Amid tight space conditions and muted construction throughout much of the country, high demand for pad sites is delivering greater financial flexibility for shopping center developers and investors.

Traditional pad site users are fueling the lion’s share of that demand. First and foremost are expansion-minded food-and-beverage brands, from fast food and boutique drive-thru coffee concepts to full-service dining operators, observers say. Medical groups, automotive parts and services, preschools and child care centers, and banks and credit unions are also among the users seeking pad sites, they report.

“When we’re scouting properties, we very much focus on those that have outparcels that are developed and that we can flip or that are undeveloped and we can sell off to a developer or a tenant or otherwise figure out a way to develop ourselves,” said J. Blake Dickinson, vice president in charge of anchor and development leasing for Continental Realty Corp., which owns more than 8 million square feet of retail, primarily in the Mid-Atlantic and Southeast. “Over the past couple of years, demand for pad sites has definitely been robust.”

At Shoppes at Pelican Preserve — a 79,970-square-foot grocery-anchored center in Fort Myers, Florida, that Continental Realty purchased in 2018 — what started out before the pandemic as a 2.2-acre pad site ground-lease discussion with EoS Fitness morphed into a $2.2 million sale to Barclay Group, EoS Fitness’ preferred development partner. Barclay Group completed the deal in February and plans to build a 42,000-square-foot gym on the site.

Continental Realty is tracking about 80 similar pad site opportunities across its portfolio, Dickinson said, noting: “When occupancy in our industry is as solid as it is today, sometimes users have to get creative to meet their expansion goals.”

Juicing Returns

Demand by 1031 exchange buyers continues to drive interest in pad sites, observed Micah Ashford, a managing director who heads up acquisitions, financing and dispositions for Younger Partners Investments, which owns 1 million square feet of retail in Texas since 2020. That’s particularly true for parcels occupied by highly desirable credit tenants, which has kept capitalization rates for outparcels at around 4%, compared with around 6.5% for shopping centers, she said. Younger Partners purchased the 147,161-square-foot Midlothian Towne Crossing in suburban Dallas in late 2023 and this year sold three parcels there occupied by Chili’s, McDonald’s and Chick-fil-A.

“We’ll spin off some of these pad sites as a way to increase our internal rate of return on assets that we buy, but we look at it from a deal-to-deal basis,” Ashford said. “The bigger the shopping center, the more comfortable we are selling. At smaller centers, we like to keep pad sites because they enhance the value of the overall property when we’re ready to exit.”

Some developers, though, are reluctant to relinquish pad sites at all. Vestar, a developer that owns 30 million square feet of retail assets in the western U.S, rarely sells off individual parcels or pad sites. Well-established brands often prefer to buy sites so they can avoid rent escalations, but Vestar similarly aims to control its own destiny, said Ryan Ash, a vice president with the firm who oversees development and leasing strategies.

“It’s a business decision as to whether users want to spend money to buy land or if they want to conserve cash and go with a traditional ground lease,” he said. “The latter is definitely our preference. It can be hard to enforce operational and maintenance standards when you sell off parcels. By holding on to them, you have more control over the property and overall shopping experience.”

Pad Sites as Construction Capital

Yielding some control, however, may provide the financial wherewithal to move a project to move forward. Today’s higher cost of capital has fueled a resetting of property values and lending constraints, said Tom Fidler, a principal at MacKenzie Commercial Real Estate Services, a brokerage that has a handful of offices across Maryland and Virginia.

To obtain a construction loan, for example, developers typically need to bring around 30% in cash to the table, compared with as low as 10% before the pandemic, he said. In such an environment, developers can choose either to raise equity that’s subject to higher rate-of-return requirements or to sell an outparcel or two.

“Developers are scratching their heads because ground leases have been great,” he added, “but if they sell parcels, they can not only get a loan because they’ve increased their liquidity, they can also negotiate some shared costs for things like parking, stormwater management and utilities. The buyer is now more of a partner rather than just a tenant.”

Evolving with the Market

Still, developers who have Class A-plus corner locations would be wise to pursue ground leases rather than dispose of the pad sites, Fidler is quick to point out. But in less-developed markets, it can take some time for ground lease momentum to build.

Cole Brodhead, a principal with brokerage Edge Realty Partners, recounted how one pivotal intersection in Manor, Texas, 20 minutes northeast of Austin, developed over time. One owner controlled three corners. Around 2012, it sold land on one corner to Walmart and to some pad site users. About six years later, it sold all parcels on a second corner except for two to pad site users. It reserved those two for future ground leases, which are just now in the works. Now, an H-E-B-anchored center under development nearby, an indicator of the escalation of demand in the area. For that third corner’s 30 acres, the owner plans to pursue ground leases for pad sites.

“Ten years ago, people couldn’t tell you where Manor was, and ground leases didn’t exist because the demand wasn’t there,” Brodhead explained. “Now, Manor is a huge, growing suburb and you just can’t get enough users for the market.”