FEATURE ARTICLE, MAY 2006

RETAIL IN THE SOUTHEAST: A LENDER’S PERSPECTIVE
Unless factors force the market to take an unexpected turn, retail will continue to be a heavy favorite for lenders.
Chris Thorn

Southeast Real Estate Business recently spoke with Thomas G. Jeffery, senior vice president/regional group in the National Institutional Real Estate division of LaSalle National Bank N.A., about the state of lending for retail properties in the Southeast.

SREB: What is the current lending climate like in the Southeast?

Jeffery: Naturally, capital flows to where the greatest returns can be found. During the last few years, construction and development resources were focused largely on the condo boom in Florida and along the coast. Now that the appetite for condo developments has softened, the retail market provides an attractive product for lenders as it helps to diversify their portfolios which are heavily weighted with condo developments, and the market indicates a strong need in the areas where condo development has occurred to support the needs of new populous. Moreover, the retail market continues to become more sophisticated as national developers (many times in joint venture with local efforts) leverage synergies in tenant mix and dynamic. This helps to isolate risk factors that encourage debt investment.

SREB: What loan products do you anticipate being popular in the Southeast in 2006?

Jeffery: As long as the yield curve remains flat, the CMBS loan product will continue to be a strong debt vehicle for stabilized retail product. Additionally, as cap rates for existing product remain low despite increasing interest rates, discriminating investors have turned to ground-up development to obtain suitable returns. As such, construction activity is expected to be strong this year throughout the majority of the Southeast as construction debt terms move in favor of the developer. Due to a flat yield curve in a raising interest rate environment, interest rate hedging will be a popular product for floating rate loans because the cost to fix is inexpensive relative to the historical rate environments.

SREB: What trends in RE financing are you seeing for retail in the SE?

Jeffery: The largest trend in retail in the Southeast has been the incorporation of a retail concept into a larger lifestyle development. This model, primarily undertaken by the larger regional or national developers, has proven successful enough to date to attract a competitive lending landscape. It is anticipated that this year will experience substantial deliveries of the lifestyle concept developments. Also, there has been a trend in the debt markets to provide up-front take-outs by institutional investors on construction projects. The institutional take-outs provide, through a tri-party agreement, the ability for a developer to get optimal capital structure and favorable lending terms by displacing construction risk from the institutional investor toward the construction lender (commercial banks and capital groups), and displacing the refinance risk from the

construction lender to the institutional investor. The ability to isolate these risk factors to those parties best equipped to underwrite them creates an attractive investment environment for lenders, developers and institutional investors alike.

SREB: How does retail lending in SE compare to other markets?

Jeffery: The coastal markets — Florida and the Carolinas in particular — continue to remain one of the strongest retail markets in the nation due to the density throughout the coast and affluence of the demographic. Less dense markets will continue to benefit from the increasing comfort national retailers and developers find as the competitive environment in the coastal regions offers limited supply and forces both retailers and developers to find returns elsewhere.

SREB: What geographical markets of the SE are hot right now? Will these markets continue to grow?

Jeffery: There is clearly a strong positive correlation between disposable income and consumer demand for retail product. So as the economy picks back up, retailers will benefit, regardless of the market. Moreover, the markets that experienced heavy residential growth due to the condo boom during the last few years, such as Florida and the Carolinas, will now experience the retail infrastructure needed to support the new populous.

SREB: How do lenders view the Gulf Coast areas damaged by Hurricane Katrina and other storms?

Jeffery: Lenders are cautiously optimistic about the Gulf Coast areas as an area for potential opportunity. Clearly, it is important to pursue a premeditated, thoughtful strategy to join in the rebuilding process for the Gulf Coast areas, in an effort to avoid an opportunistic or otherwise irresponsible development plan that ultimately doesn't correspond with the needs of the consumers and the communities impacted by the rebuilding process.

SREB: Please comment on the net lease market. How would you describe the financing for the net lease market and what do you predict?

Jeffery: The net lease market has seen an influx in capital largely in part due to 1031 and TIC sponsors, who are attracted to net lease product because, relative to other real estate product types, net lease real estate is less complicated to own and manage, while providing acceptable returns. However, as a result of the inflow of capital the returns in this market have grown razor thin, and when combined with increasing interest rates, it is not unthinkable that investors may begin looking elsewhere for better returns. Notwithstanding a change in legal status or tax treatment for 1031 buyers, the net lease market will be an attractive home for capital, and should remain a strong place for investment in the upcoming 12 months.

SREB: How does retail lending right now compare with lending this time in 2005?

Jeffery: Largely, the appetite for retail in 2005 was very similar to today, but due to an increasingly competitive landscape for debt, spreads and returns have compressed, both in the Capital Markets and for commercial banks.

SREB: How do you think the retail lending environment will change this year?

Jeffery: Provided the economy continues to experience positive growth, in accordance, the stock market, inflows of capital into the real estate market should stabilize; as cap rates begin to move upward, investors and lenders alike will experience returns consistent with historical levels.

SREB: How will changing interest rates affect the retail lending environment?

Jeffery: A rising interest rate environment will clearly impact investor returns during the coming months. It is not unreasonable that a small portion of this would be absorbed by the institutional investors, lenders and ultimately sellers as cap rates begin to float back to more historical levels.

SREB: What are the biggest factors affecting the real estate financing industry? How so?

Jeffery: One of the major factors influencing the retail financing industry for 2006 will be the stayed compression of cap rates, despite rising interest rates. Because the capital markets (CMBS, REITS, etc.) ,1031 and TIC investors and institutional investors are attracted to retail product, unless given some unforeseen circumstances, the retail market in general should remain a strong product type for real estate investment. Another factor that will affect the willingness of retailers to expand presence and market share by opening more stores will be the performance of the economy. When the economy performs well, and consumer disposable income is high, retailers are optimistic with respect to the opening of new stores. However, when the opposite is true, this impacts the developers ability to secure pre-leasing (a necessity to get conventional lending terms), and can devastate an otherwise feasible business plan. So, how bullish retailers are to new store expansion will dictate the debt markets receptiveness to new product in this year. Lastly — and arguably most importantly — consumer sentiment will play a large part in determining the future direction of the retail industry. As the concept of downtown and central business district retail development, as well as a larger lifestyle centers, takes the retail crown away from mall shopping centers and strip retailers, this will play a large role in determining where the debt market wishes to allocate its loan dollars. 

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