Economists and real estate experts are warning retail landlords to prepare for buffeting winds. A slowdown in consumer spending that is all but certain will curtail demand for retail space, they claim. Plus, increasing supply threatens to exacerbate the problem and force shopping center landlords to offer more concessions to fill their buildings.

One harbinger of doom reared its head in October, when giant Wal-Mart Stores Inc. posted sales growth of less than 1% and conveyed little hope for any improvement in November. Standard & Poor's subsequently downgraded the retailer to “buy” from “strong buy.”

But even if 2007 sees some economic erosion, will it be enough to strangle the move toward retail property consolidation? Not if private capital continues to chase the sector, particularly within the open-air formats such as power centers, lifestyle centers and community centers.

Discovering a new appreciation

“Retail real estate's been an asset class that was under allocated by a lot of pension funds because it's probably the most management-intensive and least commodity-type of property,” says Scott Wolstein, CEO of Cleveland-based Developers Diversified, a shopping center REIT that owns and manages 118 million sq. ft. of shopping centers in the U.S., Puerto Rico and Brazil. “Until private capital got dialed into the joint venture concept, it never really had a great track record [of owning retail properties].”

Wolstein should know: In mid-October, Developers Diversified struck a $6.2 billion deal to buy Oak Brook, Ill.-based Inland Retail Real Estate Trust Inc., a private REIT with some 307 properties of primarily community centers and neighborhood centers in the Southeast.

As part of the deal, Developers Diversified is carving out 67 community centers valued at $3 billion, which it will buy with New York-based pension fund advisor TIAA-CREF.

Benefits of joint venture

TIAA-CREF will pony up 85% of the equity for the properties. Developers Diversified will provide the balance and receive fees for operating the portfolio. The deal gives TIAA-CREF the opportunity to increase its retail holdings while partnering with an experienced operator.

It allows Developers Diversified to generate income while reserving its cash for developing or acquiring higher-yielding properties, Wolstein says. While the joint venture is paying a price that represents a 6.2% capitalization rate, Developers Diversified can generate an 11% return on new development.

As for a projected slowdown, Wolstein says that some submarkets will suffer, but he prefers to focus on the macro picture. “The appetite from most retailers we deal with is to expand very aggressively.”

The deal represents the third major non-mall property merger within the retail REIT sector in the second half of 2006. In July, Kimco Realty launched a $4 billion acquisition of Pan Pacific Realty. Centro Properties Group, a publicly traded Australian real estate investor and operator, announced a $3.4 billion buyout of Heritage Property Investment Trust.

At least one of those deals include private capital, as well: New Hyde Park, N.Y.-based Kimco partnered with Prudential Real Estate Investors, which pitched in $1.1 billion. The transactions mark the first consolidation within the retail property sector since private capital started plowing cash into real estate in 2005.

Since then, some $70 billion in mergers and acquisitions have occurred, and Wolstein confirms the non-mall retail property sector remains fragmented and ripe for more consolidation.

Potential pitfalls

Investor interest may quickly wane, if retailers start to stumble. In fact, analysts are skeptical that retail properties can keep outperforming other property sectors, a situation to which investors have become accustomed.

“Retail looks attractive because it has demonstrated such stability over the last cycle when office properties, in particular, saw vacancies skyrocket,” says Sam Chandan, chief economist at research firm Reis. “But going forward, we're sounding some real notes of caution.”

The vacancy rate rose 20 basis points in the third quarter to reach 7% at neighborhood and community centers, which include shopping centers over 5,000 sq. ft. except for stand-alone stores and malls, according to Reis.

Meanwhile, developers added 6.6 million sq. ft. of new supply in the third quarter, slowing absorption to 4.1 million sq. ft. Reis estimates that vacancies will rise to 7.2% in 2007 as developers complete 38.7 million sq. ft. of shopping centers compared with 33.3 million this year (for more on development, see page 32).

While effective rents grew 2.5% through the first three quarters of 2006, that figure lags asking rent growth of 2.8%, Chandan notes. That's an indication that concessions are increasing, and he predicts landlords will have to make even more concessions in 2007 as developers open new shopping centers.