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Retail Leasing Continues to Strengthen, But Investment Activity Remains Sluggish

Although Retail Landscape Improving with Increase in Leasing, Rents and Sustained Investment Activity Still a Year or Two Away From Full Recovery
July 28, 2010
Retailers, consumers and the general economy are clearly better off than they were a year ago -- and that’s translating into an increase in leasing activity and overall occupancy together with a deceleration in rent declines for retail property owners.

The picture remains very mixed for real estate investors focused on the retail sector with dollar volume in investment sales transactions still well below the long-term average. However, compressing capitalization rates and other positive investment signs are emerging which should help break the stalemate between buyers and sellers and halt the long slide in shopping center prices.

The positive indicators in the retail leasing market over the first half of this year follow similar recovery stories in the nation’s office and industrial markets, as CoStar Group reported in its State of the Commercial Real Estate Industry Mid-Year 2010 Retail Review and Outlook.

With shoppers beginning to spend again, most retailers are seeing year-over-year growth in same-store sales, a precursor to growth in real estate demand that is now showing up in improved leasing numbers, said CoStar Group Real Estate Strategist Suzanne Mulvee, who delivered the update and forecast this week to CoStar clients along with Jay Spivey, CoStar director of analytics, and Norm Miller, vice president of analytics.

While far below 2007’s hyper-inflated peak of 64 million square feet, the 12.8 million square feet of absorption in the second quarter of 2010 continued a positive trend that began a year ago in third-quarter 2009. While 12 of the top 20 retail markets posted negative absorption in 2009, 16 of 20 markets recorded positive absorption in the second quarter, led by fairly strong growth in Houston, New York, Northern New Jersey, Boston and Denver. South Florida, which experienced some of the worst space losses last year, is also seeing positive growth in 2010. Dallas, Tampa, Phoenix and Chicago continue to suffer absorption losses, but at a far lower rate than last year. CoStar forecasts continued overall growth in national absorption figures for retail space in coming quarters.

The growing influence of services in the U.S. retail market, and improving conditions in the overall economy are helping to drive retail leasing numbers. Of the roughly 35,000 retail leases signed in 2010, Subway led the way with 65 new locations, while financial services firms such as Edward Jones, State Farm Insurance, Liberty Tax Service and Allstate have also added multiple locations.

Other strong tenant growth occurred among value-play retailers such as the "dollar" stores -- Dollar Tree, Dollar General, and Family Dollar. Mulvee also noted that seven of the top 25 most active retail tenants were mobile carriers, which sell phone service as well as devices.

The number of retail properties under construction or in the planning stages remains at an all-time low as a percentage of total inventory. Most of the scant amount of new supply hitting the market includes big-box/power centers, grocery-based properties and other centers with strong credit retail anchors.

The U.S. retail vacancy rate declined slightly during the second quarter from 7.6% to 7.5%. The availability rate, which includes space being marketed as available for lease but not yet vacant, edged up from 9.9% to 10%. While space recorded as available is at risk of becoming vacant, the slight rise in the availability rate can also be viewed as a sign that fundamentals are starting to firm up and owners are hoping to put space on the market with the goal of raising rents and propping up property income.

The highest average vacancy rate was found in strip shopping centers, theme/festival properties and neighborhood centers at just under 12%; while super regional malls had the lowest rate on average at 5%. Vacancies in outlet, power and lifestyle centers have declined nominally.

By market, Houston, Boston, North New Jersey and South Florida experienced decreasing quarter-over-quarter vacancies in their retail real estate. While most markets saw declining vacancies, a handful, including Washington, D.C., Dallas and Chicago, saw vacancies edge up.

"We think vacancies will drop over next three years down to between 6% and 6.5% given the low levels of new supply, and that will accelerate the process and help the market recover," Spivey said. "Overall, the leasing market is at inflection point and will improve going forward."

Quoted rents, which lag changes in vacancy by as much as one or two years, continued to decline in the second quarter, but at a slower rate.

The first-half 2010 retail investment sales market saw properties sitting on the market longer. Moreover, more discouraged sellers were pulling their unsold properties from the marketplace.

However, "we’re seeing a little bit of a leveling in the spread between asking and actual sales price, and that’s a good sign that things are starting to come together in terms of the buyer-seller demand curve," Spivey said.

Overall sales volume dropped sharply between 2007 and 2009, and although quarterly sales volume remains below the long-term average, volumes should trend upward over the next few quarters, Spivey said. Some markets such as Houston are seeing a large year-over-year percentage increases in volume, albeit from 2009’s low transaction base.

About 20% of retail properties being traded during the second quarter were distressed sales, with pricing on average at around 54 cents on the dollar compared with non-distressed assets, Mulvee said. As a percentage of total transactions, distressed retail deals are running well below rates for multifamily, hospitality and office assets, and somewhat higher than industrial.

About 45% of retail properties that traded in Atlanta were distressed, with Orlando, Jacksonville and Colorado Springs also showing high levels of distressed sales. On the other end, distress hasn’t really affected higher-growth markets with supply overhang such as Austin and Houston, where the rate of distress is around 10%, Mulvee said.

However, "If you look at mortgages coming due and the opportunity funds that are out there, the volume of distressed properties is still a fraction of what the market expected," Miller noted.

Retail cap rates, while highly skewed by the bifurcation between lower caps paid for high-quality, super core assets and higher cap rates seen in the lower-cost distressed properties, are trending downward. The average cap rate fell to 7.6% in the second quarter, and "we’re starting to see some cap rate compression" in the marketplace, Mulvee said.

The spread between cap rates and 10-Year Treasury bonds is relatively high on a historical basis, which suggests that "real estate is cheap and now is a good time to be buying if you have the capital to buy," Mulvee said. "This is the tail wind of capital flows back into real estate."

All property types except for industrial are seeing price stabilization, if not increases, according to the CoStar Commercial Repeat Sales Index, a new index which uses properties sold more than once to calculate price movement in the market, similar to the well-known S&P/Case Schiller Index for single-family residential.

Current sale prices show less deviation from the average than transactions at the peak of the market, when the astronomical sale prices of certain transactions drove up the overall average. The recent tightening in dispersion of sales prices shows there’s less disagreement on pricing between buyers and sellers -- a good sign for the investment market, Spivey and Miller said.

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