COVER STORY, MAY 2010

RETAIL INVESTMENT OPPORTUNITIES
Despite stumbling blocks, good investments exist.
Bernard J. Haddigan

Though the economy has begun to recuperate from its extended downturn, significant headwinds continue to challenge retail properties. Elevated unemployment, tight credit availability and ongoing weakness in the housing market will inhibit consumption and demand for retail space this year. Developers have responded to the drop-off in tenant demand by delaying, canceling or scaling back projects, and completions in 2010 will decline to the lowest level on record. This year also will mark a shift in the types of projects that come online, as builders shy away from big-box anchored power centers and lifestyle centers in favor of community centers that cater to necessity-based tenants. This trend will continue through the coming years as developers adjust to consumer behavior and the economy mends. Despite slowing completions, vacancies will remain elevated this year as numerous big-box anchor locations remain vacant following several high-profile bankruptcies during the recession, including those of Linens ‘n Things and Circuit City. Grocery stores and other necessity-based merchants seeking high-traffic urban corners, however, have begun to target this space, generating increased leasing potential.

Fundamentals will soften in nearly every market this year as demand remains hamstrung by the economy, but several metros also face lingering oversupply issues. Hard-hit housing markets such as Phoenix, Las Vegas and most Florida metros continue to encounter challenges absorbing retail space constructed ahead of rooftops. In these areas, operators will attempt to avoid having space go dark by discounting rents on new leases and renewals, though not as substantially as last year. As the economy builds momentum in the latter part of 2010 and into 2011, demand should strengthen, while the construction outlook will alleviate supply risks. This may allow fundamentals to begin a recovery in 2011, led by markets with historically tight vacancy rates, such as San Francisco, San Diego and Washington, D.C.

Capital Markets Conditions Remain Tight

Forecasts for weak consumer spending and further softening in retail property fundamentals point to another year of tight financing. Similar to last year, single-tenant assets occupied by strong credit tenants will dominate in 2010 as quality and risk aversion drive lenders’ decisions. Multi-tenant properties will continue to face financing hurdles, particularly lower-quality assets and/or those in secondary and tertiary locations.

While banks will remain the most active source of traditional financing, life insurance companies and conduits will ramp up lending. Life insurers started 2010 with increased allocations to commercial real estate and relatively favorable all-in rates of 6.25 percent to 7.0 percent, down approximately 100 basis points from one year ago. These lenders typically require LTVs in the 50 percent to 60 percent range, however, and exclusively target high-quality deals with strong borrowers. The previously stalled CMBS sector began to show signs of life in late 2009, with a few large, new issues coming to market after the success of Developers Diversified Realty’s $400 million TALF-eligible deal. Unlike the years leading up to the credit crunch, though, CMBS is not expected to resume its role as a primary source of financing, and conduit lenders will need to adhere to strict underwriting to effectively market newly issued debt.

At the start of this year, retail CMBS delinquency neared 5.5 percent nationally and hit double digits in a few Sun Belt and Midwestern markets. These figures will rise further as 2010 progresses and fundamentals continue to weaken, creating difficulties for owners already stretching to cover debt-service payments. Loans originated from 2005 to 2007, a period marked by record-high prices, lax underwriting and above-average leverage, will continue to account for an outsized share of distress. Maturing debt poses some risk, but lenders have become increasingly amicable to loan modifications and extensions. Foreclosures/REOs account for only 2 percent of retail CMBS outstanding and a relatively small share of distressed debt held by portfolio lenders. Most lenders will remain focused on workouts this year, avoiding additional losses as balance sheets heal.

Opportunities Await Investors

Beleaguered by falling retail sales and increased consumer caution, retailers faced one of the most challenging years on record in 2009. The persistence and intensity of the recession generated high levels of store closures and distress, forcing many retail owners to renegotiate lease terms to prevent space from going dark. As a result, forecasting cash flows became increasingly complex, further widening the buyer/seller pricing gap, and a sharp drop-off in the sales of retail properties ensued. With the economy beginning to mend, risks to tenants have abated sufficiently to provide investors a more solid perception of future revenue potential, creating greater clarity for property valuations.

This improved visibility has started to generate acquisition activity for investors targeting top-tier assets. Opportunity investment funds seeking distressed properties also have become more active; however, they have fallen short of targets due to lenders’ preference and need to postpone foreclosures as much as possible. Some buyers, for example, expected last year’s bankruptcy filing by mall giant General Growth Properties to bring a wave of distressed properties to the market, but the company is in the process of restructuring its debt and will likely not have to liquidate core holdings.

Prices have retreated in response to weakening fundamentals and soft investor demand, and valuations will likely take several years to recover from the sharp downturn of the last two years. Pricing divergence by quality and market is significant and will become even more pronounced in 2010. Cap rates for the best multi-tenant properties begin in the mid-7 percent range, nearly 100 basis points lower than the national average, while properties with above-average vacancy rates or near-term lease rollovers may have to be underwritten with cap rates approaching 10 percent to entice buyers. With uncertainty surrounding future tenant demand prevailing, deals where cash flows are most easily assessed, particularly top-tier shopping centers and national-credit single-tenant assets, will comprise the bulk of the transactions in the first half of 2010.

Bernard J. Haddigan is senior vice president and managing director of the National Retail Group of Marcus & Millichap Real Estate Investment Services.

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