Resizing Retail
Dec 1, 2007 12:00 PM, By Anne Field
Experts forecast the industry's prospects for 2008 and things look a little bumpy.
Uncertainty reigns.
For much of the past decade the retail real estate industry has been marked by a mood of unbridled triumphalism. Retail sales crested. Property values ballooned. Cap rates shriveled. Retailers drove occupancy rates to extremes as they packed centers to the brim. And developers created the largest pipeline of retail projects under construction in a generation.
Suddenly the future is a scary-looking place.
Damage from the credit crisis emanating from the subprime mortgage mess has not been contained and, in fact, keeps spreading. Credit markets seize on a weekly basis as the world's largest banks announce multibillion dollar write-downs. Meanwhile, rating agencies, scorched by the generous grades applied to subprime mortgage-backed securities and collateralized debt obligations, are changing ratings on trillions of dollars' worth of debt — and not just connected to single-family housing. And bond investors, scared by the confusion, have embarked on the typical “flight to quality” and hitched their wagons to government-backed bonds.
Until that gets sorted out, the devastating consequences will continue to seep into other industries. For retail real estate, the effects are manifold and are affecting every part of the business.
Retailers are hurting as sales fall. That in turn is causing retailers to rethink previously ambitious expansion plans. On the commercial mortgage-backed securities (CMBS) front lenders have scrapped old underwriting standards and even ditched some of the more generous financing packages that had been on offer.
“The state of everything now is nervousness,” says Greg Maloney, president and CEO of Jones Lang LaSalle's Americas retail group in Atlanta. “No one is really sure what to expect.” Marcus & Millichap Real Estate Investment Services's national retail group director Bernie Haddigan agrees. “It could be well into 2008 before we know which way the market's going,” he says.
To be sure, it's not Armageddon. The industry's fundamentals — though weakening slightly — remain robust and are far from the lows the sector has experienced in times of real crisis. Retail sales growth is slowing, but hasn't turned negative. Retailer bankruptcies have only hit home furnishing chains. Moreover, the big REITs remain well capitalized and are carrying manageable debt loads. Further, the long-term nature of retail leases means that even if sales slip, owners and developers won't see any immediate effects from that (though it could affect rental bumps, re-leasing spreads and retailer expansion plans). However, that doesn't mean executives feel good about the current situation either.
But the ironic thing about instability is that it brings about some predicable reactions. Property values on commercial real estate fell during the third quarter, according to the National Council of Real Estate Investment Fiduciaries index of properties sold — the first such drop registered in the index in five years. It's a clear indication that there's disagreement in the market about what properties are worth. As a result, buyers and sellers are at an impasse.
Meanwhile, the pace of development is dropping. Earlier this year Bethesda, Md.-based real estate information firm CoStar Group clocked the development pipeline at 188.1 million square feet — the highest level of construction in at least 25 years. As a result, the number of interested bidders on properties has dropped. And very quietly many development projects are being downscaled or ditched altogether.
And observers also predict there will be some clear winners and losers. With largely sound fundamentals, the big REITs should weather the storm, as will owners of top-of-the-line properties. For smaller players, however, the story may be very different. “The guys that do the one-off deals, they're going to have problems,” says Thomas Engberg, executive vice president of San Francisco-based Capital and Counties Development Group, a new division of Capital and Counties USA.
Development turnaround
In recent years, REITs retreatd en masse from investments and, looking for better returns, focused on redevelopment and ground-up work. Now, however, an oversupply of new construction has reduced yields below 10 percent, in contrast with returns in the mid-teens earlier this decade.
That situation seems poised to shift again in concert with the shifting lending environment. Developers that relied on debt or pursued more speculative projects may find themselves with less work this year as lenders will be more loathe to provide high levels of funding or underwrite centers that don't have high pre-lease commitments.
“The big, well-capitalized developers are going to be out there trying to seize opportunities,” says Engberg. He's heading the new division of London-based Liberty International, which is aiming, in part, to invest about $600 million a year in new opportunities in the U.S., both in ground-up development and acquisitions and by investing in deals with other developers. “This market looks a bit choppy — and that can be a time of great opportunity,” he says.
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