Retail real estate can claim bragging rights. It’s the only commercial real estate property sector to show positive absorption and rent growth over the past year, according to Marcus & Millichap, which hosted "Retail Trends 2003" on Tuesday at the Las Vegas Hilton.

What’s more, retail properties yielded a total return of 14% overall last year followed by apartments (9%), industrial (7%) and office (3%), according to Marcus & Millichap. Meanwhile, the total return for the S&P 500 was a negative 0.2%.

"If you consider the $8 trillion of stock market wealth that we’ve lost over the past 2.5 years, two wars, a tech bubble and a recession and the effect of the 9-11 tragedy, the main story with retail sales is the resilience of the consumer sector and the U.S. economy," says Hessam Nadji, senior vice president and director of research for Marcus & Millichap.

The forum, which attracted a few hundred real estate professionals, included a market overview from Nadji and a panel discussion on opportunities and strategies in a changing market. The three-member panel included Drew Alexander, president and CEO of Weingarten Realty Investments; David Henry, vice chairman of Kimco Corp.; and Michael McCarty, president of the community centers division for Simon Property Group.

Retail rents are currently growing at about 3% annually, estimates Marcus & Millichap, down from the heady days of a few years ago when rents routinely grew 7% to 8% per year. "All of us will take a minimal, but positive, rent growth over the substantial rent declines we’ve seen in other property types," says Nadji.

The economy has been slow to improve primarily because American businesses are still struggling after a severe profit recession. The unemployment rate is at 6% and expected to rise further. "We’ve lost 2.2 million jobs, and 500,000 of those jobs were lost in the last 90 days," says Nadji. "So, the momentum on the job front is negative and continues to be negative. We still have layoffs in the pipeline."

Furthermore, the growth of the Gross Domestic Product (GDP) has been lackluster. GDP in the first quarter registered 1.6%, and in the second quarter it’s projected to be 1.5% to 2%, which is well below the 3% required for the economy to begin to add jobs, adds Nadji. He doesn’t expect a recovery in the jobs sector until 2004.

"We had a very moderate recession, therefore we’re having a very moderate recovery. We have no pent-up demand on the consumer side. Consumers kept on spending right through the recession in a very hot housing market, therefore there is no spark to get this recovery off the ground."

The good news is that consumer confidence is rising and Americans are continuing to refinance their homes, giving them more money to spend on big- and small-ticket items such as home improvements, electronics and gardening equipment. "Our income growth exceeds inflation, which means we can continue to spend."

Making the Case for Retail

Prior to the recession, the conventional wisdom among real estate professionals was that apartments were a strong defensive property type and would withstand the downturn better than other property types. But, in fact, the fundamentals in the apartment sector are weak. Multifamily rental rates have fallen while vacancies and concessions are on the rise. "People are now realizing that retail has a number of merits no one focused on," says Henry of Kimco. "The length of leases is relatively long-term in the retail sector."

Kimco has about 7,000 leases in its portfolio with an average remaining term of 10 years. "That gives you a stability for retail properties. "I think that retail, on a relative basis, looks strong."

It’s a good time to buy higher-quality properties at a premium and sell some of the lower-quality assets, the panel agreed. With interest rates at historic lows, buyers can still pay a premium for the higher-quality properties and lock in a very high-leverage yield, according to Henry. On Tuesday, the 10-year Treasury yield closed at 3.38%, compared with 5.1% a year ago.

Owners should be taking a long, hard look at their portfolio to identify lower-quality properties and sell them while the buying frenzy continues, Henry adds. "The B and C properties are getting caught up with some of the A properties in terms of being attractive from a purchaser’s viewpoint."

Similarly, McCarty of Simon Property Group recommends investors buy solid income streams and prune the portfolio of underperforming assets. McCarty also puts strong emphasis on local market knowledge.: "I wouldn’t buy things in markets you’re not familiar with because there is a lot of local information that you may not be aware of."

Bankruptcy Problem to Ease

A long list of retailers have either filed for bankruptcy or gone out of business over the past few years, including Bradlees, Caldor and Service Merchandise and Kmart. But the panel agreed that the worst is over, particularly for the big-box discounters. "Last year was a rough year getting those boxes re-tenanted," admits Henry. "We don’t see any other large discounters going out of business anytime soon. We’ve also been encouraged that our small tenants have held up well in terms of paying occupancy and rents."

McCarty likens the bankruptcy problem to a boxing match – the last retailer standing wins the fight. One positive outcome of the bankruptcy mess is that retailers have learned to become much more proficient at controlling costs at their stores. "If the retailers get any lift in their sales," McCarty says, "I think they’ll have better earnings."

Weingarten has faced a limited exposure to the bankruptcy problem, according to Alexander. Eight Kmart and five Service Merchandise stores went dark in the company’s portfolio, but Alexander takes the issue all in stride. "Having lived through Texas in the middle and late 1980s, I’m a lot more familiar with the provisions of the bankruptcy code than I’d like to be, but it’s just one of the things you deal with. I’m pretty optimistic that things will get better."

Wal-Mart’s emergence on the grocery store scene is significant, according to Nadir of Marcus & Millichap, because the giant retailer has strong pricing power. Wal-Mart’s costs are 16.5% of total revenues vs. 23% for the industry average. Consequently, the panel expects some stores to go dark and some grocery chains to consolidate, but to what extent remains unclear.

"My family started in the grocery business in 1901. The industry has, and will always be, extremely competitive," says Alexander. "You’ve got to know the quality of the facility, the operations, the occupancy costs, the rent, the sales per square and the barriers to entry."

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