap rate often fail to

differentiate between overall retail cap rates and retail subsector cap rates. For example mall cap rates

differ from anchored and unanchored center cap rates. Another concern is the cap rate average.

Exhibit 11 shows that while the average cap rate rises and falls in line with general macroeconomic

trends, there is still substantial variation across MSAs. Our all‐retail cap rate model, which we present

in this section, explains only 54% of the variation in cap rates; the residual is largely reflective of MSA‐

level variation.4

Exhibit 10. The retail NOI growth rate is highly variable over time.

Exhibit 11. Inter‐MSA retail cap rate variation is significant.

Data source: Morningstar, Board of Governors of the Federal Reserve

Let’s consider just the macroeconomic factors. These factors can swamp the statistically significant

impact of the risk free rate on retail cap rates.

NCC cap rates range between 5.6% and 10.4%‐‐the average is 7.8%. The Baceline value‐add strategy

targets properties whose cap rates are in the 8% to 10% range. Higher cap rates are much less

sensitive to interest rate changes than lower cap rate acquisitions. For example, AAA‐rated corporate

bonds are more interest rate sensitive than B‐rated bonds. Thus, value add NCC strategies are less

interest rate sensitive than malls and single tenant retail properties, such as free‐standing drug stores,

a favorite of high net worth investors.

Exhibit 12 below shows that Treasury yields, the credit spread, and the one‐year lagged rate of NOI

growth are highly significant statistically. The coefficient estimates have the correct signs. The t‐

statistics, Box C, a measure of statistical significance, exceed 3.0 in absolute value. However, the

model itself only explains 54% of the variation in retail cap rates. (See Box B in Exhibit 12.) 5

4 General macroeconomic trends, while an essential area of study, fail to reveal the complete picture. 5 This unexplained variation across MSAs should interest investors who seek to devise regional diversification strategies. The capital market only rewards investors for taking risks that they cannot diversify. MSA and regional variations are diversifiable risks. Investors who do not diversify leave value on the table.

‐5%

‐3%

‐1%

1%

3%

5%

7%

1997 2001 2005 2009 2013 2017NOI growth rate, %

0%

2%

4%

6%

8%

10%

12%

14%

2001 2003 2005 2007 2009 2011 2013 2015 2017

Retail cap

rate

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Box A indicates that for all retail, a one percent increase in the ten year bond will increase all‐retail

cap rates by 0.9%, holding other factors statistically constant. This result is highly significant at the

99% level. The coefficient on the credit spread variable is 0.368, and it is highly significant as well; a

one percent increase in the credit spread increases the all‐retail cap rate by 0.4%. The effect is

clearly weaker. The coefficient for the NOI growth rate (lagged four quarters) is ‐0.203. The sign is

correct: A rise in the NOI growth rate should decrease the cap rate. A one percent increase in the

expected rate of NOI growth decreases the cap rate by 0.2%. The data range is 1997:1 through

2017:3.

Exhibit 12. Our all‐retail cap rate model is highly significant.

This analysis indicates that while the risk‐free rate is significant and has the correct sign, other

variables are significant as well; they can swamp the interest rate effect.

Date and time: 02/12/18 Time: 17:42

Sample: 1997.1 to 2017.3

RETAILCAP TENYEAR CREDITSPREAD NOIGROW

Mean 0.078 0.039 0.018 0.016

Median 0.077 0.040 0.016 0.015

Maximum 0.104 0.067 0.065 0.066

Minimum 0.056 0.016 0.006 ‐0.043

Standard deviation 0.015 0.014 0.010 0.023

Skewness 0.171 0.094 2.781 ‐0.259

Kurtosis 1.663 1.943 13.015 3.546

Dependent Variable: RETAILCAP

Method: Least Squares

Date: 02/12/18 Time: 17:47

Sample (adjusted): 1998Q1 2017Q3

Included observations: 79 after adjustments

Variable Coefficient Standard Error t‐Statistic

Probability

that null

hypothesis is

true

A CC 0.039 0.004 9.141 0.000

TENYEAR 0.926 0.102 9.079 0.000

CREDITSPREAD 0.368 0.109 3.394 0.001

NOIGROW(‐4) ‐0.203 0.058 ‐3.502 0.001

BR‐squared 0.556 Mean dependent variable 0.077

Adjusted R‐squared 0.539 Standard deviation of dependent 0.014

F‐statistic 31.364 0.000

S.E. of regression 0.009

Probability (F‐statistic)

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We have so far focused only on the all‐retail cap rate. We now estimate the same econometric model

using cap rate data for five retail subcategories and report the coefficient values for the risk free rate

and the credit spread. The retail sub‐categories include anchored and unanchored centers, malls,

drug stores, and single tenant properties. Rather than include the equations we just report the results

graphically. All of the results are highly significant statistically.

Exhibit 13. Interest rate increase affect unanchored and anchored centers the least.

Source: Zisler Capital Associates, LLC

The interest rate effect is not the same for all five retail categories. A one percent increase in the risk‐

free rate increases the cap rate by 50% for malls but only 20% for NCC. Drug store and single tenant

deals are very bond‐like so their high coefficients are expected. However, malls are very interest rate

sensitive, which should not be a surprise since malls trade at lower cap rates than either anchored or

unanchored centers. Low cap rate investments are usually more interest rate sensitive.

If not offset by other factors, increasing credit spreads can change cap rates, as shown in Exhibit 14.

Malls are the most sensitive to credit changes whereas NCC is much less. The credit coefficient for single

tenant, drugs and unanchored is not significantly different from zero at the 95% level. The anchored

coefficient is significantly different.

0%

10%

20%

30%

40%

50%

60%

Single Tenant Mall Drug Unanchored Anchored

Percentage of an in

terest rate in

crease

that increases cap rates

Interest Rate Increases Affect NCC the Least

NCC

Note: The yield on the ten‐year Treasury is a proxy for interest rates

Page | 18

Exhibit 14. A credit spread increase affects NCC cap rates less than it does malls.


When we disaggregate the data and, due to the limitations of the data base, restrict the sample range

from 1997 – 2017 to 2001 ‐ 2017, we find that the model loses some of its explanatory power. For all‐

retail, the adjusted R‐squared slips from 54% to 35%. This is normal. Disaggregating the data and

shortening the sample range reduce the information content of the data set.

Exhibit 15 shows the extent to which our model explains the total variation in sub‐sector retail cap rates.

The model does a relatively good job for malls, single tenant, and drug stores, but not as well for NCC.

(Here we are addressing the overall power of the model and not the significance of any one coefficient.)

Why is that the case? We believe that the NCC market is highly inefficient, lacking extensive institutional

trading. Malls, single tenant, and drug store markets are much more efficient and enjoy a veritable army

of brokers and investors. Such is not the case with NCC. Even though we have shown that NCC has

liquidity similar to that of other retail concepts—NCC does not have a liquidity problem—the absence of

a broad institutional presence denies NCC efficient pricing of risk. Investors who are skilled in risk

assessment enjoy a comparative advantage.

This characteristic contributes to the significant opportunity that NCC presents well‐capitalized, evidence‐

based institutional investors. To an extent that we cannot precisely measure, the inefficiency of the NCC

market actually protects NCC from interest rate and credit shocks. An inflow of institutional capital will

reduce NCC cap rates, the market will become more efficient, and our model will be more effective in

explaining NCC cap rate sensitivity to macroeconomic and urban fluctuations. Until that time, NCC is a

compelling opportunity that trades in relatively inefficient markets.

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

Single Tenant Mall Drug Unanchored Anchored

Percentage of credit spread

increase

that affects cap rates

A Credit Spread Increase Affects NCC Less Than Malls

NCC

Note: The yield on the 10‐year Treasury is a proxy for interest rates

Page | 19

Exhibit 15. Further proof that the NCC market is inefficient and ripe for consolidation.


0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

Single Mall Drug Unanchored Anchored

Adjusted R

2

Percentage of Cap Rate Variation Explained by Model

NCC

Note: The model regresses cap rate on the risk free rate, the credit spread and the expected rate of growth of NOI for the period 2001:I through 2017:III.

Factors other than interest rates, credit spreads and NOI growth explain mostNCC cap rates variation

Page | 20

Stylized fact 3: Mall tenant sales are more volatile than NCC sales; mall sales are more likely

to turn significantly negative during major recessions.

Sales volatility is an important differentiator between NCC and malls. Investors often take comfort in

mall ownership only to discover that mall sales are more volatile6, as shown in Exhibits 38 and 39.

Exhibit 16. NCC sales growth since 1993 has never been significantly negative, especially during recessions.

Data source: U.S. Bureau of Economic Analysis

During the Crash, mall sales growth dipped below negative ten percent; meanwhile, NCC volatility was

but a ripple.

Exhibit 17. Mall sales growth is more volatile than NCC sales growth


6 With greater sales volatility comes a higher probability of tenant default and loss.

‐30%

‐20%

‐10%

0%

10%

20%

30%

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

Total NCC Annualized Growth

‐30%

‐20%

‐10%

0%

10%

20%

30%

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

Mall Annualized Growth

Page | 21

NCC is recession resistant. Exhibits 18 and 19 show sales growth for selected components of tenant

services for NCC and for malls. Six of the major NCC components grew during economic downturns.

Exhibits 19 and 20 show that such was not the case for malls.

Exhibit 18. NCC is recession resistant: Change in NCC purchases indicates no significant downturns during recessions.


‐30.0%

‐20.0%

‐10.0%

0.0%

10.0%

20.0%

30.0%

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

Limited Service Eating

‐30.0%

‐20.0%

‐10.0%

0.0%

10.0%

20.0%

30.0%

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

Full Service Restaurant

‐30.0%

‐20.0%

‐10.0%

0.0%

10.0%

20.0%

30.0%

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

Pharmacy

‐30.0%

‐20.0%

‐10.0%

0.0%

10.0%

20.0%

30.0%

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

Beer and Wine

‐30.0%

‐20.0%

‐10.0%

0.0%

10.0%

20.0%

30.0%

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

Health and Personal Care

‐30.0%

‐20.0%

‐10.0%

0.0%

10.0%

20.0%

30.0%

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

Supermarkets

Page | 22

Mall sales growth in eleven sales categories was significantly negative during recessions and during

other times, as indicated by red ellipses. By comparison, NCC sales growth has been placid.

Exhibit 19. Volatility of annualized growth rates of tenant sales in regional and super regional malls is very volatile during recessions. Furniture, home improvements, books and electronics are specific examples.


‐30%

‐20%

‐10%

0%

10%

20%

30%

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

Department Stores

‐30%

‐20%

‐10%

0%

10%

20%

30%

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

Furniture and Home Furnishings

‐30%

‐20%

‐10%

0%

10%

20%

30%

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

Electronics

‐30%

‐20%

‐10%

0%

10%

20%

30%

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

Discount Department Stores

‐30%

‐20%

‐10%

0%

10%

20%

30%

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

Books

‐30%

‐20%

‐10%

0%

10%

20%

30%

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

Miscellaneous Store Retailers

Page | 23

Exhibit 20. The volatility of annualized growth rates of tenant sales in regional and super regional malls is significant, especially with regard to clothing.


‐30%

‐20%

‐10%

0%

10%

20%

30%

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

Sporting Goods and Hobbies

‐30%

‐20%

‐10%

0%

10%

20%

30%

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

Gift and novelty

‐30%

‐20%

‐10%

0%

10%

20%

30%

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

Clothing

‐30%

‐20%

‐10%

0%

10%

20%

30%

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

Shoes Stores

Page | 24

Stylized Fact 4: Comparing downside risk for NCC and mall related expenditures: NCC are

more protected.

The growth rates and volatilities of durable and nondurable consumer goods have differed

significantly since the 1980’s. The elasticities which we report in the next section have contributed to

their differential volatilities. While the growth rate of nondurables was negative during the Crash,

durables were far more negative not only during the Crash but also during the late 1980s. Even

though nondurables are closely associated with NCC, NCC tenants focus on a subset of consumer

nondurables and a limited number of consumer services as defined by the government.

Our highly disaggregate index of NCC and mall consumer expenditures (at the 4‐digit level) explicitly

recognizes the definitional overlap across consumer nondurables, consumer durables, and consumer

services. Consumer nondurables, ignoring certain service categories, such as health care, are the most

representative of NCC goods and services.

Exhibit 21. Durables, or mall good, sales are very sensitive to recessions.


The risk per unit of return varies by retail concept, as shown in Exhibit 22. (We measure the risk per

unit using the coefficient of variation, which is the standard deviation divided by the average return.)

Malls are the riskiest, followed by single tenant and drug stores. NCC is the least.7

7 This analysis, which is valid on a standalone basis, neglects portfolio effects. For example, an asset which, in isolation, is risky may be the low risk asset depending on the investor’s liabilities. Additionally, if the asset has a low or even a negative correlation with the rest of the portfolio, inclusion of the asset increases the risk adjusted

‐20%

‐15%

‐10%

‐5%

0%

5%

10%

15%

20%

25%

30%

1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016

Comparative growth, durable and nondurable nominal spending

Durable goods, annual ratae Nondurable goods, annual rate

Page | 25

Exhibit 22. NCC presents much less risk per unit of return compared to malls.


Of course, devil is in the details, and cap rate data are no exception to the rule. Investors typically

speak in terms of average cap rates and neglect the fact that there is a distribution of cap rates.

Exhibit 23 illustrates this important point.

Retail sub‐sector cap rates differ more in their standard deviation, skewness (asymmetry) or kurtosis

(thickness of left or right tail) than in their means. That means that investors should be aware of the

shape of the cap rate distribution.

For instance, Exhibit 23 show that the distributions differ most in their left tails, where cap rates are

the lowest. We have reported elsewhere that over the business cycle, the left tail (low cap rates) is

the most volatile because investors stretch for price during booms and thereby depress cap rates.

NCC is less prone to this left tail stretching by investors who like to “reach for value”. The right tail

tells a different by complementary story. The five distributions are the most alike at higher cap rates.

return of the portfolio. In other words, it increases risk without sacrificing return. This is the closest one comes to a free lunch in finance or economics.

8%

9%

10%

11%

12%

13%

14%

Unanchored Anchored Mall Single Tenant Drug Store

Coefficient of vafiation of cap rates 2001.I ‐2018

.II

Risk per Unit of Return by Retail Concept

NCC

Page | 26

Exhibit 23. Retail sub‐sector cap rates show the greatest variation across the right tails of the five cap rate distributions.

Page | 27

Stylized fact 5: NCC, unlike malls, specializes in necessities

The price and income elasticities of demand for NCC and malls are parameters that define and

differentiate NCC from malls and help explain why NCC performs better than malls during recessions

and especially during deep contractions, such as the Crash. The elasticity measures the sensitivity of a

variable, such as demand, with respect to other factors, such as income or price.

Income elasticities of demand: NCC services are necessities. The income elasticity, which tells us the

responsiveness of sales to changes in income, is the change in demand given a one percent change in

income. Exhibit 24 indicates that the elasticity of demand with respect to pre‐tax income is 0.484 for

consumer nondurables, which we use as a proxy for NCC sales. Consumer durables (mall sales) have a

1.309 income elasticity. What happens when average household income within a three mile radius of

NCC, the typical NCC trade area, increases by 10%? NCC sales increase by 4.84%. By contrast, mall

sales rise 13.09%, almost three times as responsive. During a recession, NCC provides greater stability

than malls. Reasoning in reverse, if income falls ten percent, NCC sales only dip 4.84%.

Economists call goods with a negative income elasticity inferior goods because customers consume

less of the good as incomes rise. Spam and meals at Denny’s Restaurant are examples. If the income

elasticity is zero, then demand is not responsive to income changes. Salt is a good example. Normal

goods and services, like NCC sales, have income elasticities between zero and one, and are therefore

called necessities. However, goods with income elasticities greater than one are called luxury goods

wherein their demand is highly sensitive to income volatility. Malls sales, with an income elasticity of

1.309, are luxuries and therefore are inherently volatile over the business cycle, whereas NCC is not.8

Exhibit 24. Income elasticities of demand for consumer durables (malls) and nondurables (NCC)

Pre‐Tax Disposable Income

After‐Tax Disposable Income

Consumer nondurables (NCC)

0.484 (14.286)

0.534 (11.568)

Consumer durables (Mall) 1.309 (14.267)

1.393 (11.070)

Exhibit 25. Estimates of price elasticities of demand for consumer durables (malls) and

nondurables (NCC)

Pre‐Tax Disposable Income

After‐Tax Disposable Income

Consumer nondurables (NCC)

‐ 0.025 (‐0.859)

0.054 (1.706)

Consumer durables (Mall)

‐ 0.892 (‐ 4.361)

‐ 0.824 (‐3.713)


8 We estimated the elasticities using pre‐ and after‐tax disposable income, which is gross income less tax. The pre‐tax model has greater explanatory power.

Page | 28

What exactly is the price elasticity of demand? Exhibits 26 through 29 show four kinds of demand

curves. If the demand is inelastic, revenue increases with a price increase; however, if the demand

elasticity is elastic, revenue increases with a price decrease.

Exhibit 26. An essential good the demand for which is totally insensitive to price changes. Price elasticity of demand is zero.

Exhibit 27. Perfectly elastic good: A small decrease in price leads to an infinite increase in quantity demanded. Price elasticity is infinite.

Exhibit 28. Imperfectly elastic demand: A 10% decrease in price creates more than a 10% increase in demand, thus increasing revenue.

Exhibit 29. Imperfectly inelastic demand: 10% decrease in price produces less than a 10% increase in quantity demanded; revenue falls.


Estimating the price elasticity of demand. The price elasticity of demand also distinguishes NCC from

mall sales. The price is usually negative since an increase in price decreases the demand for a normal

good or service. The NCC price elasticity is ‐0.025, which is statistically indistinguishable from zero; its

price elasticity is for all practical purposes zero. It is inelastic. (See Exhibit 27 above.) NCC price

changes, therefore, have little impact on demand. (See Exhibit 25 above.)

By contrast, the price elasticity of demand for mall goods is ‐0.892, which is close to unity. A 10%

increase in price will decrease mall demand by 8.9%.9 Mall consumers are much more sensitive to

9 The t‐statistics, in parenthesis, are highly significant at the 99% confidence level.

Price/unit

Units

Price/unit

Units

Price/unit

Units

Price/unit

Units

Page | 29

price changes, such as discounting, than are NCC buyers. Therein lies another reason why mall sales

are more volatile.

A short tutorial. Generally, the demand for essential goods, such as salt, sugar, match boxes, and

soap, is relatively inelastic (less than unity) or perfectly inelastic. The price elasticity is zero.

Consumers purchase the same quantity of these goods, regardless of increase or decrease in their

prices. Moreover, the consumption of essential goods cannot be postponed. Therefore, the demand

for these is inelastic.

The demand for necessities is also inelastic, but not perfectly inelastic. Examples include barber shop

services, for which there are substitutes, such as letting one’s hair grow or asking a friend to cut it. On

the other hand, the price elasticity of demand for luxury goods, such as a Lexis convertible or

expensive jewelry is highly elastic. The elasticity is greater than one.

Goods that are storable, such as durable goods, have a higher elasticity because consumption can be

postponed. Any change in the prices of luxury goods can cause a major change in their demand,

which helps explain some of the volatility of mall sales. There are goods with unitary elasticity. A

price increase leads to a fully offsetting decrease in quantity demanded, leaving revenue constant.

The demand for luxury goods may be elastic to lower and medium income groups, but more inelastic

to wealthy consumers.

Substitutes. The larger is the number of close substitutes among goods and service, the greater is the

elasticity of demand. For example, tea and coffee are close substitutes. In the case of NCC,

convenience is a major factor10. The higher is the wage rate, or the opportunity cost of travel time to

competing centers, the less is the price elasticity of demand for the services of NCC tenants. Locating

NCC within a dense enclave of higher income households would likely decrease the price elasticity of

demand for NCC services and goods.

Lack of information. Imagine you are looking for a car in the used car market. The used car market,

due to the presence of hidden information (or information asymmetry), prices Chevrolet’s and

Mercedes similarly. To the degree that NCC is not priced efficiently, the market fails to discriminate

among centers and price risk correctly. Therein lies an investment opportunity for firms who have

developed the institutional sophistication to price and manage risk.

Income. Wealth and income are critical in influencing the price elasticity of demand. If the price of a

good is small in relation to someone’s wealth or income, then the demand for a product would be

more inelastic, especially to the degree that the opportunity cost of time is a function of the wage

rate. (The travel decision explicitly balances time and money, which are themselves near substitutes.)

On the other hand, demand for products consumed by lower or middle income consumers would be

more highly sensitive to changes in the price. For example, if the price of mobile phones increases,

then the demand for mobile phones would be price inelastic to high income group, whereas it would

be more elastic to lower and middle income consumers. Investors should be sensitive to this point

when assessing the average household income of the NCC trade area as part of due diligence.

Price. The demand for high‐priced goods, such as expensive gold and imported cars, is more inelastic.

The change in the price of these goods produces only a very small change in their demand. Similarly,

10 Introduction of “convenience” means we are adding a time budget to the consumption optimization problem.

Page | 30

the demand for low‐priced goods, such as cheap potatoes and Coors Lite, is also inelastic. The

demand for medium‐priced goods that are neither very costly nor very low cost is elastic.

Expenditure share. If a consumer spends a large portion of their disposable income to purchase a

specific product, then the demand for that product would be more elastic. On the contrary, the

demand would be inelastic for products that comprise a small share of income. NCC specialize in

goods that constitute a small share of total household income.

Time. The price elasticity of demand reflects the amount of time consumers require to adjust to new

prices. The longer is the period of time, the higher is the price elasticity of demand.11

11 The ability to defer a decision is like a call option, the value of which increases with volatility.

Page | 31

Stylized fact 6: Even when expressed as sales per square foot, malls sales are more volatile

than NCC sales during recessions.

The growth rate of economy‐wide, not necessarily within‐mall, durables sales per square foot

has been more rapid than the growth of non‐durables sales. Durable sales per square foot

are more volatile than nondurables per square foot, especially during a recession. Why has

economy‐wide durable sales growth been greater? The price of income elastic durables has

declined faster in relation to the price of nondurables and, as a result of this price effect,

durable demand (in units) has grown relative to nondurables. However, the growth of

durables sales per square foot, or mall sales, is more volatile, especially during a recession.

Exhibit 30. Consumer durables per square foot compared with consumer nondurables per square foot, are rising faster.

Data source: U. S. Bureau of Economic Analysis

Exhibit 31. Growth of consumer durables per square foot of mall space is more volatile than consumer nondurables growth per square foot of NCC, especially during the crash.


0

200

400

600

800

1000

1200

1400

1600

1800

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

Consumer durable and nondurable sales per square foot of malls and NCC, respectively

CND per square foot of NCC CD per square foot of mall

‐20%

‐15%

‐10%

‐5%

0%

5%

10%

2006 2008 2010 2012 2014 2016 2018

Consumer nondurables expenditure volatility is one‐third the volatility of consumer durables.

% change in consumer durable sales per mall square foot

% change in consumer nondurable sales per NCC square foot

Page | 32

Stylized fact 7: The nondurable price deflator is rising while the durable price deflator is

falling, which has important positive implications for the long term demand for NCC space.

A little recognized, but essential, stylized fact that fundamentally affects the long term evolution of

NCC is the divergence of the nondurable and durable price deflators. The nondurable deflator is

rising but the durable price deflator continues to fall. Why is this so? (See Exhibits 32 and 33 below.)

Exhibit 32. The durable and nondurable price deflators diverge.

Data source: U. S. Bureau of Economic Analysis Exhibit 33. The growth rate of the durable price deflator is negative but the nondurable deflator is growing on average.


0

20

40

60

80

100

120

140

160

180

200

1988 1991 1994 1997 2000 2003 2006 2009 2012 2015 2018

Implcit price deflators, index 1988 = 100, SA

Nondurable price deflator Durable price deflator

‐6%

‐4%

‐2%

0%

2%

4%

6%

8%

10%

1988 1991 1994 1997 2000 2003 2006 2009 2012 2015 2018Growth in

value of deflator

Year‐over‐year change in price deflators for consumer durables and nondurables

Nondurable price deflator Durable price deflator

Page | 33

Differential growth between CN and the rest of the economy. The divergent paths of the CN and CD

price deflators suggest deeper, underlying economic processes that affect all economic sectors. These

processes have eluded most retail investors as well as real estate analysts. What are these processes?

Unbalanced growth. Consider a highly stylized and what might seem like an unrealistic model.

Assume that there are two economic sectors: A high productivity sector and a low productivity sector.

The high productivity sector, for example, makes computers wherein average costs continue to fall

precipitously and the wages of high productivity workers rise just as dramatically.12

Wages in the high productivity sector rise faster because labor efficiency is greater. By contrast, in the

low productivity sector, two good examples of which are health care and symphonic music, average

cost keeps increasing. Why? The key insight in this highly stylized model is that both sectors bid for

labor from a common pool and essentially pay the same wage rate.13 The low productivity sector bids

for the same labor, but without offsetting productivity increases average costs must rise. Clearly labor

quality varies greatly, but this is just a model with high predictive value. This model predicts the

behavior of the implicit price deflators: CN (services and nondurables) for NCC and CD (durables) for

malls and other non‐NCC centers.

Consumers increasingly demand increasingly costly services that form the backbone of NCC. The

demand is highly inelastic with respect to income as well as price. (See Stylized Fact 5 above.) In the

low productivity sectors, average cost and prices rise relative to the economy‐wide average. Due to

lower productivity, real, or inflation‐adjusted, output should grow slower in the low productivity

sector. If the demand is price inelastic, NCC services should command a rising share of nominal

output.

What is the impact of low productivity growth on retail labor? If the demand for retail services is price

elastic, then employment will grow. If it is inelastic, then employment will grow more slowly. We

observe just this relationship with regard to services: Slower retail employment growth despite a

rising share of disposable income.

Substituting space for retail workers. What is the relationship between unbalanced growth and the

demand for space?

Virtually anything can be changed. However, the cost of adjustment affects the speed of adjustment

and in retail, as in life, old practices die hard. Technological change in the creation and delivery of

retail services14 can affect and change the ratio of inputs, such as the ratio of retail floor space to retail

workers and other inputs. A critical distinction is the short‐ versus the long‐run. In the short run,

certain inputs are practically fixed. For example, if NCC space is fixed in the short‐run, then an

increase in the retail worker wage rate will not readily induce the firm to substitute out of labor. The

12 In an efficient market, the wage rate is the product of the marginal product of labor and the price of output. In the high productivity sector, entrepreneurs combine large amounts of capital with labor, thus increasing their productivity faster than prices fall. 13 We assume that labor is undifferentiated or homogeneous. Note that the best models often have unrealistic assumptions. Does the model make good predictions despite the assumptions? That is the critical assumption. 14 Inputs to retail services include retail labor, retail space, marketing and many other factors. For the sake of exposition, we focus on retail labor and retail space.

Page | 34

degree of substitutability is impaired by the fixity of space to labor. In the long term, the demand for

labor becomes more elastic because space is no longer fixed.

Now, what happens if the ratio of inputs is fixed over the longer term? For example, the symphony

cannot readily reduce the ratio of musicians to stage area if musician salaries increase relative to rents

any more than it can increase performance productivity (and thereby lower average cost) by

eliminating the fourth movement of Beethoven’s Ninth Symphony. Health care is another example

wherein increasing productivity by varying inputs is difficult not just in the short‐run but the long‐run

as well. The variation in inputs in response to the ratio of the prices of these inputs is called factor

substitution.

We now focus on NCC, wherein substitutability between labor and space is very low. We would guess

that NCC inputs are far more substitutable than they are with the symphony or Michelin Five Star

restaurants. If NCC labor and retail space are combined in fixed proportions, we say that at any level

of output, the ratio of factor inputs, labor and space, is fixed; there is zero substitutability. In practice,

this assumption is true only as an approximation. Limited substitutability, we shall see, has important

implications for the demand for space.

Exhibits 34 though Exhibit 37 illustrate the importance of substitution. A tenant combines inputs,

space and retail workers, to create output, which we call retail services.15

Usually, it is possible to produce a given output with many combinations of inputs. The blue lines in

Exhibit 34, U1V1 and U2V2, are call isoquants, and they signify the loci of the same output with

different combinations of inputs. In this example, they are convex. The budget constraint, which

equals the product of inputs and input prices, are depicted by green lines, DB and AC. The optimal

output and combination of inputs is determined by the tangency between the budget function and

the isoquant. The ratio of inputs is determined by the ray from the origin to the point of tangency, G.

If income rises, the new point of tangency is point F in this example. Note that due to the income

shift, the ratio of labor to space has increased; the ray from the origin has rotated from OG to OF.

Rising income has shifted output to more labor‐intensive output.

15 Mathematically we represent the firm by a production function. The firm provide inputs and the production function creates output, or retail services. Exhibits 34 through 37 introduce the concept of a production function. The firm can sometimes achieve the same output with different combination of inputs. An isoquant is the combination of inputs that produce the same output. The shape of these isoquants varies according to the substitutability of the inputs.

Page | 35

Exhibit 34. Unitary elasticity and a shift in income.

Data source: Zisler Capital Associates

Exhibit 35 shows that a decrease in the price rotates the budget line from AB to AC. Two things

happen. The rental reduction has an income effect and a substitution effect. Output increases from

U1V1 to U2V2 and the optimum input combination shifts from D to F. This substitution effect changes

the labor‐to‐space ratio. The production of retail services becomes more space intensive.

Exhibit 35. Unitary elasticity of substitution and a change in rent relative to retail worker wages


NCCLABOR

NCCSPACE

Elasticity of substitution: Unitary substitutability

CB

A

F

E

D

V2

V1

U2

U1

Rising income—a shift in line DB to AC—increases the ratio of labor to space from OG to OF.

O

G

Substitution due to a rise in income

Income rises

NCCLABOR

NCCSPACE

Flexibility in substituting more labor for less space

CB

A

F

O

D

V2

V1

U2

U1

Higher ratio of labor to space as rents rise in relationship to wage rate.

Fall is labor to space ratio

Fall in rent

Page | 36

The continuous, convex isoquants ensure substitution as a result of change in income or relative

prices. However, what happens if there is no possibility of substitution? The next two examples

address this question and the answer is highly relevant to the expansion of NCC over the coming

decades.

Exhibit 36 shows fixed proportion isoquants that do not allow any substitutability. Imagine that we

are thinking about the symphony, a high‐end restaurant or any other kind of service that we might

expect to find at NCC. The New York Symphonic Orchestra will not substitute high school musicians

for world‐class expert musicians just because high school students are cheaper, nor will they eliminate

a musician from a Mozart quartet. A fall in the price of space rotates the budget line from AB to AC,

but the input proportions do not change. Output increases from U1V1 to U2V2.

What happens if there is an income shift, such as a rise in average household income in the NCC trade

area? Exhibit 57 shows that an increase in income shifts the budget line (green) outward from D to E.

Note that once again, the ratio of inputs does not change.

An important insight is that the greater is the substitutability, the greater is the output for a given

amount of input. Flexibility augments output.

Implications for the demand for NCC space.

As income rises, the demand for services, especially those provided by NCC tenants, will rise. We

believe that while the provision of those services is not perfectly inelastic, it is imperfectly inelastic, at

least in the short‐ to medium run. Therefore, an increase in demand for services will stimulate not

just an increase in the demand for NCC labor but also for NCC space. If the income elasticity of

demand for NCC retail services is inelastic, as we showed earlier, then the enduring and strong

demand for NCC goods and services will propel the demand for NCC property. (See Exhibit 37.)

Exhibit 36. Zero substitutability between NCC labor and NCC space with change in rent relative to retail worker wages.


NCCLABOR

NCCSPACE

Elasticity of substitution Zero substitutability

A

C

E

D

B

U1

V1

U2

V2

FFall in rent

If the price of space relative to wages decreases, the ratio of labor to space does not change. Output expands but not as much as if there were substitutability.

Page | 37

Exhibit 37. Zero substitutability between NCC labor and NCC space with change in disposable income.


NCCLABOR

NCCSPACE

Elasticity of substitution Zero substitutability

A

C

E

D

B

U1

V1

U2

V2

F

If disposable income increases, the ratio of labor to space does not change. Output expands, but not as much as if there were substitutability.

Income rises

Page | 38

Stylized Fact 8: Our short‐term (two‐year) forecast, which assumes no recession before 2020,

indicates stable consumer durable and nondurable sales growth. However, when a recession

occurs, NCC and nondurable sales will perform better than mall and durable sales.

We forecast CN and CD changes for the period 2018 through 2020.16 The two‐year forecast for the

growth in consumer nondurables is 2.9% and the growth in consumer durable sales is 5.8%. Owing to

the low elasticity of substitution between NCC labor and space, the impact on NCC investment

performance should be favorable and enduring. Our forecast assumes no recession before 2020.

Exhibit 38. Consumer durables are more volatile than nondurables. Consumer durables will grow faster than nondurables.


We present the forecast and history below. Durables have a higher growth rate.

Exhibit 39. Forecasts 2019 – 2012 indicate continued growth over the next two years.

Pre‐tax consumer nondurables Pre‐tax consumer durables Forecast Average growth 2.3% 5.8% Standard deviation 0.1% 0.2% Coefficient of variation 0.04 0.04 History Average growth 2.2% 5.4% Standard deviation 1.7% 5.4% Coefficient of variation 0.79 1.00


16 We forecast the trend, not the volatility.

‐20%

‐15%

‐10%

‐5%

0%

5%

10%

15%

20%

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020

History and Forecast of Pre‐Tax Consumer Durable (Mall) and Nondurable (NCC) Growth, %

Pre‐tax consumer durables (mall) Pre‐tax consumer nondurables (NCC)

Forecast2018M09

Page | 39

Economic drivers used in the forecast are shown below.

Exhibit 40. Change in core inflation

Exhibit 41.Change in price deflators.

Exhibit 42. Change in housing permits

Exhibit 43. Savings rate.

Exhibit 44. Change in after‐ and pre‐tax disposable income

Exhibit 45. Change in nondurables (CN) and durables (CD) consumption


0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

5.0%

1989 1992 1994 1997 2000 2002 2005 2008 2010 2013 2016 2018

Chan

ge in

core de

flator, %

‐8%

‐6%

‐4%

‐2%

0%

2%

4%

6%

8%

10%

12%

1989 1992 1994 1997 2000 2002 2005 2008 2010 2013 2016 2018

Chnage in price deflator, %

Nondurable deflator Durable deflator

‐60%

‐40%

‐20%

0%

20%

40%

60%

1989 1992 1994 1997 2000 2002 2005 2008 2010 2013 2016 2018

Chan

ge in

housing permits, %

Housing permits

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

1989 1992 1994 1997 2000 2002 2005 2008 2010 2013 2016 2018

Savings rate, %

‐6%

‐4%

‐2%

0%

2%

4%

6%

8%

1989 1992 1994 1997 2000 2002 2005 2008 2010 2013 2016 2018

Chan

ge in

after‐a

nd before‐tax disposable in

come,

%

After‐tax disposable income

Pre‐tax disposable income

‐20%

‐15%

‐10%

‐5%

0%

5%

10%

15%

20%

Chan

ge in

consumer durables an

d nondurables, %

Consumer durables Consumer nondurables

Page | 40

Discussion of forecast and equations. The right hand variables drive the forecast. (See Exhibits 40

through 44 above.) The baseline forecast for the right hand or independent variables includes no

recession. Current GDP nominal annual growth is 3.25% while potential growth is 1.75%. Core

inflation is 2% to 2.25%. The Federal Reserve will likely increase the Fed Funds Rate another 25 basis

points by the end of the year and another 75 basis points in 2019, which by 2019 raises the rate by

one percentage point.

Econometric models for the study of CN and CD over the business cycle and for forecasts. Exhibits

46 through 49 are the estimated regressions for the changes in consumer durables and nondurables.

We estimate two regressions for each, one for pre‐tax income and the other for after‐tax income. We

note that the results are strongest using pre‐tax income. If current income is insufficient to support

purchases, consumers will often take the remaining consumption dollars out of savings.17

Consumer nondurables. Exhibit 46 explains the change in consumer nondurables. The coefficient for

that change in pre‐tax disposable income, the elasticity of demand with regard to income, is 0.484. A

10% increase in disposable income will increase CN consumption by 4.84 %. The price elasticity is ‐

0.025, which indicated that the price elasticity of demand is highly inelastic, practically zero. (See

Exhibit 46.) More building permits increases CN consumption. A one percent increase in the overall

rate of inflation reduces CN consumption by 0.28%. Modest economy‐wide inflation has only a small

effect on CN change. An increase in personal savings increases CN. A 10% increase in the savings rate

will increase the change in CN by 0.8%. This equation explains 47% of the variation in the change in

CN. We prefer this regression over Exhibit 47 because the model has higher explanatory power.

Exhibit 46. CN as a function of pre‐tax disposable income and other variables.

Source: Zisler Capital Associates 17 All explanatory variables except the personal savings rate are percent changes.

Dependent Variable: Consumer nondurables Note: All variable are changes, except for savings rate.

Method: Least Squares * indicates significance at 95% or greater significance.

Date: 10/20/18 Time: 18:56

Sample (adjusted): 1990M01 2018M08

Included observations: 344 after adjustments

Variable Coefficient Standard Error t‐Statistic Probability

C 0.937 0.346 2.710 0.007

Pre‐tax disposable income* 0.484 0.034 14.286 0.000

Price deflator consumer nondurables ‐0.025 0.029 ‐0.859 0.391

Building permits* 0.022 0.005 4.445 0.000

Price deflator overall economy* ‐0.278 0.129 ‐2.146 0.033

Personal savings rate(‐12) 0.079 0.056 1.402 0.162

R‐squared 0.472 Mean dependent variable 2.176

Adjusted R‐squared 0.464 Standard error dependent variable 1.716

Standard Error of Regression 1.256 Akaike information criterion 3.311

Sum squared residuals 533.162 Schwarz criterion 3.378

Log likelihood ‐563.483 Hannan‐Quinn criterion 3.338

F‐statistic 60.494 Durbin‐Watson statatistic 0.554

Probability (F‐statistic) 0.000

Page | 41

Exhibit 47 shows another version of Exhibit 70 but using after‐tax disposable income. The income

elasticity is a bit larger but so is the coefficient on the savings rate. The income elasticity of demand

using after‐tax income is further support that CN, a proxy for NPP sales, is a necessity. Consumers will

dip into their savings if after‐tax income is insufficient. The price elasticity is not significantly different

from zero—perfect inelasticity.

Exhibit 47. CN as a function of after‐tax disposable income and other variables


Consumer durables (mall goods) are qualitatively distinct from nondurables (NCC). For example, mall

goods are luxuries. A 10% increase in pre‐tax disposable income will increase consumer durable

spending by 13.1%. The price elasticity of demand is ‐0.892, which is close to unity. An increase in

price has little impact on revenues—as price increases by 1%, quantity decreases by 0.9%. The

personal saving coefficient is much higher than the CN personal savings coefficients. Durables are

more expensive and they are more subject to impulse purchases, thus increasing the likelihood of

financing the purchases from savings. Overall inflation has a much larger and negative impact on the

purchase of consumer durables. The sensitivity to inflation probably affects real wealth and this

wealth effect suppresses durable purchases much more than nondurable purchases. In other words,

durable purchases are much more sensitive to monetary shocks that affect inflationary expectations.

(See Exhibit 72.)

The after‐tax consumer durable regression tells a similar story with respect to the income and price

elasticities as well as with regard to CD sensitivities to inflation and the savings rate.

Page | 42

Exhibit 48. CD as a function of pre‐tax disposable income and other variables


Exhibit 49. CD as a function of after‐tax disposable income and other variables


Page | 43

Beyond our two‐year forecast. The domestic macroeconomic environment over next two years

should be benign, especially since we do not forecast a recession.

Looking beyond two years, we can say with confidence that whenever, not if, a recession occurs, NCC

and nondurables will perform better than malls in the event of a downturn.

Long term forecast. The fundamentals deserve a short summary: NCC sells necessities that are

nondurable, relatively price insensitive, and non‐storable. Purchases of necessities are difficult to

defer.

The demand for NCC services is income inelastic and consumer service expenditures, especially on

health, will increase as a share of total expenditures. Since the ratio of NCC retail workers to NCC

space is relatively inelastic and the long term growth in demand for NCC retail services will likely be

robust, the demand for NCC will be strong.

The sustained demand for NCC space will increase the value of NCC properties (and lower NCC cap

rates). These properties, especially in infill locations, will appreciate.

Now add institutional capital. With the inflow of institutional capital will come professional

management and risk assessment. The new owners will consolidate the NCC sector and drive down

cap rates.

Early investors will be richly rewarded.

Page | 44

D. Conclusion

Eight stylized facts summarize the essentials that address volatility and differentiate NCC from malls.

NCC are physically and financially different than malls; investors should not paint NCC and malls with

the same brush.

NCC and malls differ substantially according to risk and their performance during recessions; NCC fare

the best. NCC is recession resistant.

Institutional investors, often prey to cognitive biases, should take notice because the NCC opportunity

is significant and durable.

Fundamentals are strong short‐ and long‐term.

The NCC inventory is three times the size of the troubled mall sector. Institutions have neglected this

sector for no evidence‐based reason.

NCC is an historic consolidation opportunity that invites professional management and capital.

The longstanding gap between the reality of NCC’s operational performance and investor perceptions,

largely based on myth and misinformation, is the basis for an exploitable market opportunity. The

opportunity is real; it is not a will‐o'‐the‐wisp.

As institutional capital flows to the NCC sector, NCC cap rates will fall to the great benefit of early

institutional investors.

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