It all depends on the consumer. And the consumer is not looking like somebody you can really count on. After heroically propping up the economy for most of 2002, American families turned cautious as the summer wound down and talk of war with Iraq grew louder. Back-to-school sales were disappointing, and October same-store sales only showed spotty improvements. Even mighty Wal-Mart saw same-store sales climb only 3.6% and 3.7% in September and October, and it reported third-quarter earnings below Wall Street estimates.

The signs of a consumer slowdown multiplied throughout the fall season. As retailers and owners of retail real estate were bracing for what some analysts say might be the weakest Christmas in a decade, in October the Conference Board reported the biggest drop in consumer confidence since 1993 — from 93.7 to 79.4. Despite some upbeat news in November, including stronger retail sales growth than expected (a 0.7% gain vs. the predicted 0.2%), the overall tone heading into Christmas and 2003 was wary at best and pessimistic at worst. “I don't think there's going to be a substantial turnaround until 2004,” concludes Robert Welanetz, president and CEO of Jones Lang LaSalle Retail. “I think 2003 is going to be a very soft and cautious year.”

So, how will 2003 shape up for retail real estate? Shopping Center World looks at the issues from two vantage points that are essential to our readers — from the stores and from the malls. The view of 2003 in retail starts on p. 19. The forecast of trends for mall owners and developers begins on p. 24.

Retail: A Shadow of the Old Shopping Boom?

Suddenly, the outlook for retailers — and the owners and developers who provide their selling spaces — has dimmed. “It's a very tough period in retail, especially since you consider that we're up against horrible numbers against last year,” says Webber Hudson, president of leasing and marketing at Urban Retail Properties.

What makes retailers nervous is the possibility that the consumer spending streak that has continued through boom and bust is now exhausted. Because of super-low interest rates, consumers who might have pulled back a year or two ago continued to spend. But there are limits. At this point, economists say, most of the consumers who could take advantage of low rates to buy a first home or refinance an older one have done so — and used any freed-up cash to buy what they want.

And there is just plain consumer fatigue, says Wendy Liebmann, founder and president of WSL Strategic Retail. “After five or six years of extraordinary shopping, there's no pent-up consumer demand,” she says. Nor does she see any new merchandise that would make a difference. “There's nothing very new or innovative that we absolutely must have.”

There is another factor that could complicate the retail picture going forward, according to Mike Green, vice president of Cap Gemini Ernst & Young's retail practice in the United States. He fears that some of the young consumers who kept retail strong are now beginning to face up to the realities of their first real economic downturn. “You have to remember that a large portion of the consumers have never been through a recession,” he says. “I'm talking about people who are in their late twenties or early thirties and have spent a lot of money. In the 1990s they continued to spend even if they were unemployed. The general malaise in the economy is finally coming home to people that this is real and it might be here for awhile.”

Only an improvement in the economy will make cautious consumers head back to the mall, says Richard Moody, a senior economist with Economy.com. “We're going to have to see a lot more improvement in the labor markets,” he says. Unemployment remains stuck at just under 6% and layoffs still loom large in the public psyche. Outplacement firm Challenger, Gray and Christmas Inc. reported that planned job cuts announced by U.S. companies totaled 176,010 in October, compared to 70,057 in September. These numbers come on the heels of falling factory orders in September, down 2.3%, or $7.4 billion, to $318.1 billion. And although the GDP (two thirds of which is consumer-driven) grew 3.1% over the recessionary third quarter of 2001, Economy.com now predicts a tepid recovery with GDP gains falling to 2.4% in the first quarter and hitting 2.8% in the second. Growth might tick up to 3.3% in the third and 3.9% in the last quarters of 2003. But, Moody adds, “If these aren't the numbers, then they're more likely to be lower than higher.”

The Move to Value

Whether consumers are cutting back sharply, becoming more cautious or are uninspired by the merchandise, the environment is sufficiently challenging that even the discounters, which have benefited most from stable consumer spending in the past couple of years, are looking vulnerable.

To be sure, chains such as Wal-Mart are still better positioned than traditional department stores as consumers try to squeeze more merchandise out of every shopping dollar. “We've moved from a world that's all about ‘good, better, best’ to one that, for a lot of consumers, ‘good enough’ is what it's all about,” says Lois Huff, vice president of retail consultancy Retail Forward.

But the discount phenomenon has been so successful that incremental growth is getting harder. As Wal-Mart, Target and other big boxers look for new places to build and/or expand, they frequently meet rising community opposition (see “Big boxers have big expansion plans,” page 45). And at least one department store chain — JCPenney — is showing signs of renewed vigor. Wal-Mart, Target and Kohl's reported low single-digit same-store sales gains in September. Kohl's bounced back in October, with a same-store sales increase of 18.3%, but the others did not. However, in October JCPenney surprised investors with a 13.7% same-store sales increase and it more than doubled its earning per share in the third quarter.

If Penney can fight back, perhaps there is hope for other retailers who have lost so much ground to the discounters. Certainly, these companies are trying, emulating such innovations as Wal-Mart's supply chain and even some of its store layout tricks. Federated's “reinvent” strategy, implemented in 42 preexisting and new stores in mid-November, incorporates discount store features such as shopping carts. At the same time, the Kohl's-ification of retail design can be seen in experiments by Federated and Radio Shack with centrally located and supermarket-style cashwraps, as well as Sears' prototypes of freestanding stores.

Assuming a soft retail climate — not a plunge — Welanetz of Jones Lang Lasalle says he does not predict a rise in retailer bankruptcies this year. That's mainly because the weakest players have already succumbed. However, he adds: “All bets are off after the first of the year if anything occurs like a launch of activity against Iraq.”

When Strong Consumer Segments Turn Weak

While it may be difficult to get a clear handle on how macroeconomic and geopolitical events will affect consumers in general, retail executives are seeing changing sentiment in some key demographic segments. For example, the message for Gen Y specialty retailers seems clear — their clientele is feeling the pinch. In interviewing 710 teenagers across 10 states, U.S. Bancorp Piper Jaffray analyst Jeff Klinefelter found that estimated yearly spending among teens was $1,154, down from $1,536 in fall 2001. Apparently, financially stretched parents are cutting allowances: Klinefelter's survey of 200 parents showed that parents contributed $935 yearly to their children's spending, against $1,015 in fall 2001.

This is bad news for 2003 for retailers such as American Eagle Outfitters and Aeropostale, whose shares reached 52-week lows in October. On the other hand, the tighter budgets could favor new store concepts, like Five Below, which sells candy, bath and beauty products, furnishings and other non-apparel items for teens, all of which will be tagged at $5 or less. The first Five Below location opened in Wayne, Pa. Gateway Shopping Center, and the second store opened in the King of Prussia Mall on November 1.

At the older end of the 17- to 25-year-old Gen-Y cohort, there is another phenomenon that could hurt the Aeropostales of the world. These young adults are beginning to veer toward the home furnishings stores. “They're entering the household establishment phase,” says Huff.

These new customers, however, may not be enough to keep home furnishings hot, says Geoff Wissman, also a vice president of Retail Forward. Post-9/11 anxiety and the booming housing market kept home furnishing stores hopping in 2002. “In the coming 6 to 9 months you'll continue to see a lot of activity in terms of home improvement, home furnishings and those types of products.” But, he warns, there's not enough demand left to keep sales growing at the 5% to 9% rate of recent years. “I think we're going to see some pullback there in the second or third quarter next year.”

If Wissman is right, expect to see more intense competition between Home Depot and Lowe's. Wissman says that Home Depot will see the greater risk in 2003, because “Home Depot is reaching market saturation, and cannibalization. And there's some fairly compelling evidence that a certain portion of the population, particularly female shoppers, prefers Lowe's.” He believes that international expansion will be more important to Home Depot next year than its ventures into new urban and garden center formats.

In sum, 2003 is shaping up to be a year of uncertainty — a time when it's going to be more difficult to squeeze out same-store sales gains and when bold expansion plans may move to the back burner. No retailer or developer is assured a smooth ride, even those with supposedly recession-proof operations.

2003: A View from the shopping centers

The retail real estate industry led a charmed life in 2002. Despite the recession and serious setbacks to key retailers such as Gap Inc. and Kmart, operators of retail real estate saw healthy returns and retail REITs were the toast of Wall Street. But, heading into 2003, the question for the industry is whether it can avoid some of the pain as tenants wait for consumers to pick up the pace again.

So far, evidence of stress in retail real estate is still anecdotal. Lehman Brothers managing director David Shulman points out that despite signs of serious erosion in consumer confidence, same-store sales are the numbers that count. And so far, those numbers have only been lackluster to middling — not alarming.

So, investors continue to snap up retail real estate and despite scattered reports of rising vacancy rates in some strip malls, for example, the overall numbers remain healthy. In 2002's third quarter, according to real estate information firm Reis Inc., neighborhood and community shopping centers saw a 7% vacancy rate, and regional and super-regional malls stand at an average vacancy of 6%, versus 6.3% and 5.8%, respectively, last year. However, while strip centers have seen stronger rents for non-anchor spaces, in-line mall rents have decreased, year over year, from $37.06 per sq. ft. to $36.16 per sq. ft.

The Rouse Co.'s Chairman and CEO Anthony Deering expects that his REIT's portfolio will maintain the same occupancy — 95% — next year. He notes that his assumption is predicated on the effect of “very low interest rates, which have undergirded consumer spending up to this point.” Despite the signals of slowdown through the fall, he says that consumers who benefit from low rates will continue to spend.

In this tenuous environment, it's nice to be the owner of regional malls, says John Bucksbaum, CEO of General Growth Properties. “The beauty of the regional mall is the stability that it's shown over the last 40 years,” he says. “If you go back and look at all the different cycles that we've experienced, during that period of time the cash flow, the occupancy and the sales history of the properties have all remained very stable.” Anthony Deering concurs: “One of the things that we're learning is that the large-scale shopping center, over a long period of time, is incredibly resilient.”

As the year 2002 was drawing to a close, there were signs of a new wave of deals to build up such assets — including Simon's hostile bid for Taubman Centers (see page 10). At the same time, says Douglas Healy, principal managing director of Lend Lease Real Estate Investments, investors are displaying an “auction mentality” in purchasing class A and class B regional malls, as well as grocery-anchored shopping centers.

Money, apparently, is no object — as prices go up and cap rates decline. In October, General Growth purchased Glendale Galleria in Los Angeles for $415 million, representing a 7% cap rate. That set a recent low, below the rate on The Oaks in nearby Thousand Oaks, which was sold by the California State Teachers' Retirement System in June to The Macerich Co. The $153 million price of that deal represented a 7.9% cap rate, says Cushman & Wakefield director Andrea Pierce-Stopestad.

Meanwhile, non-institutional investors are flocking toward B and C malls. With lenders permitting loan-to-value ratios as high as 80% and interest rates below 7%, high net worth individuals and opportunity funds are targeting lesser-quality properties, such as what Healy calls “the survivable Bs.” Cap rates have fallen from 11% to 12%, to about 10%. “There is tremendous leverage opportunity there,” he says, “and you're producing low teens-double digit returns on a cash flow basis.”

But there's a big risk that accompanies that high yield: “What's your exit strategy on a deal like that — will the REITs be there to buy it tomorrow?” says Healy. If there isn't a buyer, owners have other options, ranging from remalling to simply defaulting on the mortgage. “In most cases the exit strategy is to get the turnaround solution and the trend line established so you can exit to a REIT,” says Welanetz. “And there have been REITs buying C properties for awhile.” Lehman Brothers' Shulman disagrees, noting that investors are “playing more on the B, B-minus side” and he points to CBL & Associates Properties' 2001 acquisition of a 21-property Richard E. Jacobs Group portfolio as one example of such activity.

Investors in grocery-anchored retail should be thinking about repositioning strategies, too. The strongest of these shopping centers are trading at just above an 8% cap rate, and they are perceived to be healthy because of the belief that necessity retail is all but immune to economic downturns. But grocery-anchored properties are not protected from the grocery wars. While the big discounters are slowing the expansion of traditional stores, both Wal-Mart and Target are adding supercenters. Wal-Mart plans to open 200 to 210 Supercenters, bringing giant new grocery stores to communities across the U.S. Target spokesperson Cathy Wright says that SuperTarget stores will account for 25% to 40% of its 2003 expansion, which will expand its store space by 8% to 10%; the fashion-conscious discounter now operates 1,107 stores.

REIT investment performance by property sector and subsector
Property Sector/Subsector 2001 October YTD Yield # of REITs
EQUITY REIT INDEX
Industrial/Office 7.09 -5.58 -4.52 7.57 34
— Office 6.65 -6.73 -11.04 7.97 20
— Industrial 7.42 -4.43 11.62 6.35 7
— Mixed 8.15 -4.65 1.26 7.68 7
Retail 30.42 -3.42 14.49 6.88 41
— Shopping Centers 29.89 -1.80 11.39 7.13 26
— Regional Malls 31.88 -5.53 17.17 6.60 9
— Free Standing 23.95 -0.81 18.37 6.93 6
Residential 9.04 -6.05 -11.99 8.13 23
— Apartments 8.66 -5.69 -12.22 8.16 18
— Manufactured Homes 13.72 -10.33 -9.05 7.76 5
Lodging/Resorts -8.63 -6.01 -7.78 4.41 15
(Percentage changes, except where noted, as of October 31, 2002)
Source: National Association of Real Estate Investments Trusts®.
Notes: 1 Includes all REITs that trade on the New York Stock Exchange, American Stock Exchange and NASDAQ National Market List.
2 Dividend yield quoted in percent and for month end.
3 Equity market capitalization and implied market capitalization represented in thousands of dollars. Data as of October 1, 2002.
4 Relative weights equal to the ratio of the equity market capitalization for each property sector and subsector divided by the total equity market capitalization for the index. Data in percent as of October 1, 2002.

The arrival of these new stores “will wreak some havoc in properties that have the third-best grocery store in town,” says Healy of Lend Lease. “What we've seen where Wal-Mart comes in is they come in, establish themselves, their prices are 20% below competitors', and so the No.1 and No.2 do a little better, Wal-Mart does well, and everybody else goes way.” The only exception, he says, are groceries that specialize in goods offered at a premium, such as organic foods markets.

Center owners have already seen effects of the superstores in Houston, San Antonio and Memphis, where Albertson's has closed stores in the face of competition from Wal-Mart. On Halloween, Boise, Idaho-based Albertson's, the nation's second-largest supermarket chain, lowered profit forecasts, and announced a comp-store sales decline of 2% in the third quarter of 2002. Kroger and Safeway have also posted or forecasted falling profits.

Healy suspects that consolidations will accelerate next year, and that also means that some groceries will go dark. What do owners do with the empty grocery anchors? “Some of these we're converting to other retail use, such as soft goods — it's been primarily fashion coupled with home improvement uses,” says Jodie McLean, president and chief investment officer of Edens & Avant. “In some cases, we decided that there may be a higher and better use for the property.”

Frank Hall, senior vice president of real estate at CVS, says, “I see the office supply product guys, the Party City guys, are coming into those old 30,000- to 50,000-sq.-ft.” grocery stores that have gone dark. At the same time, Hall says he sees grocers trying to adapt to the supercenter challenge. “Stop ‘n Shop has gone out and forged allegiances with other retailers,” such as Starbucks and Office Depot, Hall observes. “The neighborhood supermarket is going to tend more toward the one-stop shopping and is going to bring more of those amenities into the stores. They're probably a little less vulnerable than if they stayed selling dry goods, produce and meat.”

Bottom line, however, says Pierce-Stopestad, the turmoil in the grocery business raises risks. Now is not the time to put more money into grocery-anchored retail, she says, because the profit margin on this product is so small, any rocking of the boat could make trouble.

Changing Times

The same can be said for other forms of retail real estate, despite the high prices still being paid. “If the fundamentals don't start improving sooner or later,” says Pierce-Stopestad, “investors are going to ask, ‘Why am I investing in this?’”

Developers, of course, are looking for new ideas that will keep the consumers coming and the values high. For example, “What I do see already happening is that the mall owner, whether it's the REITs or an individual, is understanding that the Target, the Kohl's, the Wal-Mart can be a part of the mall, it doesn't need to be across the street,” Urban Retail's Hudson states. “You'll begin to hear of deals where those are incorporated in the tenant mix.” In fact, the Rouse Company's forthcoming Kendall Town Center will include a mix of fashion, value and discount retailers. Although each of these storefronts will not be connected through the mall, Deering says, they will all connect via the project's ring road.

Despite the higher rents, developers figure that the discounters will eventually have to link up to regional malls. “How does a big box get into Long Island, for instance?” asks Hall. “You know there's only one Wal-Mart out there, so I think it's very viable for big boxes to go into regional malls.” That regional malls and lifestyle centers typically charge higher rents and common area maintenance is a “bottom-line consideration,” says David J. LaRue, executive vice president and COO of Forest City Commercial Group. “The top-line consideration,” he says, “is how you best reach your market.”

Bucksbaum of General Growth Properties estimates that his company will spend $100 million to $150 million a year on redeveloping properties. Many of these projects involve retenanting with box retailers such as Barnes & Noble and Bed, Bath & Beyond that have not been traditional mall tenants. They also include lifestyle elements.

The lifestyle format in general, whether in new products or conversions, remains a favored development theme (see SCW, October 2002). It is a trend that Hudson says may have grown too popular. “The lemmings are running a little too hard in that direction,” he says. On the other hand, he says that town centers are the property type to emulate. Tattersall Park and Tattersall Commons in Birmingham, Ala., a project that Urban Retail is now working on for owner EBSCO Properties, creates a kinder, gentler power center by adding smaller tenants as well as streetscaping and friendlier landscaping. The two Tattersall properties face each other across the street, but together, with these components integrated into the entertainment district, restaurants and offices, Hudson expects them to become a regional draw as one entity.

Another trend in development involves fitting centers into underserved submarkets. George Wickwire, a partner with Seattle-based architecture firm Callison, sees a lot of potential in dense locations found between cities and suburbs. “We're dropping smaller products into these communities, where people had to drive several miles to a big shopping environment that's pretty homogenized or extruded.” Such projects range in size from 250,0000 sq. ft. to 750,000 sq. ft., and are either anchored or unanchored, but they all include necessity retail such as supermarkets and drug stores.

Will these adaptations be enough to sustain healthy returns in retail real estate? Innovation has helped developers keep the consumers coming in the past. On the other hand, if consumers simply refuse to buy, no new tenanting or design strategy will keep owners from sharing the pain of their tenants.

Dwindling GDP

The U.S. gross domestic product has waivered. Will 2003 figures drop again?

Quarter: Change in GDP
2001 2nd Quarter: -1.6%
2001 3rd Quarter: -0.3%
2001 4th Quarter: 2.7%
2002 1st Quarter: 5.0%
2002 2nd Quarter: 1.3%
2002 3rd Quarter: 3.1%
2002 4th Quarter: 1.4%
2003 1st Quarter: 2.4%
2003 2nd Quarter: 2.8%
2003 3rd Quarter: 3.3%
2003 4th Quarter: 3.9%
Source: U.S. Commerce Department & Economy.com