For years everyone connected to retail real estate has been saying that the good times couldn't last forever. But no one predicted the downfall could look like this.

Today, the biggest question marks facing retail real estate all emanate from the rapidly deteriorating housing market. Consumers are hurting and unable to pull equity out of their homes to fund purchasing habits. By some estimates, 2 million homes will be in foreclosure by the end of the year.

At the same time, some companies that got burned playing in the mortgage market — most notably Capital One — have started jacking up interest rates on their credit cards. Toss in higher gas prices and you have an extremely overburdened consumer.

That's not all.

The contagion from subprime mortgages has not been contained, contrary to what Federal Reserve Chairman Benjamin Bernanke claimed months ago. Entities no one expected to be affected — like Bear Stearns, Macquarie Bank and other major financial institutions — have taken big hits. Panicked bond investors have dumped securities indiscriminately (including CMBS) and fled for the safe haven of 10-year Treasuries. Pricing and terms on financing and loans changes on a daily basis. Borrowers are either balking at the new terms or else taking a step back and waiting until things settle down a bit (see p. 38).

By late August, the Federal Reserve had calmed markets. It released billions of dollars a day to ease the stock market. It also opened the “discount window,” dropping the primary credit rate by 50 basis points to 5.75 percent from 6.25 percent.

There's also a big question hanging over the commercial side of the equation. So far, there has not been a parallel to the subprime fallout in the CMBS sector. But troubling signs do exist. CMBS vintage years 2005 and 2006 have seen delinquencies rising at a faster clip than previous years. Moreover, CDOs that owned CMBS also owned subprime mortgages. They've been trying to sell CMBS to cover margin calls. But in a market where bond investors are spooked, there's a lot of supply and not many buyers stepping forward.

The saving grace for retail real estate remains the industry's solid fundamentals. Across the country property values remain high and vacancies remain relatively low — even if they have crept upward a bit (see p. 97).

It will be interesting, though, to see if that worldview holds true given that the industry will deliver a record 188.1 million square feet of space this year. For now, that space is committed. Most retailers have long finalized 2007 openings and been working out where they're going to put stores in 2008 and 2009.

However, there has been more talk of late of retailers slowing expansion plans. Firms as diverse as Wal-Mart, Office Depot and P.F. Chang's have all announced slowdowns. At the same time, there are loud rumblings coming out that this holiday season may be a weak one. The industry has been blessed in recent years in that there have been few bankruptcies and store closings for several years in a row.

If retailers are on the brink, which they seem to be intimating, that could change the demand picture radically in just a few short months. Rather than looking to expand more, some may look to contract.

So is it time for the panic button?

Not yet. But these next few months — as the credit markets get sorted out, and as we see what happens during the holiday shopping season — will tell us a lot.