Uncertainty reigns.

For much of the past decade the retail real estate industry has been marked by a mood of unbridled triumphalism. Retail sales crested. Property values ballooned. Cap rates shriveled. Retailers drove occupancy rates to extremes as they packed centers to the brim. And developers created the largest pipeline of retail projects under construction in a generation.

Suddenly the future is a scary-looking place.

Damage from the credit crisis emanating from the subprime mortgage mess has not been contained and, in fact, keeps spreading. Credit markets seize on a weekly basis as the world's largest banks announce multibillion dollar write-downs. Meanwhile, rating agencies, scorched by the generous grades applied to subprime mortgage-backed securities and collateralized debt obligations, are changing ratings on trillions of dollars' worth of debt — and not just connected to single-family housing. And bond investors, scared by the confusion, have embarked on the typical “flight to quality” and hitched their wagons to government-backed bonds.

Until that gets sorted out, the devastating consequences will continue to seep into other industries. For retail real estate, the effects are manifold and are affecting every part of the business.

Retailers are hurting as sales fall. That in turn is causing retailers to rethink previously ambitious expansion plans. On the commercial mortgage-backed securities (CMBS) front lenders have scrapped old underwriting standards and even ditched some of the more generous financing packages that had been on offer.

“The state of everything now is nervousness,” says Greg Maloney, president and CEO of Jones Lang LaSalle's Americas retail group in Atlanta. “No one is really sure what to expect.” Marcus & Millichap Real Estate Investment Services's national retail group director Bernie Haddigan agrees. “It could be well into 2008 before we know which way the market's going,” he says.

To be sure, it's not Armageddon. The industry's fundamentals — though weakening slightly — remain robust and are far from the lows the sector has experienced in times of real crisis. Retail sales growth is slowing, but hasn't turned negative. Retailer bankruptcies have only hit home furnishing chains. Moreover, the big REITs remain well capitalized and are carrying manageable debt loads. Further, the long-term nature of retail leases means that even if sales slip, owners and developers won't see any immediate effects from that (though it could affect rental bumps, re-leasing spreads and retailer expansion plans). However, that doesn't mean executives feel good about the current situation either.

But the ironic thing about instability is that it brings about some predicable reactions. Property values on commercial real estate fell during the third quarter, according to the National Council of Real Estate Investment Fiduciaries index of properties sold — the first such drop registered in the index in five years. It's a clear indication that there's disagreement in the market about what properties are worth. As a result, buyers and sellers are at an impasse.

Meanwhile, the pace of development is dropping. Earlier this year Bethesda, Md.-based real estate information firm CoStar Group clocked the development pipeline at 188.1 million square feet — the highest level of construction in at least 25 years. As a result, the number of interested bidders on properties has dropped. And very quietly many development projects are being downscaled or ditched altogether.

And observers also predict there will be some clear winners and losers. With largely sound fundamentals, the big REITs should weather the storm, as will owners of top-of-the-line properties. For smaller players, however, the story may be very different. “The guys that do the one-off deals, they're going to have problems,” says Thomas Engberg, executive vice president of San Francisco-based Capital and Counties Development Group, a new division of Capital and Counties USA.

Development turnaround

In recent years, REITs retreatd en masse from investments and, looking for better returns, focused on redevelopment and ground-up work. Now, however, an oversupply of new construction has reduced yields below 10 percent, in contrast with returns in the mid-teens earlier this decade.

That situation seems poised to shift again in concert with the shifting lending environment. Developers that relied on debt or pursued more speculative projects may find themselves with less work this year as lenders will be more loathe to provide high levels of funding or underwrite centers that don't have high pre-lease commitments.

“The big, well-capitalized developers are going to be out there trying to seize opportunities,” says Engberg. He's heading the new division of London-based Liberty International, which is aiming, in part, to invest about $600 million a year in new opportunities in the U.S., both in ground-up development and acquisitions and by investing in deals with other developers. “This market looks a bit choppy — and that can be a time of great opportunity,” he says.


Take Beachwood, Ohio-based Developers Diversified Realty (DDR). “If some developers we compete with have difficulty financing their projects, we will find opportunities to take those projects over. We will be more aggressive in light of the subprime crisis,” says CEO Scott Wolfstein. Still, that won't be the focus of his efforts. In fact,Wolfstein expects to do a lot of churning next year. “We will be a net seller in 2008,” he says. According to industry observers, most developers will probably follow the same path as DDR, becoming net sellers overall.

As for new development, companies such as DDR, General Growth Properties and Simon Property Group still have plenty of projects in the pipeline. According to Wolfstein, for example, DDR has around $4 billion in domestic and international projects planned. But, analysts and some companies expect construction to slow down. While properties already under construction will continue, those in the planning stages for 2010-2011 will be considerably delayed. “With a surplus of new houses, there won't be as many shopping centers opening to support those homes,” says Nuveen Jaggi, senior managing director for retail services at Los Angeles-based CB Richard Ellis. “New development will be more cautious than in the past.”

Simon Property Group is a case in point. “We would certainly expect some of the new projects that are in various stages of the pipeline to be delayed in their execution,” said Richard Sokolov, Simon's president and COO during a recent investor conference call. Meanwhile, General Growth already pulled out of a previously announced project. In early October, the REIT confirmed it would not pursue development of the proposed one-million-square-foot Pabst Farms Town Centre outside Milwaukee.

What's more, suddenly stringent lenders are requiring higher levels of preleasing, according to Haddigan. He sees a range of 60 percent to 70 percent, compared to the 50 percent to 60 percent more typical of the past decade. “Most developers will build to suit as opposed to spec,” he says.

New projects will mostly be in open-air properties, since it's easier to get approval for their construction than for enclosed malls, predict analysts. Mixed-use will also continue to be emphasized by developers as a whole. Lenders like the projects because of the diverse uses.

But mixed-use projects are also undergoing changes. Developers are cutting out residential components on projects being built now because of the uncertainty in housing. For example, Emerick Cosi, executive vice president of development for Cleveland-based Forest City Enterprises has 13 mixed-use projects in the works. In hard-hit markets such as Florida, he's scaling back the residential part of the projects. “You have to be selective by the market,” he says.

There is a big downside to mixed-use, however, especially in uncertain markets. The buildout takes longer than a single-use property. And with no one quite sure what things will look like in 12 or 24 months, developers pursuing mixed-use may be taking a bit of a gamble and may even slow down the development of such projects to ensure they open in stronger market conditions, according to Jaggi.

The good news for developers planning new construction is that costs are moderating. The Producer Price Index for construction materials and their components fell by 0.2 percent between the second and third quarters of 2007, yielding a year-over-year change of 1.2 percent from September 2006 to September 2007, according to REIS Inc., a New York-based real estate information company. That compares to a 6.1 percent increase in 2005 and 4.3 percent in 2006.

Some analysts predict that the big focus will be a renewed emphasis on redeveloping existing properties. In a recent conference call with analysts, Simon's CEO, David Simon, pointed to a $3 billion to $4 billion redevelopment program in the works. “It's very easy to underwrite, you know what tenant demand is going to be and not only do you add value from the redevelopment, but you add value from the existing asset,” he said.

Private equity hiatus

Perhaps the most striking feature in the market recently has been the sudden halt of the private-equity-fueled acquisition frenzy during the past several years, as access to cheap debt has dried up — and that's likely to continue. That's slowed investment activity both at the property and company level.

For the first three quarters of 2007, the total volume of transactions was slightly higher than the previous year. But, analysts expect that to fall precipitously over the next six months. “Activity has slowed dramatically in just the last month and a half,” says Richard Latella, senior managing director of New York City-based brokerage Cushman & Wakefield Inc.

In the third quarter of this year, for example, there were $14 billion in transactions, the same amount as the year before. About half that amount, however, was in July, according to Dan Fasulo, director of market research for Real Capital Analytics. In fact, about 63 percent of respondents to a recent survey conducted by Chicago-based real estate law firm DLA Piper reported that they had delayed or cancelled commercial real estate transactions because of the credit crunch. And, 61 percent anticipate that it will take as long as 12 months before the real estate markets stabilize.

Making matters worse, there seems to be a standoff between buyers and sellers — and that's predicted to last for another three to six months. On the whole, buyers' and sellers' expectations are worlds apart. “Sellers want early 2007 prices and buyers want 2008 prices,” says James Spitzer, a partner with Holland & Knight, a New York-based law firm. That reaction has stalled activity even further.

The few deals that are being made are going at much lower amounts than expected — a 10 percent to 15 percent decrease over the past six months, according to Latella. “Buyers are having trouble getting funding and are able to negotiate a lower price.” Jason Lail, senior research analyst in the research group at SNL Financial, points to Gramercy Capital's acquisition of American Financial Realty Trust for about $3.4 billion.

“I was pretty shocked at the price,” he says. According to Lail, the price is a 29 percent discount from the 52-week high, while most deals traded at a 5 percent to 10 percent discount from 2006 to 2007. He expects such deflated prices to continue throughout much of 2008.

The secret to success will lie in the locations investors select. “Investors are going to need to be smarter about the markets they choose to invest in,” says Fasulo. “It's a city by city type of situation.” That means that the strongest markets — on the East and West Coasts, in New York, Los Angeles and the Pacific Northwest — are likely to remain strong, while tertiary and B-caliber areas will be hurt. “Quality property in top locations have been little affected,” says Latella. As a result, while the spreads between class-A and class-B level properties have been close recently, that is changing. Cap rates in those places have seen up to 25-basis-point increases, according to Latella. In less desirable markets, cap rates have taken more of a hit. They're at 50 to 100 basis points, according to Latella.

In addition, as more investors target the same class-A properties, the number of available places is likely to decrease. “A year from now, you'll see the supply of class-A products dwindle,” says Jaggi.

There will also be an increase in REIT joint ventures, which were up 26 percent for the first half of 2007, according to Latella. They'll continue to partner with foreign investors, as well as institutional investors, like pension funds.

“When money is tight we have to turn to institutional partners who understand the risks and have the capacity to step in quickly,” says Wolfstein. DDR is looking at “dozens” of these relationships, similar to last year's joint venture with TIAA-CREF's real estate group. In that deal, the partners purchased a portfolio of 67 community retail centers for about $3 billion of total asset value. Then there are new players, like Engberg's Capital and Counties Development Group, which plans to do equity deals with developers.

Lenders are also likely to continue reducing the amount of money they'll fork over and requiring more stringent terms. Spitzer expects to see terms of 75 percent against loans, versus the 60 percent to 65 percent of recent years. At the same time, however, commercial banks, pension funds and life insurance companies are stepping in to “fill the void,” says Latella.

“Over the last five years pension funds have increased their target allocation to real estate — and that will increase even more going forward,” says Brad Case, vice president of research and industry information at the National Association of Real Estate Investment Trusts. Investment from foreign investors is also likely to step up. But, that will also slow down the time it takes to do deals, since such institutions typically don't move as quickly as other lenders.

Whither the consumer?

The big question mark, of course, is where the consumer is going.

The pressures that have mounted on consumers for years have finally reached a tipping point and retail spending is dropping. Consumers have lost the $600-billion-a-year subsidy in the form of new home equity lines of credit. Instead, there are estimates that 2 million homes will be in foreclosure by the end of the year. And without the safety blanket of appreciating housing prices, Americans have become more debt-averse and have cut back on credit card spending as well.

Retail sales slowed in October, rising by 0.2 percent, according to the Commerce Department, compared to 0.7 percent in September. Already, vacancy rates of neighborhood and community shopping centers have increased by 10 basis points to 7.4 percent in the third quarter of 2007. That's the tenth consecutive quarter of flat or declining retail occupancy, according to REIS, the result of “retailer hesitancy to sign leases.” It should hit 7.7 percent in 2008. Projects in newly developed suburbs where home buyers haven't materialized have been particularly hard hit. “The markets that are going to remain strong are markets that haven't overbuilt,” says Fasulo.

What's more, growth in non-anchor tenant asking rents slowed for the fourth consecutive quarter, to 0.6 percent; the effective rent increased just 0.4 percent. Through the end of 2008 effective rent growth will trail asking rent growth. The former should rise 2.7 percent compared to 3.1 percent for the latter. In general, “Rents will see a modest growth, but generally will be flat in secondary locations,” says Haddigan.

Vacancy rates in power and regional center have held steady. But some analysts also foresee a slowing of leasing in regional malls over the next year. “Leasing activity happens early on in a construction cycle, so many leases were signed when the market was robust,” says Sam Chandan, chief economist at REIS. “The vacancies will come later.” When retailers seek to renew, they may ask for different terms or more concessions.

In general, there's also a possibility that centers with grocery stores, drugstores and the like may ultimately fare better than power centers. That, of course, is because consumers feeling the pinch are less likely to cut back on purchasing necessities than on the kind of goods sold at other malls. In addition, shopping centers may start switching to anchors such as grocery stores as opposed to big-box retailers.

At the same time, not everyone thinks that a slowdown in sales is bad news for developers. Leases — which, of course, provide the vast majority of income — span a three- to five-year term. As a result, he argues, REITs aren't likely to feel the pinch. “It's probably going to be a rough Christmas. But we don't think that will have a dramatic impact on tenants' decisions,” Wolfstein says.

Still, even if he's right, 2008 will be a year for living cautiously for just about everyone in the industry. “Developers will need to spend more time analyzing the marketplace, making sure they have the right tenants and the right investors,” says Jaggi. “They'll have to be more strategic in all their efforts.”