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9-803-008R E V : J U L Y 7 , 2 0 0 8

________________________________________________________________________________________________________________ Research Associate Ani Vartanian prepared this case under the supervision of Senior Lecturer Arthur I Segel, parts of which, including the numbers, have been fictionalized. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. Copyright © 2002, 2003, 2008 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http://www. hbsp. harvard. edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of Harvard Business School.

A R T H U R I S E G E L

Value Retail

In March 2002, Scott Malkin, the Chairman and Chief Executive of Value Retail, a developer and operator of European outlet villages serving luxury brands, hosted a dinner during Milan’s Fashion Week with some of his most important existing and potential clients in Italy including Prada, Gucci, Tod’s, Zegna, Versace and Ferragamo. Before dessert, Scott proposed a toast to working together on his company’s new 18,503 m2 open air outlet village to be built 98 kilometers south of Milan on land he was about to acquire for �7.26 million.1 Although the dinner sparkled with a convivial atmosphere, there was a tension in the room. What he was proposing was new and possibly a real threat to the brands represented that evening, in a location close to their home. Scott smiled and put down his champagne glass. Someone shouted out “Buona Fortuna” or “Good Luck” while another shouted out “Bocca Lupo.”

Scott bent over to ask his friend joining him that evening, Dario Cecchini, the famed cook and “mad butcher” of Florence, what “Boca Lupo” meant. Dario responded, “Well, the literal translation is ‘in the mouth of the wolf.’ In Lombardy, it also means ‘Good Luck,’ but in Tuscany, it means ‘Go to Hell.’”

As with everything else he had seen in Italy, Scott was left perplexed as to what was intended by his guest. Were there limits to his company or to any real estate company going transnational? Was Italy going to be Value Retail’s downfall? He knew he was introducing a real estate product almost entirely new to the market. Italy was home to many of the leading luxury brands of the world and was also still a nation dominated by multi-brand fashion retailers. Could Value Retail pursue its outlet strategy in Italy?

The Family Breakaway

Scott was from a New York based real estate family. His Grandfather, the lawyer, Lawrence A. Wien, had been the originator of real estate syndication. Wien had put together landmark deals like the Graybar Building in 1958 and the Empire State Building investment in 1961. Wien was interested in big ideas, disliked IRRs (though he knew them instinctively) and was a thoughtful and skilled investor. He did not need market research; he acted from his personal experience and sense of the

1 1 square meter = 10.76 sf., �(Euro) 1 = $0.95, as of August 2002.

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market. He relied upon his thorough, operations minded business partner, Harry Helmsley, to scrub the detail of the properties during due diligence and then to manage them once purchased.

Scott’s Dad, Peter Malkin, had successfully expanded the family holdings with a hands-on approach while becoming a civic leader. The eldest of three children, Scott was expected to join the family company and eventually to run it. He spent summers and time after classes during college, law and business schools learning the real estate business, including working for his Father and Grandfather.

“I spent the summer in midtown Manhattan assisting the leasing team for a major office building. In August, when everyone else was away on vacation, a tenant prospect walked in off the street and rented 3,500 S.F. I did the deal completely by myself, at age eighteen, and it was exhilarating. I made more money from the commission on that one transaction than any of my friends who were life guards or bartenders. That experience launched my real estate career. I loved the freedom and creativity of the business. As Harry Helmsley once said: ‘You don’t want to be in a business where you get paid by the hour.’ I soon realized that I would never be a lawyer.”

After eight years of attending college and graduate school (JD/MBA) at Harvard, in 1984 Scott headed to New York City and began an apprenticeship in commercial real estate with his family. But just as his Grandfather had struck out on his own during the Great Depression, Scott felt a need to break away from the family business. His younger brother, Tony, agreed to work with his Dad. “When you leave a successful family business, the world assumes you are either incompetent or crazy,” Scott learned as he went out on his own. He raised an investment fund in London for U.S. development deals and focused on California projects, including a luxury retail development at 2 Rodeo Drive in Beverly Hills. This property captured his imagination. He liked the added value of development and the sizzle and creativity of the retail business. “When you think of it, it is kind of funny. We introduced the idea of a European shopping street to Beverly Hills (See Exhibit 1); and then, years later, ended up bringing that same vision back to Europe.”

Scott loved the energy of development, of creating value out of nothing. He moved his family to London, and he and his colleagues switched their focus to European projects. They chased several deals in Germany after the fall of the Berlin Wall but were outbid. He was drawn to retail developments because they were often complex and thus there was less competition. When the Gulf War hit and the real estate business collapsed in the ensuing recession, Scott and his team had to figure out what to do next. He had seen factory outlets before in Freeport, Maine during his years in Cambridge. “And then we had an idea: why not arbitrage the two cultures and bring a North American style factory outlet center, which could become a tourist destination, to Great Britain?”

Bicester

The hunt began for a suitable site. In the United States, one would first focus on a traditional highway interchange with high visibility. In England, that option did not exist as local and regional planning authorities forbade that kind of development. Traditional lack of mobility, ease of transport, and the willingness of the British consumer to drive up to an hour or two to shop were all in question.

After considerable searching, Scott and his colleagues found a 22 acre site in Bicester (pronounced “Bister”) in Oxfordshire separated from London by hilly sheep farms. Located two miles from a motorway interchange some 62 miles northwest of London, and near the tourist attractions of Oxford University and Blenheim Palace (Churchill’s family home), the site met Value Retail’s criteria. It was also en route to the Cotswolds and the Bard’s birthplace at Stratford-upon-Avon. There would be

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limited infrastructure improvements required to develop the site, as opposed to many which required the construction of whole highway interchanges or rail stations.

“They thought we were aliens when we originally proposed the idea of a 107,000 square foot outlet village for 50 stores with 1,100 parking spaces. There was no grand welcome,” explained Scott. “You see, the European culture is fundamentally hostile to entrepreneurship.” Bicester was later increased by 75,000 square feet for a total of 95 stores and 1750 parking spaces. European laws were heavily codified. Unlike in the United States, where the real estate developer could proceed if the project was not against the law, the presumption in Europe was the reverse. Scott went on, “the advantage of being an American in Europe is that you are viewed as irrelevant rather than hated (reflecting the thousands of years of enmity between European neighbors).”

The approval process in Oxfordshire was daunting, taking over three years. Oxfordshire had competing political parties and the politics were delicate. Surrounded by ring roads, the downtown of Oxford was virtually pedestrianized with no traffic. “It was hard to puncture through this process. All European countries were generally against new retail ideas, especially when it meant a new non-urban shopping center. They saw it as a threat,” recalled Scott. As in the U.S., real estate was localized and fragmented. But it was more so in Europe. Very few retailers, for example, were transnational. There was limited transferability of brands from one country or region of a country to another, although this seemed to be slowly changing. Some brands were known throughout Europe; most were native to each country.

Every downtown store owner in Bicester had to be convinced that his or her business would not be emptied out, and that the Bicester outlet village would be a destination location bringing more tourists, but not too many automobiles, to the area. The zoning authorities hated traffic; but the site was located between two relatively unused rail links. The first step was getting the support of the locals, the politicians and the community. Next, was to receive the approval from national entities, including the central government and the Minister of Transport and The Environment. Said Scott: “imagine a U.S. Cabinet member signing off on a small shopping center or a 10,000 SF shopping center expansion in the United States.”

Figuring out the approval process was the first hurdle; getting it leased was the next challenge. To get around the nature of European leases and specifically the British Landlord Tenant Act of 1954, Scott and his colleagues came up with the idea of developing a department store style contract. It would last for ten years and the “tenant” would pay a higher percentage of sales than is typical in the U.S.

Brands would pay a base rent of ₤35 per square foot annually, plus their share of the operating costs and local real estate taxes. They would also pay a percentage rent of 12.5% of VAT exclusive sales2, which would be offset against the base rent. So if a brand had ₤500/SF in sales, it would pay ₤62.5/SF in rent, which, as it was higher than the base rent of ₤35/SF, would obviate the need to pay the base. It would still pay its share of the operating costs over and above the base or percentage rent. If a tenant could not achieve an appropriate level of sales, the landlord (the exact mechanism varied by the country) could cancel the contract.3

Attracting brands to this unusual arrangement was the next big challenge. Critical was convincing the brands that customers would want to come in the first place. Scott added, “My litmus test was: would Gucci find this to be an acceptable environment?” The village needed to represent

2 Refers to sales exclusive of value added taxes or a consumption tax paid to the government.

3 Percentage rents are typical in retail. There is usually a minimum or base rental after which percentage rates kick in as a percent of sales.

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quality and integrity. The buildings had to be well designed to make shopping entertaining, to make it a tourist attraction, and to get people to spend 3-4 hours at a minimum. Brands paid for their own fit-out which was often quite expensive. “We had to convince brands that this was their country store, while their city store on Bond Street in central London could exhibit the latest styles and fashions at prices 40% to 60% more.” Polo Ralph Lauren signed up first. Cerruti, Jaeger, Tommy Hilfiger, Calvin Klein, Versace, Ferragamo, Burberry and Villeroy & Boch followed. The high quality merchandise was important to Value Retail.

One large location was held in reserve. It had been so for 1½ years with the aim of attracting one of a few dominant brands such as Gucci. As of the spring of 2002, it was still vacant. “We have had countless offers for that space and if this were a normal shopping center company, it would have been leased a long time ago. But this is not a property company, it’s a retail organization committed to creating the best merchandising offer. We are trying to build a sense of place that is sustainable.” said Scott. “Our goal is to appeal to the brand aware, but not the fashion forward consumer, to cater to the spending or economic groups who “aspire” to these brands and are willing to wear prior season’s fashions.” The high-fashion business has a life all of its own. As the president of a leading luxury brand stated, “Our products have very short lives. We are selling fish; it rots quickly. We have to reinvent ourselves every three months.” (See Exhibit 2.)

Bicester and Beyond

Bicester Village opened in 1995. By the spring of 2002 Bicester was a big success, attracting 2.5 million visitors per year. It was also the number one attraction for Asian shoppers visiting Britain after central London, achieving average sales of approximately ₤600/SF. Over the next four years Value Retail expanded the concept to other major European cities. “How little I knew,” said Scott, reflecting on the vast difference between Europe and the United States. U.S. real estate developers typically came to Europe and showed little respect and patience for European culture and values. But through long hours, hard work, a valid idea and good luck, Value Retail successfully opened new outlet villages outside of Barcelona, Brussels, Paris and Madrid based primarily on the same formulae, which Scott articulated as:

• locating within one hour of a large urban area providing a strong “catchment”;

• assembling the highest quality portfolio of brands;

• providing quality goods which were typically at least one year old;

• ensuring that the pricing was typically 30% to 70% reduced from the pricing in the brands’ full price locations;

• customizing each village to the local culture including architecture, merchandise mix and personnel;

• phasing development to build demand over time and minimize up-front risks;

• making each village a tourist destination in itself;

• keeping brands on short term, cancelable service contracts;

• maintaining the highest standards and integrity with brands, employees, investors and the community at large.

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Each village was a separate, stand alone investment and legal entity. Each was typically capitalized with 20% equity and 80% debt. While traditional institutional investors were wary of investing equity in properties with potentially unstable short term “leases,” private equity and individual investors were willing to take those risks, especially for the potential of greater returns. Investors received a 10% simple cumulative preferred return plus 50% of the cash flow after debt service and 50% of the residuals after a return of capital, payment of the preferred return and repayment of the then outstanding debt. Holding periods were projected to be up to ten years; although Scott felt the sale of interests in individual centers or of the company as a whole might occur within five to seven years. All numbers and sharing arrangements were pre-tax and would obviously differ for each investor according to his or her own tax situation. Investors could trade interests in a private, but relatively illiquid, secondary market. In Bicester, for example, some of the investors had sold their limited partnership interests for 10 times their original equity investment.

The Organization

By 2002, Scott had 145 employees managing five villages and developing three more, dividing his organization between the retail operations for the existing villages, where most of his employees worked, and the new developments. Everyone was based at the properties themselves—the only office other than at the properties consisted of three small rooms in central London, convenient for visitors and the banks. Employees in the operating company at each of the centers worked in maintenance, security, leasing, retail, marketing, accounting and finance.

Scott added, “We are not a conventional property company. This is a retail management organization. In the end it’s all about the people.” Scott had grown his team steadily, often attracting “misfits” from traditional companies, rebels who needed to be challenged beyond the typical large organizational structures. For example, Emmanuelle Delanöe had spent years developing centers and identifying new concepts for a huge European retail developer. She found European corporate life, especially for a woman, stifling. Another professional woman came from Hermes. They welcomed the company’s “American spirit” of giving everyone a chance.

Desirée Bollier, the CEO of the operating company, came from Polo Ralph Lauren. She was raised in France and had spent her adult life living in the U.S. and the U.K. Prior to joining Value Retail she worked for Polo for 14 years and ran their retail business in the Middle East and Europe, and their outlet activity in America. “My job is to develop the right tools,” Desirée began,

“to analyze stocks, oversee marketing, advertising and store design. I do deals. This is a retail, not a real estate culture. Ultimately, my goal is to drive sales. In a shopping mall in the United States, you talk about the anchor store. In Europe we talk about the “ITZA” (In Terms of Zone A) or the best retail location. In our outlet villages, we have no anchor stores. It is the mix of stores that is our anchor. In doing so, in keeping us constantly at the cutting edge with the best portfolio of stores, I am maximizing the real estate value. If I see a brand whose sales are going down while footfall4 is doubling, I know we have a problem.

I watch the sales numbers week by week. Marketing is an engine for positioning. The brands get involved. The local citizenry gets involved. We have to market smartly. You can’t put cashmere in stores in the Midlands. We are a top-of-the-line boutique. We position our whole village as a brand as much as the brands themselves.”

Scott hired another retailer who reported to Desirée to act as the director of Bicester Village, Aleksander Michalowski. Alek, who ran Versace in the UK and Ireland for 6 years, was half Polish,

4 “Footfall” is a retail expression referring to the number of feet coming to a center.

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half Scot, and grew up on the Amalfi Coast in Italy. He commuted by plane from his home in Loch Lomond in Scotland. Alek said:

“I run Bicester Village like one big department store, continually positioning and upgrading with new blood. Locations in an outlet village are not as important as in a traditional shopping mall. Our target shoppers are 18 to 48 year old women who live within an average of a two hour drive from Bicester or tourists coming to England. They are brand loyal and price conscious. We can never be too arrogant or too complacent. We need to be humble, to keep in touch. It takes time to cultivate these brands.”

Another senior member of the retail operations team in the business was Frank Blanchette. Frank had come from the rag trade in the garment district in New York City before joining Value Retail. He continued Alek’s and Desirée’s themes: “We help companies to rationalize their production by giving their goods a second life, thereby allowing brands to generate additional cash flow. What makes sense for the brands makes sense for the consumer. In Europe, we have a monopoly in this high quality brand niche. Howard Schultz of Starbucks said, “You have your work, you have your home, and you have a third place to escape to.” Ideally, for Schultz, Starbucks, should be one of those places for escape. “For us,” Frank added, “it is a Value Retail village. Everyone is happy: the shoppers, the community (where we create jobs), our investors, and most importantly, the brands. . . . We help people participate in their dreams.”

Roderick Gibbs oversaw the expansion into new markets for the company. Raised in England, he had extensive real estate development experience in Europe. Working with Roderick was Ann Marie Scichili, an independent consultant. Ann Marie was the oldest of five from Dallas, majored in design and marketing at the University of Texas and worked for five years in Hong Kong as the President of Production for Banana Republic, after which she moved to Florence to head Donna Karan’s operation in Europe. She met Scott at an Urban Land Institute conference. “Annie is our research and development, our overall liaison to the brands,” added Scott, “She is our spiritual guide and conscience. Last year she got the whole company involved with Elton John and his AIDS foundation.”

“We find out what our clients are planning ahead of time,” Ann Marie chimed in, “They are going to dictate to us, not the other way around. We are always inventing as we go along, but always listening to what the brands are thinking so we can support them.”

“Everything depends on customer service and attention to detail,” Scott added, “and these can only be done with quality people. We have a very horizontal, informal cross-cultural organization.” Everyone is on a first name basis. “Not many European company chairmen are called by all of the employees by the first name.”

Fidenza, Italy

The Milan region was an important market for Value Retail if they were truly to provide a European coverage serving the significant population centers. After six years of studying the market, they identified a highly visible, reasonably priced 35 acre site at an exit on the dominant North-South road, the Autostrada A-1, at Fidenza. The research on Italy was led by Tony McAuliffe, another Harvard MBA, based in the U.S., who had a real estate development background and had been with Value Retail since its inception.

Fidenza had a small population of 23.1 thousand people and was famous for its Parma cheese. Located 98 kilometers south of Milan and 111 kilometers north of Bologna, the site had a catchment within 120 kilometers of 26 million residents and an annual traffic count of 18.5 million cars. 9.1

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million people were located within 60 kilometers and 19.2 million within 90 kilometers. (See Exhibit 3). The site required minimal work on the infrastructure for access and egress. Unieco, a reputable regional construction firm, owned the property and was willing to sell it in stages to Scott and his colleagues beginning in the Spring, 2002. Unieco would also serve as the project contractor.

In addition to its excellent location, the site benefited from its proximity to leading tourist destinations such as Florence, Padua, Portofino, and Venice. Some 4,350,000 foreign tourists from the Netherlands (21%), Japan (18%), the UK (16%), Germany (13%) and the United States (10%) visited the region annually, with another 12 million domestic visitors from Italy. Visibility and a dedicated exit from the A-1 would make Fidenza Village readily accessible to tourists driving through the region on their way to and from the popular southern destinations of Tuscany, Rome, and the Amalfi Coast.5 Scott hoped that the Fidenza project would attract area residents as well as Italian and foreign tourists passing through or visiting the region. Table A shows the demographics for Italy’s leading cities.

Table A Leading Italian Cities: “Population & Per Capita Income”6

City Population City

Population Province

Per Capita Income in �1,000’s

Rome 2,655,970 3,817,133 16.8

Milan 1,301,551 3,757,609 20.1

Naples 1,000,470 3,099,366 10.3

Turin 900,987 2,214,282 18.6

Genoa 632,366 907,583 19.6

Bologna 379,964 917,110 21.6

Florence 374,501 953,973 19

Verona 257,477 821,563 17.8

The Process

If the government decision making process was highly centralized in England, in Italy it was the reverse. “In Italy you need the local council 150% on your side. There is typically no development in Italy because everyone wants the status quo. Why would a local mayor risk saying “yes” and have all of the local shopkeepers against him? You have to sell an idea and show the locals they cannot get hurt. You also need a local partner who has credibility,” said Paul D’Analeze, the proposed new leasing broker on the project from Healey & Baker, one of the largest real estate brokerage firms in the market, and with a particular expertise in retail.

Italy had been pretty much unchallenged by large retailers until the late 1990’s. It was one of the most steadfastly resistant countries to large format commerce and, in fact, implemented Law 426 in

5 Data derived from statistics provide by Healey & Baker and ISTAT.

6 ISTAT 2001

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1971, which imposed stricter rules for obtaining licenses and favored existing shopkeepers who wished to transform and enlarge their shops.

The average size shopping center in Europe was 54,000 SF versus almost ten times that in the United States. 7. There are numerous large malls serving most U.S. cities but they are rare in Europe. In Europe, large shopping centers usually focus around a hypermarket, which is a combination grocery/department store. In Italy, a permit from the regional authority had to be obtained for new stores larger than 1,500 m2 or with sales areas over 400 m2 in towns with populations of less than ten thousand. A slight relaxation of permit approvals in the 1980s led to an influx of large format retailers, but the tightening of the law in the 1990’s had significantly slowed down their growth. In addition, as of 1991, much of the approval authority had been devolved to the provincial and local levels, with the result that agreement had to be reached with numerous different parties.

Part of this regulation was a historic response to the guild tradition of small shopkeepers, dating back to feudal times. The local shopkeepers often dictated to the government what new stores could enter and where. Recently, for example, in Spain, a regional law in Catalonia was passed in advance of the local elections restricting the development of any new concentration of stores over 500 square meters from being within 300 meters of another such project, thereby effectively ruling out any commercial concentrations of large stores or shopping centers of any kind.

Each jurisdiction was different, but local councils all reviewed the retail use and the moral requisite of the applicant. For example, Bologna and Venice were known to be particularly stringent. All historic centers in Italy were protected for their historic, archaeological, artistic or environmental value. These criteria were evaluated by the Sovraintendenza ai Beni Pubblici or the public body which deals with the national heritage. Although there was a judicial appellate process, it was costly and time consuming and only used after going through a precise and generally inflexible government review process.

In the 1990’s, in one year alone, local retailers were battling 513 foreign owned retailers, including Sweden’s Ikea and Germany’s Lidl. An Italian retailers’ association estimated that from 1995 to 2000, Italy lost annually 10,000 specialty chains and family owned shops in city centers. 8 But Scott believed that Italy would do everything it could to remain a country of small shopkeepers.

The Market

Italy had the most fragmented retail distribution system in Europe. Many of the top luxury brands were manufactured in Italy, and it was the most style conscious country in the world. Everything was sold through specialty stores and boutiques. There were few malls or department stores. The Fidenza site itself had minimal retail competition in the catchment area, although two moderate and lower price retail chains both had stores in the city.

Retail densities in Europe were 4 SF per capita versus 31 SF per capita in the United States. Table B demonstrates this wide difference9. In Italy, retail density per capita was extremely low compared to other countries in Europe. (See Exhibit 4.) As of 2002, the number of shops was about 720,000 with multiple retailers accounting for only 3% of sales, which was low compared to any other

7 “Scope” in The Harvard Design School Guide to Shopping (Taschen Publishing, Boston 2002) ICSC Harvard Project on the City: Shopping Estimates; p 51, 52.

8 The Harvard Design School Guide to Shopping (Boston, 2002) p. 638 & 642

9 “Scope” in The Harvard Design School Guide to Shopping (Taschen Publishing, Boston 2002) ICSC Harvard Project on the City: Shopping Estimates; p 51, 52.

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European country.10 An independent market study commissioned by Value Retail indicated that the Fidenza development site would capture 2.1% of all the retail sales within the extended catchment area (including from international tourists), and estimated total retail sales for the catchment of �3.1 billion.

Table B Total Retail Area: World

Total Retail Area, World = 1,998,171,000 m2 (est.)

0 m2

100

200

300

400

500

600

700

800

900

United States772,350,000 m2

8,313,575,000 ft2

Asia736,950,000 m2

7,932,530,000 ft2

Europe180,600,000 m2

1,943,978,000 ft2

Latin America146,400,000 m2

1,575,850,000 ft2

Former USSR29,000,000 m2

312,156,000 ft2

Africa7,300,000 m2

78,577,000 ft2

To

tal

Re

tail

Are

a (

mill

ion

sq

ua

re m

ete

rs)

39%37%

10%7%

1%0.3%

— percentage of World total retail area

! U.S. Shopping malls

579,259,000 m2

75% of total U.S.29% of total World

! U.K.55,894,000 m2

31% of total Europe

! Japan102,051,000 m2

14% of total Asia

!W

al-M

art

(wor

ldw

ide)

28,0

10,0

00 m

2

3.6

% o

f to

tal U

.S.

Total Retail Area, World = 1,998,171,000 m2 (est.)

0 m2

100

200

300

400

500

600

700

800

900

United States772,350,000 m2

8,313,575,000 ft2

Asia736,950,000 m2

7,932,530,000 ft2

Europe180,600,000 m2

1,943,978,000 ft2

Latin America146,400,000 m2

1,575,850,000 ft2

Former USSR29,000,000 m2

312,156,000 ft2

Africa7,300,000 m2

78,577,000 ft2

To

tal

Re

tail

Are

a (

mill

ion

sq

ua

re m

ete

rs)

39%37%

10%7%

1%0.3%

— percentage of World total retail area

! U.S. Shopping malls

579,259,000 m2

75% of total U.S.29% of total World

! U.K.55,894,000 m2

31% of total Europe

! Japan102,051,000 m2

14% of total Asia

!W

al-M

art

(wor

ldw

ide)

28,0

10,0

00 m

2

3.6

% o

f to

tal U

.S.

Many markets in Europe such as France and Germany had predatory pricing regulations which were intended to redress the imbalances between the shopkeepers and the large stores, especially to protect small family owned businesses unable to compete with 9-9 operating hours and the labor constraint this posed. Land’s End, for example, was prohibited by the courts in Germany from advertising its no questions asked return policy.

Paul D’Analeze, the proposed Fidenza leasing broker, added, “It is very difficult to do business in Italy. Business people are stunned when they come here. When it comes to information, Italians keep their mouths shut.” There was no U.S. style openness of information. As in much of Europe, there was a long tradition of patrimony, of passing real estate on from one generation to the next. Because of this, property sales were less frequent.

If information was hard to find in the United States, then in Europe and, in particular, Italy, it barely existed. Even when properties were under contract, it was often almost impossible to get sales or lease information. The banks, families and corporations who owned the real estate were extremely reluctant to share information. Some of this lack of transparency was due to their pride, their image, their style. People went out of their way to underestimate their wealth, for example. But part of it also reflected their fear and the years of terrorist incidents. There was also a huge and culturally accepted black market. It was the norm. “There is corruption at all levels,” Paul added, “getting worse as you travel down the Italian boot.”

10 Information from “Shopping Centres: Italy” (Healey & Baker), November 2001.

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In addition to a lack of transparency in European real estate, there were strong and complex legal restrictions, dating back again to the Middle Ages, against shopping on Sundays. In much of America, there was a well established tradition reaching back to the 1890’s of going to church on Sunday mornings and shopping in the afternoons. In Europe, Sunday hours were virtually prohibited although this varied by country and was changing in some. This reflected two factors: the strength of the trade unions and the Church. The Church emphasized that Sundays were devoted solely to church and family despite the fact that recent surveys showed Americans regularly attended church (44%) at nearly four times the rate of Europeans (11.5%).11

These were all major concerns for Scott and confirmed that Italy was quite different from the other countries where he had already been developing in Europe. For example, Scott pondered, would the customers come if there were no shopping center tradition in Italy? Would the brands themselves want to come? While Scott was convinced that there would be a growing internationalization of brands over time, opening in Italy might be too close to home for some of the world’s most famous brands. Furthermore, Scott felt he had to keep the total occupancy costs (rental rate plus all costs) to not more than 17% of sales, which was still somewhat high compared to the United States, where total occupancy costs are typically not more than 14% of sales.

Even if one could attract the brands, Scott questioned whether Value Retail could function in a culture with so little information. Not only was there limited, if any, data on transaction sales and leases, but how could Value Retail expect tenants to report accurately their sales in order to make their percentage rent payments? “How does our model work in a country with an extensive and accepted black market tradition?” Scott asked.

There had been some limited precedents. An Anglo-American developer, McArthur Glen, had recently opened a 19.3 thousand m2 outlet center in Seravalle near Genoa, in a much smaller catchment area but on the main highway spine to the coast, just with a rental rate formula similar to that which Scott was contemplating for Fidenza. Gucci had also just opened a successful outlet store for itself near its factories between Florence and Arezzo and had recently announced an expansion at that site to create a small scale, multi-store center. Dolce & Gabbana had confirmed its intention to be represented in that project.

Leasing

Leases were different in Italy and Europe than in the United State. Leases were typically only a few pages based on state and local civil codes as opposed to a typical U.S. lease of over 100 pages. In Italy, leases were for 6 years with a 6-year renewal and an annual bump of 75% of the increase in inflation (RPI). By contrast, in England initial lease terms were typically 25 years.

Tenants also had different rights and obligations than in the United States. For example, in Italy, tenants usually had one-way options to renew and were virtually impossible to evict unless the landlord or the government took the property for its own use. Under the same law, a tenant was allowed to break the lease as a result of “gravi motivi” (serious motives) at any point if, for example, the rent grossly exceeded the market rate.

Tenants also had rights of preemption to match the rent, which a new tenant could be willing to pay. In a few instances, the landlord was actually obligated to pay the old tenant 18 months of termination rent for relocation costs if the old tenant moved out to another space. Tenants could usually sublet and keep any profits, without the landlord’s consent, as long as there was no negative

11 “Thou Shalt Not Shop” in The Harvard Design School Guide op. cit. p.729.

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impact on the property. Finally, in many instances, tenants were responsible for structural repair costs, especially in countries where lease terms were more than ten years.

Often more important than the annual leases themselves was the so called “key money,” or the right to the value of buying into an already existing lease. In England, the key money was traditionally low, but in Italy, potentially huge. Sometimes owners or developers traded key money in exchange for lower rents. For example, a recent key money transaction on a lease near the Spanish steps in Rome sold for �12 million while the annual rent was only �150,000.

The Design

Value Retail’s Development Director Brian Garrison created the vision for the Fidenza project. Scott and Brian had worked together since their days in the U.S., when Brian had been responsible for building 2 Rodeo Drive. The concept called for a phased development of 120 units in 18,503 m2 usable with 2,116 parking spaces, which was considerably more parking than is the standard in the United States. The first stage would consist of 50 units in approximately 10 thousand m2 with the balance of approximately 8500 m2 usable built by year 3.

Brian came up with an unusual idea for a design inspired by the stage sets of Guiseppe Verdi’s operas (the Fidenza area was Verdi’s home) and incorporating elements of a medieval fortress town, ancient Egyptian monuments and a 19th century Italian palazzo, the latter in an architectural style well known throughout the region. Brian also found inspiration from the area’s history of filmmaking and borrowed concepts from the design of Paramount Studio’s production facilities in Burbank, California. (See Exhibit 5) “Europe is replete with talented North Americans misreading the culture and facing real difficulties. Look at EuroDisney or Canary Wharf, both successful in the end, but having suffered along the way” said Scott. The design was exciting but risky.

The architect also called for using local building materials wherever possible. “We learned the hard way, one uses steel in England but concrete in France. Who would have thought Eiffel’s favorite material would be used in England and not in France?”

The Financing

The complete development costs were expected to run �56.2 million (see Exhibit 6) with cash flow from operations before any debt service, and after a 5% vacancy allowance and all costs, of �7.747 million upon stabilized occupancy in three years. Value Retail expected to obtain a loan of �39 million at 7.5% interest with no amortization for 5 years. While the project was projected to generate high returns by American standards, more akin to venture capital, so, too, were the risks higher in this type of development.

Debt was also different in Italy than in North America. “Development financing was more akin to project financing for a power plant.” There was little concept of construction financing. Bankers did not have construction lending expertise. Instead, a developer got one loan for both construction and permanent financing secured by leases or other assets from the balance sheet of a company or by guarantees from the owner or developer.

Rates were typically fixed if the loan was provided by an insurance company or floating and often fixed with a swap if provided by a bank. Loans were usually for 70-80% of the value of the project and were amortization free for the first 2 to 3 years, followed by twenty-year amortization period. Rent was also typically paid quarterly in advance (as opposed to monthly in the U.S.), but again, this could differ by country. There were no U.S. style depreciation in Europe; although Italy did have

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803-008 Value Retail

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incentives to encourage development in areas of high unemployment. So there were no tax benefits as there were in the U.S.

Scott was not sure whether his rental rates could be achieved because there were so few comparables and the product was unique. But in discussing the proposed terms with tenant prospects, Value Retail felt they could reasonably expect to get the rents if they could get enough of the brands on board. Similar to his other projects, the structure would consist of a base rent of �450 per m2 plus operating expenses offset by 12.5% of sales12. For projection purposes he assumed total occupancy costs of �626 per m2, of which �176 per m2 were for service charges and all operating costs including marketing expenses, real estate taxes, maintenance, repairs and utilities based on stabilized 95% occupancy.

Since there was no anchor tenant for the project as in a shopping mall or grocer anchored center in the United States, he could not expect preleasing before the development commenced, but he expected to achieve 50% of the cash flow from operations from lease-up in year 1 and 75% in year 2. Of total operating costs of �3.1 million at 95% occupancy, �1.3 million were fixed and �1.8 million were variable. Scott knew that while some of his brands from other Value Retail villages might eventually add another store in Fidenza, he and his colleagues probably would have to start construction before securing any signed commitments

One of the advantages of Europe versus the United States was that with so few transactions and such limited supply, the values of European real estate had historically stayed high, with retail properties often trading at much lower capitalization rates than in the United States. Some significant retail properties in Germany had even sold at cap rates of 4.5%, versus 7.0% to 7.5% for the best properties in the United States. Scott felt that he could sell Fidenza at a 6.5% to 7.0% cap rate versus 10% to 11% in the United States. Because assets could generally be sold at yields at or below the cost of borrowing, there was a tremendous pressure to build with lower interest coverage and then to sell upon achievement of stabilized cash flow from operations.

Typically, Scott gave his investors a 10% cumulative preferred return, plus 50% of the excess cash flow after debt service, and 50% of the residuals after return of the investors’ equity, payment of the preferred return, and repayment of the debt, leaving the balance to Scott and his colleague. Prior to bringing his investors into the Fidenza project, Scott and his team had spent 5 years and �5 million in pre-development. He had waited until the project contractors obtained all the necessary zoning permits before looking to bring in the investors that would buy out Value Retail (the work in progress would now be bought from Value Retail at cost). Thus Value Retail bore all the front-end risk and thereafter, the equity risk was transferred to the investors.

Scott wondered, now that Value Retail was more established and interest rates had fallen to forty

year lows, if he could strike a better deal with his partners. He also had an organization to compensate. Could he, for example, charge a development fee beyond his direct costs? Was there some new proposal he could put forward? How could he persuade his longstanding investors that a change to the deal was fair? What would the numbers look like if he sold the project upon stabilization in year 3?

12 As in Bicester, if, for example, a brand had sales of �5,000/ m2, it would pay �625/ m2 in rent, which higher than the base

rent of �450/ m2, would obviate the need to pay the base. The tenant would still pay its share of the operating costs over and above the base or percentage rent.

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Conclusion

As he pondered his latest development opportunity, Scott listed his primary concerns. First, he was concerned that Italy might present too much risk.

Second, he needed to see if the numbers would work. What level of occupancy must his tenants achieve to pay the rents that he needed in order to justify the investment and the returns? What occupancy was required to break even after debt service? What would his returns to his investors be if sales were 30% less? What other kinds of sensitivity analyses might he do?

Did rules of thumb work in markets where information was limited and the product was so new and different? What could he do to mitigate his risks? What could he do to ensure his tenants would be honorable in making their rental payments? Finally, Scott had to develop a proposal for his investors, which made sense to all the parties, including himself and his growing company. Who would get what, assuming a sale at the end of year 3 upon projected stabilized occupancy? What was fair?

Scott was glad he was back in London, where he lived with his wife and four daughters, as he rolled up his sleeves to crunch the numbers and to figure out what to propose to his partners. Thinking back to that toast in Milan during Fashion Week, Scott mused, maybe they really did mean “Go to hell.”

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Exhibit 1

Two Rodeo Drive

Source: Value Retail

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Exhibit 2

Source: Value Retail

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Exhibit 3 Fidenza Village: The Location

Source: Value Retail

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Exhibit 4 Shopping Center Density in Europe

0100200300400500600

Nor

way

Luxe

mbo

urg

U.K

.

Aus

tria

Den

mar

k

Fin

land

Por

tuga

l

ITA

LY

Hun

gary

Pol

and

Tur

key

G.L

.A.

(Sq

.m.)

per

1,0

00 I

nh

abit

ants

Source: Healy & Baker Research Services

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Exhibit 5 Fidenza: the Design

Source: Value Retail

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Exhibit 5 (cont.) Fidenza: the Design

Source: Value Retail

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Exhibit 6 Fidenza: The Development Budget (�)13

Value Retail Fidenza International Outlets

Type New Build Site Area (acres) 22.24 Build Area (sq. meters) 19,375

Usable Area (sq. meters) 18,503 Units 120 Car Parking Spaces: 2,116 Gross Rent (�/year) 626

Construction Cost (�/ usable sq. meter) 1,275

Total Cost (�/usable sq. meter) 3,038

Cash Flow from Operations Before Debt Service

Base Rent (450*18,503) 8,326,000 Expense Reimbursement (176*18,503) 3,257,000 Gross Rent 11,583,000 Vacancy (5%) 579,000 Effective Gross Income 11,004,000 Operating Expenses 3,257,000 Cash flow from Operations 7,747,000

13 Figures disguised

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Exhibit 6 (cont.) Fidenza: The Development Budget (�)

Site Acquisition Land Cost 7,260,000 Stamp/Registration/Notarial Fees 231,223 Legal: Acquisition & Planning 184,986 Expended Predevelopment Costs 1,222,765 Agent's Fee 277,483 Valuation Fee 8,765 Miscellaneous 21,836 11,195,973

Construction External 3,248,688 Contract 19,044,971 Contingency 1,309,548 23,603,207

Professional Fees Architects & Engineers 981,685 Design Consultant 118,262 Quantity Surveyors 349,218 Project Management 336,547 Professional Fees 154,607 Contingency 484,664 2,424,983

Marketing Costs Agents' Fees 1,364,832 Legal Fees 436,516 Direct Marketing Costs 1,460,722 Marketing Consultant 454,923 Brochure Advertising & Promotion 305,548 Center Opening Promotion 305,539 Brand Incentives 1,819,643 Contingency 812,579 6,960,302

Finance Fees Bank Fees 1 2,408,788 Legal/Notary/Registration 755,939 Interest on debt financing 2,826,196 5,990,923

Permits & Miscellaneous Legal & Professional Fees 811,648 Overheads 1,517,063 Local Administration 1,116,960 Miscellaneous Pro-Development 1,047,090 Planning/Impact Studies 174,515 Appraisal Fees 61,077 Contingency 1,308,783 6,037,136 TOTAL COST 56,212,524 DEVELOPMENT RETURN ON COSTS 13.8

Source: Value Retail

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Exhibit 7 Proforma Returns and Cash Flow Statement

Proforma Returns Pre-Split (000s)

Stabilized Cash Flow from Operations

Debt Service

Cash Flow

Partners Equity

Cash-on-cash %

Residual Calculation

Stabilized CFO

Cap Rate

Residual Value

Residual Calculation

Residual Value

Less 5% Transaction Cost

Less Debt

Less Return of Equity

Funds Available

Split to Limited Partners @ 50%

Residual to Limited Partners14

14 Split + initial equity investment

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Exhibit 7 (cont) Proforma Returns and Cash Flow Statement

Projected Cash Flow to Partners

Year 0 Year 1 Year 2 Year 3

Cash Flow Before Financing

Less Financing: Interest Only

Cash Flow After Financing

Less Equity Preference**15

Preference Carry Forward

Available for Distribution

Split to Limited Partners @ 50%

Cash Flow to Limited Partners

Partners Projected Returns Pretax

Year 0 Year 1 Year 2 Year 3

Original Investment

Cash Flow (Preferred + Split)

Residual Split to Limited Partners

Total to Limited Partners

IRR

15 Year 1 cash flow falls short to cover preference. The balance of preference is carried forward on a cumulative basis