By Merrie S. Frankel

The concept of paying less than retail price is clearly a big seller with Americans, as outlet centers have become increasingly popular from coast to coast. Originating in Reading, PA, outlet centers began in the U.S. as employee stores where manufacturers would sell flawed or overstocked merchandise to their own workers at deep discounts. Eventually outlet stores opened their doors to the general public, and the outlet business began its rise with manufacturers clustering together in a strip-shopping center format.

These shopping havens have successfully differentiated themselves with consumers from other types of retail centers, becoming an accepted distribution channel for many retailers and manufacturers. In the last decade, some outlet center REITs and real estate operating companies (REOCs) have ventured overseas to lever their skill bases and garner incremental growth. There are several factors that distinguish non-U.S. outlet center businesses from those in the U.S., such as local development nuances, consumer shopping patterns and lease structures.

Overseas Growth

As defined by Value Retail News, a publication of the International Council of Shopping Centers (ICSC), an outlet center is a shopping center where at least 50 percent of its tenants are "manufacturer's outlets." In other words, the tenants in outlets typically are the manufacturers themselves, rather than retailers selling their own brands or those of manufacturers at reduced prices. The goods are not damaged seconds, but usually quality merchandise in styles or colors that did not sell out at their primary retail locations, or the goods are manufactured specifically for outlet sale.

Using that definition, there are currently 261 outlet centers in the U.S. and approximately 131 currently operating or to be completed by year-end 2002 in 24 other countries, according to the May 2002 Value Retail News.

As many retailers have become more promotional and focused on sale merchandise, and as discount stores have proliferated, outlet centers have had to find new ways to differentiate themselves and to maintain their value proposition with consumers. In both the U.S. and overseas, successful outlet centers are typically considered to be destination-shopping experiences, and tend to concentrate on either mainstream or upper-end merchandise. Since shopping is a key activity for many travelers, foreign outlet centers, like their U.S. counterparts, are increasingly being situated near popular tourist destinations, as well as closer to residential areas.

Number of Outlet Properties by Country (Currently Open or To Be Opened by YE2002)

Source: Value Retail News, March 2002, www.icsc.org/vrn

Top 10 Foreign Outlets

Source: Value Retail News, March 2002; and company web sites *Includes outlets either currently open or projected to be completed by year-end 2002.

The 2001 report "Where People Shop," by Healey & Baker, included a survey showing that 51 percent of the European respondents shopped at town center shops, but only 5 percent of these shoppers visited outlet centers. And since only 2 percent of non-U.S. retail centers are outlets, according to Healey & Baker's report, there is plenty of room for expansion.

Overall, the number of U.S. outlet centers has been declining since 1993, according to Value Retail News. However, it is a different story overseas. With overall square footage stable, expansion is the watchword for foreign outlet centers. In fact, there are expected to be approximately 131 foreign outlets by the end of 2002, whereas there were only 40 in 1998, according to Value Retail News.

What companies are leading this expansion? The top 10 outlet center developer/owners own 44 percent of non-U.S. outlet centers and 40 percent of the square footage, with the remaining developer/owners usually owning only one or two centers each. (See accompanying charts.)

Local Knowledge Is Key

There is one key principal that applies regardless of how many outlet centers the operator owns. Whether selling pricey Prada bags or Bass shoe bargains, knowledge of local retail and property markets remains a crucial ingredient for success in the outlet center business. What works in German retail is not necessarily what works in the U.K. or Japan. Zoning and development issues vary significantly by country, city and province; thus, much foreign expansion by U.S.-based outlet center firms has been accomplished through joint ventures with local partners.

For example, Chelsea Property Group, Inc. (NYSE: CPG), the U.S.-based REIT and leader in the premium outlet business, has followed this pattern by establishing joint venture developments in Japan with Mitsubishi Estate Co. and Nissho Iwai Corp., both prominent Japanese property firms. Chelsea Japan Co. has opened two centers; Gotemba Premium Outlets near Tokyo and Rinku Premium Outlets near Osaka since 1999, and plans to open three more outlet centers over the next four years. Nearly half of the retailers in these centers are local, with the remainder consisting of international retailers, demonstrating the importance of local market knowledge and contacts. Chelsea also announced in May the formation of a joint venture in Mexico to develop a Premium Outlet in Mexico City.

In addition, onerous barriers-to-entry are caused by the strict development rules, difficulty in procuring building permits and high land costs in many nations. These barriers can actually benefit outlet center developers through stronger sales densities and higher upsides since fewer centers are built.

As a reflection of these factors, non-U.S. outlet center development often takes place with smaller centers and phased-in projects. Whereas the average U.S. outlet center is 212,000 square feet, the average is only 165,000 square feet overseas, according to the May 2002 Value Retail News. However, Chelsea Property Group's non-U.S. outlet centers have been phased in with approximately 200,000 square feet at each stage, and now include 450,000 square feet centers in Japan including expansions—around triple the norm.

In for the Long Haul

Foreign expansion has great potential for profit, however it will not happen overnight. Cap rates range from 5 percent to 6 percent for good European properties largely due to the scarcity of land and the difficulty of attaining entitlements. As a result, most outlet center expansion overseas occurs by development, rather than the acquisition of existing assets. The entitlement issue also creates a long lead time, often three to four years from start to finish.

Outlet center lease structures in foreign markets differ from the U.S. as well. In Japan, for example, most of the rent is driven by percentage rent, producing returns that can be high if the center is really successful ($700 to $1,000 per square foot in sales compared to an industry average of $250 to $300 in the U.S.). In Mexico, however, there tend to be fixed rents with no percentage rent feature, which limits the upside, according to Value Retail News.

Finally, foreign exchange and tax issues add complexity and risk. For example, Japan's low nominal cost of capital creates a large spread between rent and interest costs, but repatriating the profits back to the U.S. may necessitate currency hedges to protect profits.

Although overseas expansion can be a profitable addition to an U.S.-based outlet center REIT or REOC, it requires careful planning and execution if it is to be successful and result in acceptable risk. While the format has struck a chord with consumers in many nations, additional education is needed to boost outlet center penetration. As the format solidifies its position in more nations, U.S. outlet center firms will become key participants in this growth.