Eighteen months ago, Joshua Weinkranz's phone was practically ringing off the hook with calls from tenants looking for space in Kimco Realty Corp. properties.
Now, however, while vacancies remain extremely low — the REIT's occupancy levels were at 96.3 percent as of December 2007 — finding a tenant for just one dark storefront, depending on the location, can be a chore. Weinkranz, vice president for the Northeast region of New Hyde Park, N.Y.-based Kimco, can no longer afford the luxury of being too picky when it comes to renegotiating leases. Facing slowing sales and reluctant consumers, hard-pressed retailers are asking for all kinds of concessions, from more free rent to lower annual increases. And, often, Weinkranz meets those demands, even occasionally agreeing to flat raises in rent for as long as 10 years. What's more, becauseare taking longer to hammer out, he's willing to make concessions if a tenant will sign sooner rather than later. “It's not worthwhile trying to hold out for another dollar a foot,” he says. “A bird in hand has a lot of weight these days. Who knows what might happen tomorrow?”
That, in fact, is a question on the minds of just about everyone in the retail real estate industry. As the housing and credit crises create ever-more havoc throughout the economy, the engine that has fueled growth over the past five years — consumer spending — is finally slowing down. And that spells major trouble for the industry, from retailers to developers and investors. Housing prices are plummeting throughout the country, down 18 percent from their peak in 2006, wiping out $416.3 billion in household wealth in the process. Even more harrowing is the fact that currently 9 million homeowners are now in negative equity positions, meaning they owe more on their mortgages than their houses are currently worth.
At the same time, oil prices, at more than $110 a barrel, are at a record high creating inflationary pressures on food prices and other staples. Plus, hourly earnings have stagnated and unemployment is rising. Not surprisingly, consumer confidence is at a 35-year low — and recent retail sales have declined. The bottom line: “We're experiencing an economic downturn that's being led by a slowdown in consumer spending — and retailers are on the front lines,” says Scott Anderson, senior economist with San Francisco-based Wells Fargo. “They're going to bear the brunt of it.”
Indeed, developers and investors have already started feeling the effects. Hardest hit are smaller developers. But with credit difficult, or impossible, to come by for everyone, new ground up development has slowed to a crawl. “Our development deliverables for 2008 will be lower than in recent years,” says David Oakes, executive vice president and chief investment officer of Cleveland-based Developers Diversified Realty Corp. The total amount expected to be brought on-line this year, including developments held in joint ventures, is $126 million, compared to $164 million in 2007.
Most companies, including cash-rich REITs, will devote more attention to redeveloping existing sites rather than building ground-up. In addition, except for top-of-the-line properties, developers are being forced to make concessions to tenants, including what amounts to effective rent decreases. As for transactions, they're at a standstill, as sellers generally refuse to budge on prices.
Will it get worse?
Is this the tip of the iceberg? The answer to that question lies in just how bad the economy is — and how much worse it might get. While naysayers have insisted for months that we haven't yet met the generally accepted definition of a recession — two consecutive quarterly declines in GDP — in early April, Federal Reserve Chairman Benjamin Bernanke announced that he expects the economy to contract in the first half of the year. Other economists say, regardless of whether or not we meet the traditional definition, we're already in what could be called a recession.
The National Bureau of Economic Research is the official arbiter of whether or not the economy is in a recession. It “looks at a number of statistics — a general downturn in unemployment, retail sales and building. It's the combination of these metrics that determine the answer.” By that definition, according to Anderson, we probably entered a recession earlier this year. Further, the International Monetary Fund in its latest World Economic Outlook expects U.S. GDP to shrink in every quarter of 2008. By the fourth quarter, it is projecting the U.S. economy will have shrunk by 0.7 percent.
Consider these figures: First, there's the downturn in the housing market, fueled in large part by the subprime fiasco and skyrocketing foreclosures. In January, the Standard & Poor's/Case Shiller Home Price Index, considered to be the bellwether indicator of housing health, was down 10.7 percent from the year before.
Then there are jobs. Private-sector employers cut 98,000 jobs in March, largely in manufacturing and construction, the most in five years and the fourth consecutive month of losses. Overall, the U.S. economy shed nearly a quarter of a million jobs during the first three months of the year. On the positive side, those are fewer job losses than in previous U.S. recessions when the pace of layoffs has been in the 150,000 to 200,000 job range.
Initial claims for unemployment benefits reached 353,000 in March, which, according to Sam Chandan, chief economist of Reis Inc., the New York-based commercial real estate information firm, suggests employers have already started to slow their hiring. And, while the rise in the national unemployment rate — to 5.1 percent from 4.8 percent — may not seem alarming, it's actually misleading, since the number doesn't count the ranks of the discouraged: people who've simply stopped looking for work. In addition, those figures ignore the proportion of individuals who don't have jobs. For men in the prime working age group of 24 to 55, it's 13.1 percent, according to the Labor Department, the second time since World War II to reach that level. There's more: An estimated 28 million people are projected to receive food stamps this year, the highest number since the program started in the 1960s, according to the Congressional Budget Office.
The key element: It's the consumer, stupid. At a whopping 70 percent of GDP, personal consumption has become the ultimate workhorse of the economy. Now, consumer spending has finally started to fall. It rose by just 0.1 percent in February, following a 0.4 percent increase in January, the poorest showing since September 2006, according to the Commerce Department. Adjusted for inflation, spending was flat, the third straight month of sluggish activity. In February, retail sales decreased 0.4 percent from January; sales, excluding automobiles and auto parts, fell 0.2 percent. However, in March, retail sales rose 0.2 percent from the month prior.
Inflation has further eroded spending power. Both core prices, which exclude food and energy costs, and consumer prices increased 0.1 percent in February. For the year, core prices have gone up 2.0 percent and consumer prices have risen 3.4 percent. That comes on the heels of 2007, when overall consumer prices rose 4.1 percent and core prices rose 2.4 percent. At the same time, real hourly and weekly earnings fell by about one percent in 2007, according to the Economic Policy Institute, a Washington, D.C.-based research group.
With all the bad, not surprisingly, consumer confidence dropped significantly in March, down to 64.5 from 76.4 in February, according to the Conference Board. Most ominously, the expectation indexing consumers' outlook for business conditions, the job market and their income prospects reached a 35-year low. According to the Reuters/University of Michigan survey, consumer sentiment is near its lowest level since 1992. And that could create a vicious spiral: As consumers become more fearful, they'll spend even less, causing more job cuts. “Consumer confidence will be eroded further, slowing consumer activity, undermining expansion and supporting further cutbacks in hiring and investment by business,” cited a recent Reis report.
In for the long haul
How long will it last? According to some observers, despite the intense pressure on consumers, strong market fundamentals mean that the pain should be short-lived. “I expect we'll start rebounding by early fourth quarter,” says Greg Maloney, CEO and president of Atlanta-based Jones Lang LaSalle Retail.
Maloney also points to aggressive rate cuts by the Federal Reserve, something the Fed didn't do during the harsh recession of the early 90s. As it stands, real interest rates are now close to 0 percent. Ideally, this will stimulate businesses to borrow and invest and create jobs. A recovery by the end of the year will also match the pattern of the last two recessions, which each lasted eight months. However, many observers think the pain could be spread longer than that.
The industry is also eagerly looking forward to benefiting from the government stimulus package. Overall, $105.7 billion is being sent to taxpayers in checks going out starting May. Anderson predicts that even if 20 percent of that is spent, it will be enough to boost GDP a bit.
At the same time, many of these same economists also contend there's a good chance this will be a longer and deeper recession, lasting well into 2009 or later. For one thing, some studies show that many consumers plan on saving their tax rebate or using it to pay off debt, instead of spending it on, say, new TV sets. That's even true for more affluent people. For example, 27 percent of households making more than $100,000 surveyed in a recent study said they intend use their check to pay off debt, according to Unity Marketing, a research group in Stevens, Pa. About 60 percent of respondents reported they will receive a rebate. There's also the matter of home equity lines of credit, which had been providing consumers with approximately $600 billion a year in extra pocket money that has been wiped out. The loss of access to those funds could easily dwarf whatever windfall could come from the tax rebates. (For more on the effect of the stimulus checks, see page 242.)
What's more, according to Anderson, despite the Fed's actions and the federal stimulus package, the indications — low consumer confidence, real estate declines, tighter bank lending — point to a long-lasting recession more like the slowdown of the early 90s. During that so-called jobless recovery, it took two years or more before employment picked up and, in some cities, as long as six years before the housing markets recovered fully.
Another factor hurting sales is the so-called negative wealth effect. During both the tech boom and the housing bubble, consumers were encouraged to spend because of rising stock prices and rising house prices, respectively. Today, with housing values collapsing, consumers are increasingly saving. In fact, the savings rate in the U.S. has moved out of negative territory where it bottomed out in 2006 and is now up to 0.3 percent.
The end of that wealth effect also means the death knell for another seemingly unstoppable retail phenomenon: mass luxury, in which middle-class consumers shelled out money to buy high-priced discretionary goods. “When the stock market is up and housing is up, even if you're middle income you feel you can buy,” says Suzanne Mulvee, senior real estate economist for Property & Portfolio Research (PPR). “Now, luxury for the masses is over.” In February, Neiman Marcus posted its first monthly comparable sales decline in five years. And, in March, Saks Inc. chairman and chief executive Stephen I. Sadove told analysts the company expects “to continue to face an increasingly challenging macroeconomic and promotional environment in 2008 and we are taking a more conservative approach to planning the business for this year.”
Still, not all sectors are alike. “It is not correct to paint retail with a broad brush,” says Abigail Marks, a retail economist with Torto Wheaton. Nonhousing related retail sales, according to Marks, have been growing, though at a slower rate. “They're not going gangbusters but they are accelerating,” she says. And, it's likely that centers with discount chains and wholesale clubs and the like will fare better than others. According to Michael Winters, vice president of acquisitions for Cedar Shopping Centers, grocery chains, which generally do better in recessions, are expanding nationally, and his company has a pipeline of $400 million in grocery-anchor developments.
Impact of store closings
For developers and owners, it spells a tougher environment all around. Take the matter of leasing. A number of major companies — the Sharper Image, Lillian Vernon Corp. and Bombay Co. declared bankruptcy recently and a litany of others have announced store closings and restructurings. There were 2,600 store closings announced in the first two months of the year, the most since 2004, according to PPR. Earlier in the year, Ann Taylor announced that it would close 117 underperforming stores between 2008 and 2010, Liz Claiborne shut down 54 Sigrid Olson shops, and Talbots announced closings of its Talbots Mens and Talbots Kids lines, in addition to shutting 22 stores and, more recently, announcing a major restructuring.
While those numbers are within historic norms, they are also misleading, according to Mitch Salmon, senior vice president leasing for Mall Properties Inc. “That doesn't take into consideration the cumulative effect of prior years,” he says. “So you're working off a lower base in the number of tenants.” What's more, stronger chains may open up new stores simply to grow the top line, most likely hurting sales of other retailers and leading to more store closings, according to PPR. In addition, even Wal-Mart changed its plans for new Supercenter stores at the end of last year, when it revised its earlier estimate from 350 openings down to 200 for 2008 and 155 a year for 2009 through 2011. Most of the retailing giant's attention will be on conversion or redevelopment of existing discount stores.
Managing the property
Vacancy rates also do not bode well. Rates in neighborhood and community centers were already up at the end of the first quarter of 2008 — 7.7 percent compared to 7.1 percent in 2006. That's the highest level since 1997 and the eleventh straight quarter of flat or declining retail occupancy, according to Reis. According to Marks, during that time, developers built too much supply, especially in areas where new housing developments failed to attract buyers, at the same time consumers were hit hard by rising gas prices. While Marks expects better results for 2008, thanks to a lower supply of new properties, that's not a view shared by everyone. Reis, for example, forecasts an 8 percent vacancy rate in 2008 for neighborhood and community centers.
What about rents? According to Marks, gross effective rents haven't come down. But, “once leases come up for renewal, owners aren't going to have the bargaining power they once had,” she says. In fact, for neighborhood and community centers, while effective rent for 2007 was up 2.4 percent, the pace of growth will slow to 1.6 percent for 2008, according to Reis.
For retail REITs a recession of as long as 12 months would have little impact, according to Richard Moore, an analyst with RBC Capital Markets, because their tenants are locked into leases. And, so far, at least for the fourth quarter, FFO at the big regional REITs mostly showed year-over-year growth. Still, Moore concedes that a recession of 18 months or more would mean a different story. What's more, although leases at regional malls are drawn up earlier in the development cycle, there are signs of trouble ahead. Regional mall vacancy rates increased by 30 basis points in the fourth quarter, to 5.8 percent from 5.5 percent. That's the highest level in three years, according to Reis. And, with little wage growth, higher unemployment, and continued lackluster consumer spending growth, vacancy rates are likely to rise and “effective rent growth will trail asking rent growth,” says Chandan. While asking rents will grow 2.4 percent in 2008, effective rent growth will be just below 2 percent, according to Reis.
In fact, Kimco's Weinkranz isn't the only one bending a little — or a lot — on leases or trying to move deals along as fast as possible. At Developers Diversified, says Oakes, “We're trying to get our leases done earlier rather than consistently holding out for the last 50 cents on the dollar.” According to Oakes, they're approaching tenants as long as nine months away from lease expiration dates, “to put as much risk to bed as possible.”
At the same time, despite their best efforts, many companies find negotiations are taking longer than before. Steve Ifshin, chairman of DLC Management, headquartered in Tarrytown, N.Y. points to one recently inked lease that took nine months to complete. And, in many cases, while owners aren't lowering rents, the concessions they're offering are resulting in what amount to rent decreases for tenants.“We pay a lot of attention to micromanaging how we can keep retailers in place — potential rent reductions or other concessions to help them through this process,” Ifshin says.
Those efforts also include other kinds of aid as well. Albert Jay Krull, director of the Englewood, N.J.-based the Real Estate Equity Company, LLC., for example, says he has helped with spot marketing for certain tenants needing assistance with their advertising budgets. He's been keeping an eye on how retailers are doing and taking the initiative to approach those that seem to need a helping hand.
Other companies are closely watching their spending, even monitoring such expenses as sweeping and maintenance work. Kenneth Breslin, president of Breslin Realty Development Group, in Garden City, N.Y., recalls that his director of property management recently warned him about spending too much on capital improvements, “given that some of them are improvements we amortize into CAM,” he says. “We really have to balance maintaining the property and maintaining the tenants.” (For more on today's leasing challenges, check story on page 170.)
The environment for transactions is also tricky. For now, sales, at least in secondary and tertiary markets, have “slowed to a trickle,” says Maloney. In top-of-the-line markets, speculative activity by buyers looking for a quick buck has also stalled. This lack of activity partly reflects a disconnect: a refusal by sellers to lower their prices and buyers' more stringent due diligence and demand for more favorable deals. It's a buyers' market, but sellers don't seem to realize that yet. In February, for example, retail properties worth about $1.1 billion were acquired, the lowest level in four years, according to Real Capital Analytics. The month before, sales transactions totaled $2.2 billion. (For more on the bid-ask gap, see story on p. 146.)
An inability to get financing is one of the main reasons for the stalemate, due to the precipitous decline of the commercial mortgage-backed securitesmarket. About $30 billion in new CMBS bonds should be issued in 2008, compared to $230 billion the year before. At the same time, spreads and cap rates are widening. Cap rates over the last nine months moved from 25 basis points for class-A properties to as high as 150 for the weakest, according to Richard Latella, managing director of the retail industry group for Cushman & Wakefield. Community and neighborhood centers had rates of about 50 to 75 basis points. That's likely to get worse, as prices on properties decrease.
What's more, foreign investors might not be able to fill in the gaps. The reason: International financing could decline as the dollar loses more value against other currencies, since that is likely to make the value of those investments appear to have fallen. As a result, foreign investors are likely to snap up properties only in primary markets where they can be sure they'll find a buyer, if necessary. (For more on international investors, see page 154.)
Financing for small developers, of course, is the most problematic. Indeed, the properties in the most precarious position are probably class-B and class-C sites. For that reason, Oakes of Developers Diversified expects to step up partnerships with struggling smaller developers unable to find financing or attract enough leases. Like other bigger players, Oakes is also turning to insurance companies to secure debt. The company recently closed on a $350 million five-year loan at a 5 percent rate to finance their 2008 activities. Still, owners with plenty of cash, such as Simon Property Group, Macerich and Kimco, are in a better position than others, according to Moore, since companies are also using more equity financing than before.
For example, Ross Glickman, chairman of Urban Retail Properties, points to two recent purchases, the 1.5-million square-foot Oakland Mall in Troy, Mich., and the 392,000-square-foot Manhattan Tower Center in Manhattan Kan., which were bought for an undisclosed sum. “We had to finance the debt side and buy on the equity side,” he says. “We had to go to both sides of the equation.”
Thanks to the uncertain financing environment, development is also at a standstill. Generally, projects that have already been started and have leasing commitments are going ahead. But, brand-new ground-up development is another matter. In a recent analyst conference call, David Simon, CEO of Indianapolis-based Simon Propery Group, indicated the company would delay construction on some projects because of slower retail sales. Similarly, Most retail REIT activity will be aimed at redevelopment and improving core properties.
Where do we go from here?
One likely outcome of the current decline is more consolidation in the industry, as bigger investors and other players snap up struggling ones. “Our company is looking for ways to position ourselves for growth,” says Maloney. The firm has made a handful of acquisitions so far this year, according to Maloney. Companies with enough muscle may also step up international expansion. Urban Retail Properties, based in, for example, just announced a joint venture with Long Runn Investment Group, a Shanghai-based development specialist, to do commercial property consulting, development, leasing and property management. Oakes points to the company's moves to expand into Brazil, Russia and Canada.
Of course, the ultimate question mark is just how widely the subprime contagion may spread. If the Federal Reserve's March bailout of Bear Stearns is just the beginning of many such crises — or losses spread to credit card or other financial services sectors — then all bets are off. In that worst-case scenario, Kimco's Weinkranz and a host of others in the industry may find that giving away more free rent is the least of their worries.