Those in the retail real estate industry who hoped a market recovery would come swiftly and painlessly in the early stages of 2009 are going to disappointed. Instead, 2009 is looking very much like it will be a lost year for the sector with investment sales volume down, fundamentals continuing to weaken and no sign of recovery until the fourth quarter at the earliest. Even the most bullish forecasters advise industry pros to hunker down and muddle through 2009 and then hope a turnaround takes hold in 2010.

Real estate Pollyannas insisted for much of 2008 that the credit crunch would pass, that plenty of cash-flush buyers sitting on the sidelines were waiting to pounce and that property fundamentals would not erode much. The wave of buying never materialized and throughout the year store closings accelerated and the credit crisis deepened. Now it's looking like those cash-rich buyers may sit out 2009 as well. Worse, they may turn their backs on retail altogether and opt to invest elsewhere, such as infrastructure.

The stark reality is that the credit crunch is no longer the only culprit for depressed sales volumes. Retailers are hurting and that's damaging existing properties where vacancy rates are rising and its stopping the construction of new projects in their tracks.

So with the freewheeling days of 2006 and 2007 unlikely to reemerge, the industry is likely to face a continued shakeout. Property values could continue to fall. And cap rates — once thought to have undergone a secular change resulting in risk-free lower levels in the 6, 5 and even 4 percent range — seem to be on the way up. In the third quarter of 2008, cap rates for retail properties stood at 6.8 percent, according to New York City-based Real Capital Analytics. To spur more investment activity, that number will likely have to move into the 8 percent to 10 percent range, experts say. Cap rates across all sectors will need to move up 150 basis points to 200 basis points, to a range of 7.5 percent to 8.5 percent for acquisitions to start making sense again, according to ULI's “Emerging Trends Report.” Cap rates on class-B and class-C properties might see increases of up to 300 basis points.

Overall, commercial property values could decrease 30 percent to 40 percent peak to trough, according to JPMorgan research. Since the beginning of the downturn in 2007, retail property values have already fallen between 10 percent and 20 percent, according to research from brokerage firm Cushman & Wakefield.

As a result, the retail real estate sector is not likely to see a lot of acquisition activity next year, according to Stephannie Mower, head of the capital markets group in the Dallas office of Cushman & Wakefield. She expects more transactions will start taking place in the third and fourth quarters of 2009, as a greater number of loans come to maturity and landlords face increasing pressure to sell. “The cash buyers are certainly out there, but because of what's occurred in the stock market everyone is thinking that prices will continue to go down and everyone wants to make sure that [they are] at an absolute bottom,” Mower notes. “By the second quarter of 2009, you'll see [acquisition activity] pick up quite a bit. But I think we will not see a real recovery for another 12 to 18 months.”

Suzanne Mulvee, a senior real estate economist with Boston-based Property & Portfolio Research (PPR), takes a similar view, noting that transaction volume will not start picking up until late 2009, with many closings taking place in 2010. The September bankruptcy of Lehman Brothers didn't help matters. After the Lehman news broke, commercial mortgage originations, already down to a trickle, came to a complete halt, says Andrew Oliver, executive vice president and principal with Cushman & Wakefield Sonnenblick Goldman, a global real estate financial services firm. Wall Street is now out of commission, commercial banks are either dealing with their own solvency issues or are at a complete loss about how to value real estate properties and insurance providers have already exceeded their real estate allocations for 2008. Those issues aren't likely to go away at least until the third quarter of 2009, according to Oliver, limiting the amount of money available for new acquisitions next year.

Right now, portfolio lenders are focusing on smaller deals, $25 million and under, while money for transactions worth more than $50 million is virtually impossible to come by. To line up, say, $250 million in financing once required working with two or three banks. Now it means dealing with a consortium of 10 or more. What's more, market experts expect that underwriting criteria will continue to be stringent, particularly on retail properties, which are perceived to pose the most risk. In October, the retail sector experienced the greatest increase in the 60-day CMBS loan delinquency rate out of all commercial property types, by 9 basis points, to 0.40 percent, according to JPMorgan. Delinquencies for all sectors rose 5 basis points, to 0.51 percent. As of Nov. 10, the overall commercial mortgage-backed securities (CMBS) delinquency rate for retail was at 0.68 percent, according to JPMorgan analyst Alan L. Todd and he expects it to range between 1.5 percent and 2.0 percent next year.

This ongoing difficulty in obtaining financing, coupled with a grim prognosis for the retail sector, will help prolong the transaction stalemate in retail investment sales. Already in the third quarter of 2008, retail property sales, at $3.4 billion, were down 80 percent compared to the same period in 2007, reports Real Capital Analytics. Year-to-date sales volume, at $16.1 billion, has been off 71 percent compared to last year, and the number of properties sold, at 1,330, down 60 percent. The firm estimates that the total volume of transactions in 2008 will total a little more than $20.7 billion. The last time retail sales volume was at this level was in 2002, which saw activity worth $26.8 billion. Next year, we might see similar figures, says Fasulo.

As a result of all this, Bernard J. Haddigan, managing director of the national retail group with Marcus & Millichap Real Estate Investment Services, an Encino, Calif.-based brokerage firm, projects retail deal volume next year might not go much higher than $17 billion. Dan Fasulo, managing director with Real Capital Analytics, thinks it could be a little higher, projecting the total might reach 2002's level of $27 billion. Either way, the projections are a big drop from the industry peak of $71.6 billion in 2007.

Lagging indicators

Because retail real estate statistics tend to lag behind general economic indicators, retail center owners have so far avoided feeling the brunt of the pain from the massive drop-off in consumer spending, according to Joel Bloomer, an analyst with Morningstar. Over the next several months, however, they will face increasing pressure from rising vacancy rates, falling rent levels and a difficult refinancing market.

In fact, on Oct. 22, Morningstar raised its uncertainty ratings, which measure the margin of safety around the fair value of a stock, to high from medium for a number of companies in the retail REIT universe, including Kimco Realty Corp., Macerich Co. and PREIT, citing possible losses in revenue because of consumer spending and the financing environment. Then, on Oct. 31, Goldman Sachs' REIT team issued a note advising investors to avoid any company with high leverage or a large development pipeline. The advisory was based on the calculation that cap rates for commercial properties will come back to the long-term average of 9.3 percent, rising 260 basis points above the current average of 6.7 percent.

The scary thing is that REITs, as embattled as they've become having seen 65 percent of their market capitalization evaporate since February 2007, are in better shape than private real estate companies, experts say. REITs tend to have long-standing relationships with lenders and most have avoided closing too many high-leverage acquisitions during the latest up cycle. The majority of retail REITs have also taken care of their 2008 maturities and have started work on securing financing for 2009, says Rich Moore, analyst, with RBC Capital Markets.

Smaller, privately held firms, meanwhile, may face difficulties. “Given the tight credit conditions, a lot of smaller companies will have trouble getting financing and that will limit their flexibility,” says Robert McMillan, a REIT analyst with New York City-based rating agency Standard & Poor's.

Finance first

So what's going to happen to those companies in 2009, when $34 billion in securitized debt alone will need to be refinanced? The good news is the credit markets might begin to thaw sometime after the first quarter of 2009, according to Dan E. Gorczycki, managing director in the New York City office of Savills LLC, the U.S. arm of the global real estate services firm Savills PLC. While Wall Street will likely continue to be out of commission next year, commercial banks could eventually start lending again, once the money made available through the $700 billion Troubled Assets Relief Program (TARP) works its way through the financial system. The effects of the bailout plan already started to be felt at the beginning of November, when LIBOR rates declined to 3.17 percent from 3.96 percent in October. The TED spread, which reached a peak of 4.64 on Oct. 10, had come down to 1.98 by Nov. 12. However, the effects may not be as great as some had hoped. On Nov. 12, Treasury officials announced they were shifting the focus of the program from financial institutions to consumer credit, with the remaining funding now earmarked for credit card, student loan and auto debt.

In the meantime, it could take months for the $250 billion infused into the financial system to bring true relief to the capital markets, according to David J. Lynn, managing director of research and investment strategy with real estate services firm ING Real Estate. So far, the program hasn't resulted in an increase of lending, according to Bob Bach, vice president and chief economist with Grubb & Ellis, a Santa Ana, Calif.-based real estate services firm. It might not have a sufficient impact on liquidity unless the government requests that banks spend at least a portion of the money they received to originate loans, he notes. Lynn projects that the recovery in the financial services sector won't begin in earnest until the third or fourth quarter of 2009.

Unfortunately, it appears that the era of securitized loans has come to a dead end — in October, CMBS issuance came to $0, after posting similar results for the previous three months, reports Commercial Mortgage Alert, an industry newsletter. By contrast, from July through October 2007, when the credit crunch was getting under way, the market still saw $55.2 billion in CMBS issuance. CMBS issuance might begin to climb up by the second quarter of 2009, according to Todd, but nobody has a clear idea by how much.

For now, securitized debt markets remain inaccessible. As of Nov. 5, spreads on 10-year triple-A-rated conduit loans stood at 600 basis points, according to Commercial Mortgage Alert, compared to this decade's low point of 24 basis points, reached in April of 2005 and then again in June of 2006. Historically, from 1997 through 2007, spreads on triple- A-rated CMBS loans stayed below 50 basis points. And in the wake of the government's announcement that TARP money won't be used to buy toxic commercial real estate backed assets, spreads on the CMBX-NA-AJ 5 index shot up to 1,156 basis points on Nov. 13, while spreads on the CMBX-NA-AA-5 index went up to 2,051 basis points.

In recent months, some observers have held out hope for the emergence of a new securitized debt vehicle — for example, covered bonds, which function in the same way as CMBS bonds, but remain on the issuer's balance sheet, minimizing the risk for investors. That's looking unlikely according to Gorczycki. “Something has to fill that void, but who knows what it is,” he says about the $34 billion in securitized loans that will need to be refinanced in 2009.

The best indication of where the real estate lending market is headed can be glimpsed in the behavior of Mark Finerman, former head of real estate finance operations at RBS Greenwich Capital, a Greenwich, Conn.-based fixed-income capital markets firm. Earlier this year, Finerman, along with two other structured finance experts, Perry Gershon and Chris McCormack, formed Loan Core, a company with $1.5 billion in commitments for opportunistic debt investments. Loan Core eventually plans to provide commercial real estate loans using a mechanism that will allow it to retain a portion of the loan on its books and sell off the senior portion in the securitized market. Given current conditions, however, Loan Core will likely focus on whole loans for the time being. Finerman did not return requests for comment.

Because banks have to hold real estate loans on their balance sheets, they will never be able to lend as much money as Wall Street players, or to offer such easy terms. In 2007, commercial/multifamily mortgage originations totalled almost $508 billion, according to the Mortgage Bankers Association (MBA), an industry trade group, with conduits accounting for $225 billion, or 44 percent, of that volume. In the first half of 2008, however, combined commercial mortgage originations from CMBS players and life insurance companies came to only $50 billion. What's more, the banks are facing pressure from the government to limit their exposure to real estate, which means their real estate allocations will likely be below average next year. Insurance companies are in a similar bind, according to Mulvee. Their real estate allocations are already too high because of falling stock prices and they are not currently raising mountains of extra cash through the issuance of new insurance policies.

As a result, “It's not going to be an easy recovery,” says Adam B. Weissburg, partner with the Los Angeles-based real estate law firm Cox Castle Nicholson LLP. “It's like a patient who's been in intensive care. We are starting to see signs that the patient is stabilizing, but things are still grave. I think next year is going to be all about stabilization.”

In better times, when DLC Management Corp. needed to secure a loan it would enter negotiations with a handful of lenders with whom it had long-standing relationships and pick and choose its way through the competing bids, says Daniel Taub, executive vice president and COO of the Tarrytown, N.Y.-based shopping center owner and manager.

Today, however, to secure refinancing for Tower Shopping Center, a Raleigh, N.C.-based 152,273-square-foot neighborhood shopping center that has a loan maturing in January 2009, the firm had to contact more than 100 potential lenders.

Those few lenders who continue to be active in the marketplace, including national players Bank of America and Wells Fargo and small community banks, ask for such tight underwriting criteria, only the most financially disciplined landlords appear to be able to secure loans.

Any borrower who wants to get new financing better be prepared to accept loan-to-value ratios of no more than 65 percent and debt-service-coverage ratios of 1.25 percent. Non-recourse debt has become a thing of the past, says Taub, putting tremendous pressure on smaller, privately held investors. In those rare instances where no recourse might be an option, borrowers have to accept interest rates in the 9 percent to 11 percent range, up from 6 percent to 7 percent a year or two ago.

“You've had a very wide shift in terms that are [there] to protect the lender while not factoring in the property and the sponsor,” Taub notes.

Plus, even with loans that feature punishing terms, the lenders want to make sure the property is more than 80 percent leased to strong credit tenants, and they are likely to do business only with long-term clients who are bringing them repeat business.

“They are lending as though they are protecting against Armageddon,” says Gorczycki. That is not surprising given that vacancy rates in the retail sector are projected to rise until at least 2010, according to Bach.

Meanwhile, there are whispers that the market has started to hit bottom — not the absolute bottom, as retail real estate values will likely continue to fall through the next six months — but within range of the bottom, according to Weissburg. If that's true, it will give lenders a better sense of how to price commercial mortgages, he notes, and make them feel more comfortable about lending again.

One regional bank in Miami, for example, has already looked at about nine retail real estate deals in the past few weeks, says Lawrence Suchman, president and CEO of Suchman Retail Group, a Coral Gables, Fla.-based commercial real estate brokerage, acquisition and development firm.

Ryan Krauch, principal with Mesa West Capital, a Los Angeles-based privately held, institutional commercial real estate lender, notes that once banks clean up their balance sheets, they might feel more comfortable underwriting commercial real estate transactions. Plus, there will likely be some private fund lenders in the market, like Mesa West Capital. The firm has more than $1 billion allocated to loan originations over the next year, but has been having trouble finding enough deals to finance. Mesa West's loans tend to feature two- or three-year, floating rate over 30-day LIBOR terms and are 100 percent non-recourse.

As a result, most of the real estate lending taking place in 2009 will be done through commercial banks, whose allocations to commercial real estate will continue to be limited, according to both Mulvee and Lynn. The volume of commercial mortgages originated through portfolio lenders will make up only half the gap left by the CMBS markets, says Lynn. “I think the [lending environment] will stay the same for most of 2009 and that will have an impact on a lot of things in the industry,” he notes.

“If you are a blue chip company, a lot of the lending is relationship driven,” so you might have some negotiating power, according to Lynn. But if you are a smaller player applying for a new mortgage, the banks want to see plenty of equity and might insist on an interest rate of up to 11 percent.

Diminished expectations

The problems in the finance arena are leading to deals getting scuttled. On Nov. 3, Homburg Invest Inc., a Halifax, Nova Scotia-based real estate investment and development firm, announced it was cancelling a proposed joint venture with Cedar Shopping Centers, Inc., a Port Washington, N.Y.-based REIT, for the purchase of a 32-property, one-million-square-foot portfolio located throughout Ohio, Pennsylvania and New York for approximately $129 million. Homburg Invest cited troubles in the capital markets as the reason for the cancellation. The deal was scheduled to close on Dec. 15, subject to due diligence and board of directors' approval. It would have brought in approximately $49 million in cash proceeds for Cedar.

Lack of available financing has certainly played a role in the downturn, says Mower. Only those deals that feature in-place financing or all-cash buyers are getting closed right now, she notes. That has kept average deal size low, at $11.9 million, according to Real Capital Analytics. The average deal price for strip centers went down 14 percent in the third quarter compared to the same period in 2007, to $14.5 million.

The negative outlook for the retail real estate sector, however, has also been a driving force behind lackluster sales activity. In the second quarter of 2008, investors gave retail the lowest rating of all the commercial property types on a 1 to 10 return vs. risk scale, at 3.9, reports Real Estate Research Corp., a Chicago-based real estate research firm. Retail also got a value vs. price rating of 4.2, below the rating for every sector except hospitality.

Yet many sellers still have unrealistic expectations for the cap rates they can achieve in this market, with the gap between buyers and sellers running from 50 basis points to a 150 basis points, Mower says. In the past few months, that gap started to close somewhat — Suchman, for example, has seen listing cap rates of up to 8.5 percent, up from 6.5 percent to 7.5 percent at the beginning of the year, but it still hasn't reached a point where buyers feel they are getting enough of a discount. To spur sales activity, cap rates need to return to the historical 9.0 percent to 10.0 percent range, according to research from Goldman Sachs and JPMorgan.

Meanwhile, the lingering disconnect between buyer and seller expectations continued to prevent new deals from occurring throughout the third quarter, when only one out of every three offerings resulted in a closed transaction, according to Real Capital Analytics. Cap rates averaged 6.8 percent, up only 35 basis points compared to the third quarter of 2007, but the figure is misleading, Fasulo cautions. Cap rates remain low because only top-quality assets are trading hands. One telling sign of where the market is headed is that cap rates for anchored strip centers have risen faster than those for unanchored properties, reflecting buyers' concern that an anchor could go bankrupt and leave them with a huge rent shortfall, according to Lynn.

Fariba Kavian, senior vice president with Sperry Van Ness, an Irvine, Calif.-based real estate investment brokerage firm, listed one single-tenant restaurant property in a suburb of Chicago at a 9.0 percent cap last month, but says the offers have still been sporadic.

“I am starting to see sellers capitulate to the buyers' market, but the gap hasn't closed fully,” says Suchman. “Even buyers are looking out there and saying ‘I don't know what a good deal is.’ People are being much more cautious in terms of the type of real estate [they are getting] and the percentage of occupancies by credit tenants versus non-credit tenants.”

At the same time, institutional buyers and vulture funds have largely stayed away from the acquisition market because they perceive cap rates have room to go up, says Gill Warner, senior director with Stan Johnson Company, a Tulsa, Okla.-based commercial real estate investment firm.

Brokers expect the gap to start closing sometime around the middle of 2009, when inability to pay down debt and dissolving partnerships will force owners to accept lower prices. Warner closed several net-lease deals in September, involving Walgreens-anchored properties in the Midwest, but they were sold to a high-net- worth private buyer who did not need to secure financing. Furthermore, the seller, in the market for close to a year, had to accept a cap rate increase of approximately 50 basis points, to 7.6 percent.

Aware that retail values have room to fall further, opportunistic investors with cash at their disposal don't feel pressure to buy right now, says Gorczycki. They know the real estate sector's recovery will take a long time and are patiently waiting for ever steeper discounts. “If you are flush with cash, you wait for an opportunity that's so ridiculous, it's beyond ridiculous,” Gorczycki adds.

Those investors may see more opportunity outside direct investment in property, according to Fasulo, who notes there may be fewer cash-heavy prospective buyers in the market than people realize (the estimated amount for equity allocated to commercial real estate is $300 billion, according to brokerage firm CB Richard Ellis).

At the moment, investments in distressed debt, CMBS notes sold through the secondary market and REIT stocks appear to offer better value. For the next two years, that's where most of the equity is likely to go, says Haddigan. And that's to say nothing of investments outside the retail real estate arena entirely.

The unfavorable outlook on retail properties will likely get worse in early 2009, when the dismal holiday sales season is expected to bring about a dramatic number of new bankruptcies and store closings. The first half of 2009 will likely see more than 3,100 store closing announcements, according to the most recent forecast from ICSC. On Nov. 10, for example, electronics retailer Circuit City filed for Chapter 11 bankruptcy protection, after announcing it would close 155 of its 721 stores and attempt to renegotiate leases for the remaining locations. Department store chain Bon-Ton Stores might be another candidate for a bankruptcy filing, as is furniture seller Pier I Imports, according to Howard Davidowitz, chairman of Davidowitz & Associates, Inc., a New York City-based retail consulting and investment banking firm. Davidowitz estimates the total number of store closings next year will fall in the range between 10,000 and 12,000.

Excess Space Retail Services, Inc., a Huntington Beach, Calif.-based real estate disposition and restructuring firm, puts the number even higher — at up to 14,000 store closings. In October, same-store sales for U.S. chain stores declined 0.9 percent, according to the ICSC.

Luxury stores showed the steepest decrease, at 19.2 percent, followed by specialty apparel sellers, at 11.0 percent, and department stores, at 10.9 percent. ICSC projects that during the November/December 2008 holiday sales period, same-store sales in the U.S. will show only a 1.0 percent gain.

As a result, retail property fundamentals will take a hit in 2009 — the vacancy rate is expected to peak next year at 17.3 percent, according to PPR, while rent growth will decline 5.6 percent, after a 3.6 percent decrease projected for this year. The firm does not expect a retail sector recovery until 2010, making it unlikely that retail will become the favored property type for real estate investment next year.

At the same time, deteriorating property fundamentals might help bring about some distressed asset opportunities for cash-flush vulture funds, according to Warner. With one retailer after another closing stores and not a lot of alternative users emerging to take up their spaces, many landlords will find themselves in a position where they will have to offer rent relief to their tenants, says Haddigan. If the landlord has debt maturities coming up in 2009, however, that might turn into a problem. Facing pressure from the lender to pay back the loan and simultaneously experiencing rent flow shortfalls, the landlord might have one of two choices: either put more equity into the financing deal or put the property on the sales block, Haddigan notes.

That might result in some attractive opportunities for distressed asset buyers, but the rent shortfall problems will affect primarily class-B properties in secondary markets, according to Haddigan. Most opportunistic investors, however, will want class-A locations in primary markets, says Taub. “If you are buying fundamentally sound real estate, at the right pricing, with [below market] rents, then you'll be able to make a good return and you'll be able to increase that return as the market recovers,” he notes.

The Numbers Game

Though most industry researchers agree 2009 will be a tough year for the retail real estate sector, they still haven't agreed on exactly how much damage the current recession will cause.

For example, Boston-based Property & Portfolio Research (PPR), has some of the most bearish projections on retail real estate, expecting the national vacancy rate to climb 17.3 percent, while projecting rents to 5.6 percent. PPR bases its forecast on surveys of all retail properties greater than 30,000 square feet across 54 U.S. markets.

Marcus & Millichap Real Estate Investment Services, an Encino, Calif.-based brokerage firm, predicts a less drastic turn in property fundamentals. Marcus & Millichap, which tracks all retail centers greater than 10,000 square feet throughout the U.S., expects vacancies to reach 13.0 percent next year, while expecting rents to fall decline 1.2 percent.

Finally, Reis Inc., a New York City-based commercial real estate information provider, projects a vacancy rate of 9.9 percent for 2009 and a rental rate decrease of 0.6 percent. However, the firm's numbers take into account only neighborhood and community shopping centers and power centers greater than 5,000 square feet in size. Its information is based on surveys of 76 major markets across the country.