What happens when the customers who have defined the shopping center business face a future of diminishing expectations — and shrinking economic power?

For 50 years the fortunes of the retail real estate industry have been bound to those of the great American middle class. Indeed the evolution of the shopping center, from simple retail plaza to massive regional mall, was a barometer of the ascending, ever more affluent middle-class life.

But these days the middle class isn't what it used to be. Three decades of stagnating real wages, a globalizing economy that has eliminated thousands of high-wage industrial jobs — and, increasingly high-wage technical jobs, too — have taken a toll: The great American middle class is shrinking. In 1973, families with annual incomes of between $30,000 and $80,000 (in 2005 dollars) accounted for two-thirds of American households. Now, it's fewer than half, according to Sam Pizzigati, author of Greed and Good and the editor of Too Much, an online newsletter about income and wealth distribution.

And those who are hanging on are feeling increasing financial stress. Even with two wage earners, incomes in middle-class households have stalled, while costs of everything from energy to health care to local taxes to college tuition have soared.

Furthermore, the props that have held up consumer spending in the past few years — home-equity cash-outs and low-interest consumer credit — are now falling away. In 2005, before rising interest rates began to ripple through the consumer economy, Americans were still piling up bigger debts and — for the first time since the Great Depression year of 1933 — the U.S. had a negative savings rate.

“The middle is declining and retailers have to react,” says Jay MacIntosh, director of retail and consumer products research at Ernst & Young. That means new strategies will be needed by both retailers and the real estate investors and operators who depend on them. How will the stressed middle class cut corners? What are the implications for a consumer culture built on 50 years of middle-class ascendancy when the middle class is in decline and upward mobility stalls? What kind of retail, services and entertainment options will attract the new middle class? Who else can you sell to?

Nobody needs to panic about a sudden collapse of retail demand. And, in fact, there are few signs of trouble in the macro numbers. Consumer spending was barely dented by the 2000 recession and has continued to grow through the decade, despite modest job growth. Consumer spending accounted for 70 percent of U.S. GDP in 2005, the highest percentage in the post-World War II era. Retail spending grew 6.7 percent last year and is expected to ease to 6.0 percent this year, according to Ernst & Young's estimates.

On the surface, this looks like a typical recovery cycle — a stretch of healthy growth that lifts middle-class boats. At 4.7 percent, unemployment is at its lowest point since mid-2001; the latest figures from the Bureau of Labor Statistics (BLS) show annual average hourly wage growth of about 3.5 percent.

Indeed, many retail industry experts dismiss the idea that their middle-class patrons are tapped out. “The demise of the consumer has been predicted for the last four years and it hasn't happened,” says Daniel Hurwitz, senior vice president and chief investment officer of Developers Diversified Realty. “The consumer remains incredibly resilient.”

But take a closer look at the data and the picture is considerably less rosy. When you account for inflation, real wages — actual buying power — declined 0.1 percent from 2004 to 2005, according to the BLS. Median wages dropped 1.3 percent, according to the Economic Policy Institute. In real terms, average wages today are lower than they were 30 years ago. Average hourly wages were $15.72 , adjusted for inflation, in 1973, but down to $14.15 in 2000, according to BLS data. Since then wages have stagnated.

And, economists say, the historically impressive unemployment rate obscures a harsher reality: Millions of middle-class workers who are unemployed are no longer counted; they are among the “discouraged,” who are no longer looking. Nor does the statistic capture the downsized economic picture of middle-class Americans who have settled for part-time employment or, after being laid off from well-paid corporate or manufacturing jobs, have reentered the workforce in positions that pay far less. (For more on the employment picture, see page 88).

“The middle class is running in place,” says Ross Glickman, chairman and CEO of Chicago-based Urban Retail Properties. Like other industry leaders, Glickman is trying to anticipate what he will need to do to maintain his company's growth when his most reliable customers are unable to keep up.

What long-range strategies will cushion the effects of middle-class malaise? There are some obvious options, including catering to the healthier growth segments that bracket the middle class: the luxury market above and the swelling ranks of the near middle-class below. Tactics in that sector include focusing on ethnic shoppers, whose buying power is surging, even as middle-class consumers flatline.

Then there are retenanting strategies that help investors and developers hedge. These include bringing in different kinds of anchors — especially discounters — that reflect the new cross-shopping habits of middle-class consumers. Some companies are also adding non-retail tenants, such as New Plan Excel Realty Trust, which is courting departments of motor vehicles to place offices in its malls. Other options include financial services firms, trade schools or even library branches. (For more examples, see story page 96.)

Glickman is a fan of mixing price points — putting a Nordstrom in the same center as a Target, for example. “It also may involve charging lower price points than you would typically like,” he says.

Cross shopping is clearly driving projects such as General Growth Properties' Jordan Creek Town Center which blends styles, formats and price points including a regional mall, lifestyle center component and power center all in one property. Vestar Development Co.'s hybrid concepts also cover multiple price points. Desert Ridge Marketplace in Phoenix includes two strips of big-box tenants and other power center-type retailers on either side of a center island replete with upscale restaurant and entertainment tenants and trendy retailers.

Meanwhile, for retail developers that cater to the carriage trade, demographics are moving in their direction. While the middle class is faced with increasingly difficult choices — between retirement savings and new furniture, say — the rich have more disposable income than ever. Between 1979 and 2003, while the share of national personal income earned by the bottom 80 percent of households fell from 50 percent to around 40 percent, the income of the top fifth swelled to 60 percent, according to an IRS study.

Spending by the rich has tracked that same arc. According to a Federal Reserve study, the share of consumer spending by the top fifth jumped to 46 percent in 2000 from 42 percent in 1992 — a $300 billion spending spree. In 2004 and 2005, overall same-store sales increased by an uninspiring 3.8 percent in both years. But same-store sales for luxury retailers were up 9.6 percent and 6.2 percent, respectively. “Upper-income consumers have been driving retail sales for the past two years,” says MacIntosh.

Taubman Centers long ago cast its lot with high-end consumers and has been rewarded with above-average returns. In the past two years alone, its stock price has doubled to more than $40 today from $20.63 per share in January 2004. Recently, General Growth Properties and Macerich Co. have both upped their bets on high-end retail through their GGPlatinum and Lumenati programs. The properties cater to the high-end retailers and consumers, offering bells and whistles such as personal shopping services, valet parking and other perks. (See story, page 104.)

“If there is a problem with the consumer, the higher quality will weather the storm best,” says Barry Vinocur, editor of Realty Stock Review. “The rich are far less impacted by economic divergences than the middle class.”

The next best thing may be consumers at the opposite end of the retail spectrum — the growing ranks of not-quite Middle Americans in urban areas and older suburbs — markets traditionally underserved by retail. That's where Quintin Primo III, CEO of Capri Capital Advisors, a Chicago real estate investment firm, is placing his bets. In February, he forked over a whopping $136 million for Baldwin Hills Crenshaw Plaza in Los Angeles. That's $68 million more than the property fetched in 2004 — before the effect of having a Wal-Mart on the site was felt.

The Baldwin Hills Wal-Mart, one of the first attempts by the retail giant to crack the urban market, has produced a level of traffic that Baldwin Hills had not seen in decades. The 860,000-square-foot center, one of the first regional centers in the country when it opened in 1947, fell on hard times as the surrounding neighborhood became poorer.

Individual households in the largely African-American and Hispanic area of southwest Los Angeles may be barely middle class, but in aggregate they have enormous buying power, which the Wal-Mart helped prove. Since Wal-Mart opened in January 2003, the center has attracted 26 other new tenants, ranging from McDonalds to Bath & Body Works. Sales per square foot have jumped from $350 to over $500, says Primo.

Primo says he expects other investors to plow money into places like Baldwin Hills as they look for ways to make up for the declining fortunes of traditional middle-class shoppers. “I would be surprised if there were a more important strategy retailers could use to address this issue than to move into mostly underserved urban communities,” he says.

Even mighty General Growth, the industry giant whose roots are purely middle-American, sees promise in the new urban frontier and its different demographics. In particular, the Chicago-based company is looking at ways to capture the new ethnic shoppers — Hispanics, Asians and others — who are congregating in secondary cities. The company is developing retail centers in areas with populations of 150,000 to 500,000 in a three- to five-mile radius. At about $30,000 to $50,000, typical household income is less than the $60,000 to $70,000 required by most developers.

But the growth potential is great.

“The ethnic population should grow eight times faster than the non-minority over the next 20 years,” says Lyneir Richardson, vice president of urban retail development for General Growth. “And it's projected to have three times as much purchasing power as it has now.”

The company recently paid $60 million for the Mondawmin mall in Baltimore, a 50-year-old property in a trading area of 400,000. While he won't divulge names of tenants, Richardson says it will have “a large big-box retailer, a full-service grocery and two sit-down restaurants.” He's also in negotiations for a similar site in Detroit.

Meanwhile, Primo is eyeballing other underserved urban markets. He says he is raising a $1 billion investment fund that will only invest in urban markets and target a mix of new developments and renovations.

In this environment, traditional middle-market retailers will continue to face challenges, says MacIntosh. “The ongoing polarization of high-income and low-income consumers will squeeze mid-range retailers,” he says.

Indeed, the middle is not holding. Stores like Nieman Marcus and Nordstrom have thrived by focusing on upscale clientele, while Wal-Mart and Target have swept aside discount competitors. Sears, most notably, and other mid-market chains continue to suffer. The jury is still out on the Federated/May merger: Can Martha Stewart drive traffic to the now-giant Macy's chain?

In the middle, J.C. Penney Co. and Kohl's Department Stores are the only department store companies on sure footing, Citigroup analyst Deborah Weinswig says. The two chains “can coexist and succeed” in a middle market that has been depopulated.

Beyond those two, the picture in the middle is bleak. Montgomery Ward is dead. Sears seems lost. Saks gave up on its mid-level department stores, selling off its various brands to local competitors.

“There will continue to be a market for mid-level stores,” says MacIntosh. “But there's going to be less square footage devoted to that segment over time.” Those retailers who stick to that market will have to pay more attention to establishing a unique identity, a reason for consumers to shop there.

Investors and developers who want to reduce their risk may need to reconsider such relatively unsexy formats as the strip mall and pack them with value-oriented retailers. The key is to include tenants with products and services that even the most financially-distressed shoppers will need.

Using this formula, Acadia Realty Corp. for years has quietly carved a lucrative niche. Its 45 shopping centers, averaging about 150,000 square feet and located primarily on the East Coast and in the Midwest, are typically anchored by a supermarket or discount retailer, with other value-oriented retailers as its tenants. At Abington Towne Center in Abington, Pa., for example, there's a Target and T.J. Maxx, along with Payless ShoeSource, Subway, Great Clips and other low-cost retailers. Jon Grisham, chief accounting officer and director of investor relations, thinks that formula will likely remain successful. “You've always got to buy toilet paper and toothpaste,” he says. These “convenience retail” centers may have an added appeal to the time-strapped, two-income wage family who can buy groceries, go to a drugstore, and pick up dry-cleaning during one visit to the center.

Acadia also follows two other important rules. One is to focus on redeveloping assets, instead of starting from scratch. “The prices of real estate make it prohibitively expensive to build,” says Grisham. The other is to create mixed-use properties, mostly combining retail and office space, in a way that each can leverage off the other. Similarly, Glickman's new Branson, Mo., property will feature a variety of uses, including an amphitheater, condominiums and hotels.

For developers, choosing the right tenants will be more important than ever. As pressures on retailers grow, those that can't hack it are likely to be forced to close. At the same time, successful retailers will be increasingly competitive and hard-nosed in negotiations. In fact, according to Glickman, retailers are already starting to push aggressively for more concessions on such things as common area rents and upfront allowances.

One of the tricks in the next era will be to figure out what consumers will still pay full retail prices for and what they will buy for cheap. Jon Berry, senior vice president for GfK Roper Consulting, says that stretched consumers will still pick the on category on which to splurge — a new flat-screen TV, a trip to the day spa, or nice golf clubs — while cutting back in others.

“People will find the one thing they really love and blow their doors out for that and make up for it by cutting back elsewhere,” Berry says. (For more on changing consumption patterns, see sidebar on page 94.)

According to Packaged Facts, a New York-based market research firm Hispanic households spend 47.2 percent more on fresh vegetables than non-Hispanics and Hispanic men are more likely to say they'll pay anything for an electronics product they want than males from other ethnic groups.

Whenever possible, retailers and developers need to look at how they can help their middle-class clients adapt to lifestyle challenges. For example, with soaring gas prices and the nonstop pace of the two-income family, it makes sense to create ways to connect online and offline shopping. “It means seamlessly integrating bricks and clicks into one system,” says Jack Plunkett, CEO of Houston-based Plunkett Research. Retailers can take advantage of the immediacy of Web-based purchases, while still finding ways to attract consumers to their stores. During the 2005 holiday season, he notes, Circuit City had success with a program that let time-pressed customers order merchandise online and then pick it up the nearest store.

Using all these strategies — and others that are still evolving — the retail real estate industry can adapt to the squeeze on the middle class. Denial simply isn't an option: “People who say the middle-class squeeze isn't happening aren't living in the real world,” says Glickman. “The middle class makes up the bulk of almost everyone's sales. And everybody has to realize there is a problem … or else.”

When in Debt …

How much time do retailers and developers have to implement strategies to accommodate the changing middle-class demographics? Some changes may take decades to play out. But, for a growing number of over-extended consumers, the end of historically low interest rates could be a tipping point.

“They've been using their houses as pocketbooks,” says Jack Plunkett, CEO of Plunkett Research, a market research firm in Houston. Both Plunkett and Dean Baker, co-director of the Center for Economic and Policy Research, estimate that 33 percent of all the money consumers pulled out of their homes in the form of refinancings and home-equity loans have gone to consumer spending.

Now, borrowers with adjustable-rate loans are seeing monthly payments balloon, leaving less money for discretionary spending at the mall. Meanwhile, household debt continues to set records. The median level rose 33.9 percent between 2001 and 2004, to $55,300, triple the 9.5 percent rate of growth during the boom years of 1998 to 2001. Household debt as a percent of disposable personal income, is now over 100 percent. In the 1960s, the debt figure was 68 percent.

Credit card debt is nearly $800 billion, triple the amount in 1989, according to a study by the Center for Responsible Lending, a Washington, D.C.-based research group, which surveyed 1,150 low- and middle-income consumers who had carried credit card balances for more than three months. Were they using credit to live beyond their means? Not really. Seven out of 10 said they turned to plastic to help with basic living expenses and unexpected bills. And, with greater frequency, those unexpected bills are related to health care. The number of Americans without health-care coverage now exceeds 45 million.

“The question is, how long can this debt burden continue to increase,” says Sam Pizzigati, author of Greed and Good and the editor of Too Much, an online newsletter about income and wealth distribution. “There has to be a breaking point.” And, thanks to the tougher federal bankruptcy legislation passed last year, consumers who file for bankruptcy protection will not soon find their way back to the mall.

The bill makes it much more difficult to file for Chapter 7 bankruptcy — under which a person's assets are liquidated and remaining debts canceled. Instead, more people will have to file for Chapter 13 bankruptcy, which creates a five-year repayment plan before any debts are forgiven. The result is that it will take much longer for people forced into bankruptcy to turn their lives around.

With between 1 and 2 million personal bankruptcies annually, that could have big impacts for retail.
AF

Will Work For … Anything

Take a closer look at the U.S. employment data and the picture is not rosy. When you account for inflation, real wages — actual buying power — declined 0.1 percent from 2004 to 2005, according to the Bureau of Labor Statistics (BLS). Median wages dropped 1.3 percent, according to the Economic Policy Institute.

And that sub-5 percent unemployment figure? It doesn't take into account the sizable number of discouraged job seekers who have given up and removed themselves from the running and stopped looking. It also doesn't take into account former full-time workers who have been pushed into part-time jobs. Estimates vary on the “real” unemployment rate. The BLS's own “underemployment” figure was 8.2 percent as of early April, down from a peak of 10.3 percent in September 2003.

Actual employment numbers — a better measure, according to EPI senior economist Jared Bernstein — has declined, to 62.8 percent as of December 2005 from 64.3 percent in March 2001.

In fact, job growth by historical standards is nothing to applaud. Typically, at this stage of an economic recovery, the employment rolls would be growing by 3.5 percent annually. While the numbers have been better in the past year or so, the economy has been producing new jobs at less than half that historic rate, according to the Economic Policy Institute.

The economy kept shedding jobs well into the recovery, all the way to May 2003. Since then, 4.6 million jobs have been created including 2 million in 2005. That works out to a 1.5 percent growth rate less than half the average of previous growth cycles. If the recovery was matching past cycles, it would have added 4.6 million jobs alone in 2005.

But wait, it gets worse.

The jobs destroyed in recent years, including tech jobs and manufacturing, are generally being replaced by lower-wage service jobs, which is reflected in the decline in real wages posted in 2005. All this is epitomized by the fact that on one hand you've got General Motors laying off and buying out workers from their $25 to $30 per hour jobs while Wal-Mart Stores Inc., with an average wage of $10 per hour, has emerged as the nation's largest private employer.
AF

Changing Aspirations

While the urban/ethnic and luxury strategies provide new growth opportunities, the fortunes of most retailers and most developers will remain tied to the middle classes — that's who they built those stores and centers for. To sustain the performance of these assets, the new realities of middle-class life will have to be addressed.

What, for example, can be done to maintain the same volume of mall traffic if disposable income continues to shrink? Even now, the typical two-income family has spent 75 percent of its paycheck on such fixed expenses as housing, car payments, insurance and childcare before it heads out to the mall for items such as new Ipods or extra jackets.

In 1973, a middle-class family, living on just one income, would have earmarked 54 percent for those fixed expenses, according to Elizabeth Warren, Leo Gottlieb Professor of Law at Harvard Law School and co-author of The Two-Income Trap. From the 1970s to today, average mortgage payments have gone up 81 percent in real terms, according to Warren.

Consumer mood has been resilient in the face of mounting economic pressures as well as global instability. But Jon Berry, senior vice president for GfK Roper Consulting sees reason for concern. According to company research, the number of consumers who think it's a good time to buy things they want or need is just 23 percent. That's down from 34 percent in December 2004 and 40 percent in the late 1990s. In fact, Berry likens the developing picture today to some of the lowest points in the past 25 years — the recessions in the early 1980s and 1990s and the mid-'70s when the combination of Watergate, crushing oil prices, inflation and a stagnating economy put the crunch on consumers.

In spite of everything, middle-class families do cling to a core belief in upward mobility. That informs their self-image and their aspirations and helps explain the “new luxury” phenomenon: the spread of designer brands and luxury items to the middle class.

But the belief system no longer jibes with reality. Not only has the core middle-class cohort shrunk, but upward mobility has stalled. According to a study by two economists at the Federal Reserve Bank of Boston, the number of people who remained in the same income bracket in the 1990s — despite the booming economy — increased over previous decades.

For middle-class families committed to moving up — or even remaining in the middle — education is a clear priority. “A college education is the only ticket to the top,” says Sam Pizzigati, author of Greed and Good and the editor of Too Much, an online newsletter about income and wealth distribution.

Still, thanks to globalization, earnings of college-educated workers have recently declined slightly due to pressures from out-sourcing. Result: Families increasingly pay more money to buy pricey houses in suburbs with high-quality public schools that are more likely to help their children get into elite schools. Average total tuition and fees for four-year private colleges and universities for the 2005-2006 year were up 5.9 percent from 2004-2005.

Will Middle America willingly give up the trappings of the upper class? Not likely, says Berry.

“The mindset could become even more exaggerated when things tighten up,” he says. But the realities of crunched disposable incomes will mean that middle-class consumers will pick and choose — buying that one big-ticket item while cutting back or looking for cheap treats elsewhere.

“People will spend for a taste of the good life,” Berry says. “They will budget in one area to get a treat in another.”
AF