FEATURE ARTICLE, MAY 2011

RETAIL INVESTMENT MARKET SURPRISES
To the surprise — and happiness — of many, the retail investment sales market has made a comeback in recent months.
Alan Pontius

To the surprise of many pundits, the U.S. retail real estate sector is staging a comeback. Unlike in previous recoveries, retail sales have lagged economic growth, not led. Total retail sales did not increase significantly until the second half of 2010, approximately 12 months following positive GDP growth. Since then, sales have been stronger than expected, even exceeding pre-recession levels. This is based on core retail sales — excluding volatile auto and gasoline sales — which tend to skew the numbers. Demand for retail space has followed a similar pattern and is now starting to pick up pace. The overall vacancy rate climbed from 7 percent in 2007 to 10.5 percent as of year-end 2009, remaining steady through mid 2010. Vacancy has since inched downward to 10 percent. Even though effective rents are still weak, they are beginning to stabilize.

The leveling off of store closures that permeated the market in 2009 and early 2010, as well as a substantial slowdown in lease renegotiations, offer additional signs of a recovery in the retail property sector. Construction starts have plummeted, setting the stage for occupancy improvement in 2011. Despite these positive trends, except for premier locations, recapturing lost revenue will take several years for most retail property owners. The sharp increase in vacancy rates, the most severe in recent history, masks the performance gap by retail category. This gap is defined by strength in luxury sales thanks to the rebound in affluent shoppers’ spending sooner than most and, at the low end of the spectrum, where discount retailing benefits from a new level of frugality that has surprised even industry veterans. The near explosion in online sales may rekindle worries about the future of brick-and-mortar retail, but location and attraction still rule. Operating performance of infill shopping centers is a far cry from centers located in suburban, particularly fringe, areas, which captured the lion’s share of overbuilt housing. Older malls, unable to attract the “in” tenants, continue to struggle. Fortress malls in superior locations are thriving; however, having shifted tenant mix surprisingly fast and collaborated with distressed merchants to preserve occupancy.

Owners will compete intensely to attract top-performing national retailers, well-funded new concepts, and dominant grocery and drugstore names. Within the grocery and drug categories, the most sought-after tenant will be local retailers with a proven ability to survive the Walmart and Target threat. Virtually all shopping center owners worry about small, local retailers who occupy in-line shop space. Recovery in this segment is heavily tied to housing, a source of both confidence and equity for many startups and small tenants. The restoration of home equity lending and other credit lines will extend well beyond 2011. Confidence in economic conditions and job gains will set the stage for a revival in demand that will materialize partially this year and develop more aggressively in 2012.

Looking at retail fundamentals, the national vacancy rate increased 310 basis points to 10.2 percent through the Great Recession. Four consecutive quarters of positive net absorption and the lowest completions on record last year reversed the trend. The retail vacancy rate will fall further to 10 percent in 2011. Vacancies at smaller retail centers, including community, neighborhood and strip retail, ended 2010 at 11.8 percent.

Rents stabilized in late 2010 and should remain firm. Occupancy levels must improve well beyond what is expected in 2011 to stimulate broad-based rent growth, pushing strengthened gains into 2012.

New construction averaged 202 million square feet between 2004 and 2008. In comparison, retail completions in 2010 and 2011 set record lows, totaling a combined 85 million square feet. A doubling in forecast demand to 64 million square feet in 2011 will surpass completions and support recovery in space fundamentals.

More Financing Options Becoming Available

As 2011 progresses, more financing will become available for a broader range of retail properties, especially as global unrest abates. The factors behind the gradual but decisive advance include an improving economy, the bottoming of retail property fundamentals, an accommodative Federal Reserve that has held interest rates low and lenders’ strengthening capital positions. Today’s vital signs present a sharp contrast to one year ago, namely 1.3 million more private-sector jobs and the rebound in corporate profits and retail sales to pre-recession levels. The result is more visibility and confidence that the recovery will survive the recent soft patch. Lenders will shift gears from survival to putting capital to work and maximizing profits through the spread on capital costs, which remains near zero for banks. The retail sector’s tendency to reinvent and its repositioning over the past 2 years bode well for a new round of funding for the next investment cycle, a shift reflected in improved lending by commercial banks, life insurance companies and resurrection of the CMBS market.

The rising tide of retail financing will be anything but smooth. Cautious lenders will keep loan-to-values near 60 percent for all but the best-in-class properties, a far cry from the market peak. Proximity to jobs, strength and diversity of rent roll will point most lenders to infill, quality properties. As opportunistic buyers seek higher B and B- cap rates without excessive risk, however, lenders will increasingly move down the value chain to finance such assets. Weakness in housing, global unrest and international debt concerns will remain front and center.

Investors Remain Risk-Averse

Capital returned to retail real estate throughout 2010 but remained selective and risk-averse as the economy emerged from the deep recession. Institutional capital sent sales volumes soaring off extreme lows. This influx of selective capital created intense buyer competition and cap rate recompression for best-in-class assets. Retail REITs’ extraordinary recovery, at nearly three times that of the S&P 500, clearly illustrates this trend. Alongside top-tier multi-tenant assets, highly rated single-tenant properties continued to capture demand from cash-flow-oriented private investors. The balance will shift to include more diversity in asset quality and markets in 2011 as improved economic performance and stronger consumption top the list of factors encouraging investors to move beyond top-tier assets.

The tight band between best-in-class property cap rates and interest rates, along with growing confidence in the economy, will move investors down the quality chain. Improved lender sentiment and cash positions, together with investors’ perspective that retail real estate will generate healthy, if unspectacular, returns, will facilitate this progression. Lenders’ refusal to fire sale quality assets has frustrated the ambitions of opportunistic buyers, resulting in IRR goals pared from north of 20 percent. Given this distinctly different backdrop than the early 1990s real estate crisis, a low double-digit leveraged return for a mid-tier shopping center in a secondary location does not seem so bad today, especially in light of a growing economy and still-low interest rates. Risk tolerance will expand in 2011, especially among private investors who were reluctant to jump back into the market in 2010. Buyers and lenders alike, however, will scrutinize weak secondary and tertiary locations; older, unanchored centers that need repositioning; or busted development in outlying areas. Injections of fresh equity into underwater transactions and note sales offer alternative vehicles to participate in the distressed market, given limited conventional foreclosures, but discounts will narrow as lenders and owners gain confidence in the recovery.

Retail distress for this cycle totals $24 billion, only 17 percent of which has been sold off. Retail delinquencies remain elevated, with CMBS loans reflecting the highest level at 8.58 percent, but workout volume increasingly outpaces new distress, now at the lowest point in two years. The volume of distress sales will increase as lenders’ stronger balance sheets and improving property values induce more sales, but the majority will be lower-quality assets.

The retail sector reached bottom and showed signs of recovery ahead of expectations. The drop-off in store closures, the near standstill of new speculative construction and expansion by stronger tenants were welcome developments in 2010. Investors returned to the market aggressively, especially in the later part of the year, but remained extremely selective, willing to pay a premium for quality, low-risk assets and shying away from lower-tier offerings. Further recovery in occupancies and investment volumes should materialize through year’s end, leading to a solid 2011 for both, thanks largely to improved capital markets and more active lenders.

— Alan Pontius is a senior vice president and managing director of Marcus & Millichap Real Estate Investment Services, and national director of its National Retail Group (NRG).

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