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DON'T SHOOT THE MESSENGER: Full Recovery for Retail Real Estate Could Be as Far off as 2012

Execs, Research Firms Issue Reports Advising What They Expect, and How Industry Needs to Adapt to Economic Changes
March 25, 2009
[From L to R]: Marcus & Millichap's Harvey Green and Hessam Nadji
[From L to R]: Marcus & Millichap's Harvey Green and Hessam Nadji
Unless you are an investor lucky enough to acquire a "diamond in the rough" retail property at a great price, or a discount retailer profiting from penny-pinching consumers, you can count on fewer golf games over the next three quarters as current challenges will likely persist, or possibly worsen in the near term for the retail real estate industry. That appears to be the view of several reports recently published by some of the top firms in retail real estate. Their consensus forecast calls for a rebound to take hold beginning in 2010, but real growth isn't expected to return until 2011 or even 2012.

Harvey Green, president and CEO and Hessam Nadji, managing director of research, both of Marcus & Millichap, said in the company's recently released 2009 National Retail Report that the retail industry will continue to face "headwinds" in the coming year including job losses, declining retail sales, rising vacancy and falling rents."

Retail construction is expected to drop by more than 30% this year, the Marcus & Millichap report stated. However, the decline will not prevent substantial increases in vacancy expected from continued store closures and reduced retailer expansion. Specifically, the firm predicts the retail vacancy rate to increase to 10.2% in 2009. With retailers increasingly aksing for, and obtaining, rent concessions from landlords, the firm forecasts that asking rents will fall 4.5% and effective rents will drop 5% during 2009, with "many oversupplied markets [recording] steeper declines."

To partially offset these stresses, Marcus & Millichap recommends that retail property owners "closely monitor expenses to help preserve NOI and uncover money-saving operational measures that can increase efficiencies."

Despite all the economic headwinds and dramatic slowdown in sales for many types of retailers, Green and Nadji stressed that "investors should not presume the overall condition of the retail market to be distressed," adding that buyers can still find retail properties that will be "well-positioned for an eventual rebound." To finance such acquisitions, Marcus & Millichap said qualified buyers can look to "life insurance companies, credit unions, and local and regional banks" for capital, or they should look for properties offered with seller financing or assumable loans.

The firm identified "infill properties that offer a solid mix of necessity-based retailers" as the most-likely investment type but warned that the caution should be exercised when considering investing in secondary and tertiary markets, as "these markets can be more vulnerable to sudden shifts due to a lack of economic diversity."

In good news for retail investors, Marcus & Millichap said the bid-ask pricing gap is finally narrowing as sellers are now showing a willingness to adjust pricing in the property pool currently listed for sale. "Cap rates for listed properties are now 25 basis points to 50 basis points higher than the average for transactions that closed recently," said the firm.

Retail investors should "expect debt-service ratios of at least 1.3" in 2009, which is close to historical norms, said Marcus & Millichap. "With interest rates and spreads volatile, most lenders are moving away from spreads and are instead quoting all-in rates, which are averaging in the 6.0% to 6.25% range for loans with a five-year term," the firm added.

Looking beyond 2009, Marcus & Millichap said, "reduced development will help stabilize the market in 2010 before a moderate recovery starts in 2011." Green and Nadji said that in 2011, "a new cycle will start as new concepts emerge and the survivors begin to expand once again."

Richard Latella, senior managing director and Chris Sherland, both of the Retail Industry Group of Cushman & Wakefield, said the U.S. retail industry is currently experiencing a "100-Million-Square-Foot Hangover" in a special analysis provided for the PricewaterhouseCoopers Korpacz Real Estate Investor Survey first quarter 2009 report.

Latella and Sherland said that the wave of suburban shopping center development "led the supply of new retail space to greatly outpace population growth." As a result, they said owners of retail property are currently experiencing a "painful hangover" as they "discover that much of their space is now obsolete due to physical/functional limitations or demographic shifts." Adding to this "hangover", Latella and Sherland say owners will struggle to grow effective rents as retail tenants leverage their "stronger position" to control occupancy costs by "negotiating rent reductions, higher concessions, and postponements in the timing of contractual rent escalations."

During 2008, Cushman said the U.S. experienced a 50% increase in store closings, resulting in an additional 113 million square feet (2,600 acres) of big box and department store space becoming available during the year. Latella and Sherland expect the store closing total for 2009 to be even greater than 2008, possibly even double 2008 closings. "Store openings are poised to decline in 2009 for the first time in several years," they added.

Latella and Sherland warned in the report that retailers should not assume sales will improve when consumer confidence finally does, saying consumers will likely maintain their expectations of price deflation that have settled in over the last year.

The paradigm shift that occurred in consumer behavior during 2008 creating a drag on retail sales, combined with overbuilding, obsolescence, retailer instability, increasing vacancy, lower retail rental rates, and continually increasing cap rates, are driving retail property values lower, Latella and Sherland maintain, adding they expect value decreases as high as 40%.

Pricewaterhouse and Korpacz assessed the "value cycle" of retail real estate in their report and said that the majority (about 94%) of U.S. retail space will be in recession or contraction throughout 2009. Improvement in these conditions will start creeping in during 2010, but the group estimates it won't be until 2012 that the majority of U.S. retail space will be in recovery mode in terms of value.

Tom Gast, principal of Gast Retail Group, recently made a case for lenders to go easy on the owners of such value-challenged retail property. "Lenders must be flexible with borrowers whose properties remain vulnerable to refinancing and more stringent credit underwriting requirements. [Lenders'] financial statement considerations must include the possibility that repossessing over-valued assets threatens solvency as bad loans are written off, leaving the lender with a variety of numerous distressed assets it is incapable of effectively managing," he said. Gast qualified this statement by acknowledging that some owners that do choose to buy distressed properties will benefit from "tremendous upside potential over the long term."

Providing additional statistics that retail properties are increasingly in "distress", Fitch Ratings said the U.S. CMBS loan delinquency index rose 13 basis points to 1.28% in February 2009, primarily due to "declining retail performance." Fitch expects this index to rise to 3% by the end of 2009. "February marked the sixth time in the past seven months that retail led the newly delinquent loans," said Fitch, adding that it "expects that, in the near to medium term, retail will represent a growing proportion of overall defaults."

"As expected, a prolonged decline in consumer spending has forced weaker retailers out of the market, in turn placing significant stress on commercial real estate fundamentals," said Fitch managing director and U.S. CMBS group head Susan Merrick. "As retail landlords struggle with increasing vacancies at existing centers, they must cope with new market realities including a deceleration in new store openings, an overhang of new supply, and continued downward pressure on rents demanded by those tenants still in operation," she added.

Fitch said delinquencies are most pronounced among smaller properties (loans ?$15 million), including strip, neighborhood and community shopping centers. The agency also identified single-tenant properties leased to now-bankrupt tenants as a problem area, saying it expects many will "remain empty for the foreseeable future."

According to the results of a survey of city officials conducted by the National League of Cities (NLC), local retailers, particularly those located on main streets or in downtown areas, have been hit very hard. As a result, these local retailers are buying less goods and service from other community businesses and in the worst case, closing their stores.

The trend is having an enormous adverse impact on communities, said the NLC. Specifically, communities are directly feeling the impact as tax revenues decline in line with retail sales, hampering cities' ability to provide basic services. "More than seven in ten city officials note that poor retail sales and increased store closings are negatively impacting other local businesses and the regional economy, resulting in unemployment and a decline in new business start-ups," said the report.

In an effort to repair some of the damage left by retailers in the form of abandoned space, many city officials are looking to the future with an eye on mixed-use redevelopment projects, said the NLC.

PricewaterhouseCoopers, in cooperation with TNS Retail Forward, also speculated what the future of retailing will be following this recession in a recent report. First, the group said retail sales (with the exception of necessity-driven food and drug retailers) are expected to be flat for 2009 and rebound in 2010, but even then, we shouldn't expect to see the 5% sales growth pace averaged in the decade prior to 2008.

Overall, the group predicts that U.S. retailers will see "signs of improvement" in the fourth quarter of 2009, but only if government's plan is effective, consumer attitudes improve, job losses slow, and the housing market begins to stabilize, said Retail Forward's senior economist, Frank Badillo. Unfortunately, the report made the likelihood of these conditions improving sound unlikely, saying that "the unemployment rate could remain uncomfortably high through 2011" and "more than 1 million empty homes will need to be purchased in order to restore the long-term average vacancy rate."

Perhaps the most worrisome issue Retail Forward brought up is that retailers should expect the frugal shopping habits consumers have "learned during this economic crisis" to be permanent, event when the economy turns around. This could translate into certain specialty retail concepts becoming obsolete, even if they manage to last through this recession.

After this recession, Retail Forward says the industry will have to change in accordance with "new marketplace realities" that include smaller store footprints, continued slow new store growth, consolidation of big-box retailers, and mixed-use development becoming the norm.

"For years, I’ve been telling everyone that would listen that we were building too much retail," Sam Kartalis, president and COO of Henry S. Miller Brokerage, said emphatically. We've ended up with "a country full of well-intentioned, but poorly-conceived centers, many built by amateurs," said Kartalis.

A big issue with many of these "poorly-conceived", newer shopping centers (think grocery-anchored center with a few national tenants and lots of space for small shop local retailers), said Kartalis, is that many local tenants can't be profitable and manage to pay base rent plus triple net expenses. "Small tenants with no financial expertise open and close daily leaving the owner to underwrite yet another commission and finish out costs for unsuspecting replacements," said Kartalis, explaining the plight of many landlords with newer shopping centers today.

Increasingly, its landlords of older centers that are more likely to experience the silver lining of this market, said Kartalis, explaining that their ability to charge lower rents and still make a profit is working in their favor. "Older, well located, traditional centers are not giving away outrageous incentives because they don’t have to," said Kartalis. He added that this segment of the market would likely be among the first to experience a rebound out of this recession.

Kartalis echoed Marcus & Millichap's comments on "sprawl" markets, "Secondary and tertiary markets, many of which have no depth, are overwhelmed by new retail developers and realistically, many can support only one major strip center," said Kartalis.

"The future health of our industry depends on recognizing the reduced need of speculative space and the fact that there are fewer small tenants to lease such space, because the big boxes are absorbing many of the services provided by the 'little guys'. Finally, lenders have to stop lending to 'developers' who have no knowledge, nor the tenants, nor the locations for a well-conceived retail development," concluded Kartalis.

(Editor's Note: To keep up on happenings and trends in retail real estate, subscribe to CoStar's Retail News Roundup, a weekly column covering retailer expansions and new concepts, store closings, bankruptcies, cutbacks, acquisition, mergers, sales. new shopping centers, personnel changes, and sustainability. Follow this link for access to back issues of the roundup. In addition to appearing every week in the national news and retail news sections of our web site, you may also receive the Retail News Roundup for free via email by requesting to be added to the distribution list by contacting senior editor, Sasha Pardy at Also, click here to subscribe to CoStar's dedicated Retail RSS Feed.

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