Across the country, thousands of retailers have been forced to close their doors because of financial difficulties. But in New York City, American and international tourists still roam Manhattan's glamorous Fifth Avenue, buying expensive trinkets at Cartier or the occasional suit at Georgio Armani. Still, the economic malaise is creeping toward Fifth Avenue and it is likely to darken many storefronts throughout the city's boroughs.

The nation's economic crisis has intruded on a lucrative period in the financial capital. Over the past year, retailers engaged in a frantic bidding war as they tried to lease prime space in Manhattan. Abercrombie & Fitch set a city record in July when it agreed to pay $2,500 per sq. ft. for 20,000 sq. ft. at 666 Fifth Avenue. Armani set the previous record earlier this year when it leased 40,000 sq. ft. at 717 Fifth Avenue for $1,700 per sq. ft. “Demand for the best locations has been strong,” says David Green, executive director of retail services for Cushman & Wakefield.

Tourism has spurred consumer sales and strengthened demand for retail space. The national retail vacancy rate exceeds 7%, and Manhattan's rate remains competitive, says Edward Jordan, East Coast director of net lease property for Encino, Calif.-based broker Marcus & Millichap.

Can New York's good times last much longer? Probably not, says Henry Goldfarb, executive managing director of Santa Ana, Calif.-based broker Grubb & Ellis. With financial markets in turmoil, more retailers are bound to close.

As layoffs on Wall Street continued to spread, the city's unemployment rate hit 5.8% in August, up from 5% in July, according to the New York State Department of Labor. Finance jobs in the city numbered 181,000 in July, down 11,000 from the year before. Since July, thousands more jobs have been lost.

Retail vacancies are likely to start in fringe areas and spread to the main shopping districts, says Goldfarb. And bank branches may be among the first victims of the economic downturn.

In recent years, Washington Mutual, Citigroup and other banks opened dozens of branches around New York, many on prime retail street corners. “The banks helped to hold up the market by overbidding for spaces,” says Goldfarb. “If someone was willing to pay an asking price of $250 per sq. ft., a bank would come in and offer $350.”

Now many of those expensive storefronts seem likely to go dark as banks merge and struggle to cut costs, Goldfarb adds.

Cracking a tough market

New York real estate tends to be a lagging indicator, Goldfarb says, tumbling well after the big plunge on Wall Street. In the stock market collapse of October 1987, when rising interest rates and a slowing economy triggered the decline, demand for retail space stayed firm for a year after the market decline, he says. But beginning in 1989, real estate markets suffered for four years as vacancies spiked.

The current cycle could follow a similar pattern. “We have had some record rents in the past year, but the trouble in the financial markets will start hurting eventually,” Goldfarb says.

Although layoffs at investment banks seem certain to hurt retailers in the financial district, New York still stands apart from much of the rest of the country. With a population of nearly 8.3 million, the Big Apple has 27,147 residents per sq. mile, compared with 12,649 per sq. mile in Chicago, and 8,205 in Los Angeles. The teeming New York sidewalks provide an ideal environment for retailers.

But while other cities have a surplus of shopping centers, developers are hard-pressed to build stores in New York because of tough zoning and the high cost of land. Faced with little competition, the city's top outlets produce an enormous volume of sales. “New York has some of the most successful stores of chains like Target and Home Depot,” says Dan Fasulo, managing director of Real Capital Analytics, a real estate research firm based in New York.

The rich shop where they please

While middle-class households count pennies, the wealthy remain eager to shop at New York's most expensive stores. That explains why the strongest retail activity lately has centered on prime streets like Fifth and Madison avenues. Luxury retailers demand the locations because they draw executives and moguls from around the world.

Investors, including institutions and private buyers, reap the benefits. In the second quarter, Manhattan retail's capitalization rate, or initial yield based on the purchase price, averaged 4.9%, reports Real Capital Analytics. In contrast, retail cap rates nationally averaged 6.3%.

Demand in the boroughs outside Manhattan also has remained healthy, with cap rates at 6.1% in the second quarter. Manhattan rents typically range from $200 to $700 per sq. ft., while in prime borough locations such as Jamaica Avenue in Queens, rents run to a high of about $200, says Lew Kornberg, managing director of Chicago-based broker Jones Lang LaSalle. “In Brooklyn and Queens, you have a very high population density, and there are many people with solid incomes,” he says.

Some boroughs have felt a keen lack of retail space. The Bronx, with a population of 1.3 million, has few shopping malls and for years residents have traveled to suburban New Jersey or Westchester, N.Y. to shop.

Big boxes burrow into boroughs

Big-box retailers such as Wal-Mart and Best Buy long were wary of New York's crime, traffic, and scarcity of land. When standalone stores tried to buy property in Brooklyn or Queens, coalitions of mom and pop stores, backed by politicians, fought them. Developers who managed to find land often found it prohibitively expensive compared with locations elsewhere, where chains build 100,000 sq. ft. stores with big parking lots.

After Mayor Rudolph Giuliani pressed for zoning rules favoring big-box stores in 2000, Home Depot opened units in all five New York boroughs. Customers used to crowded neighborhood hardware stores embraced the big box. Target opened a large store in Brooklyn, and Whole Foods opened a 68,000 sq. ft. store in the Time Warner Center on 59th Street in Manhattan. It became one the company's busiest outlets.

Throughout the boroughs, new strip centers are thriving. “Most of the chain stores have been doing well in New York City, despite the weakening economic conditions,” says Dan Fasulo of Real Capital Analytics.

The chains' success spread to neighborhoods once considered too poor to support national retailers. On Harlem's main thoroughfare, 125th Street, pawn shops sit alongside Marshall's and Old Navy stores, not far from McDonald's and Burger King.

“Three or four years ago, some of those stores would not have seen the area as a target market,” says Lew Kornberg of Jones Lang LaSalle. “Now stores are eager to pay rents of $150 or $200 per sq. ft. to get a good location on 125th Street.”

The resilience of New York's traditional retail market will be tested in the fall of 2009 when the Gateway Center Mall opens on the site of the former Bronx Terminal Market, which once housed ethnic food vendors. The 1 million sq. ft. project will debut in the heart of the South Bronx, an area once notorious for crime and abandoned lots.

New York-based Related Cos., a private developer with $8 billion worth of properties, is spending $500 million on the project, one of the biggest private-sector investments ever made in the borough. The mall will include 2,600 parking spaces and house such chains as Home Depot, BJ's, and Toys-R-Us.

Squeezing into Manhattan

Building malls in New York requires ingenuity. Parking has to be squeezed into tall garages, and stores must limit their size. Blumenfeld Development Group, based in Syosset, N.Y., is building the 485,000 sq. ft., $440 million East River Plaza at East 116th Street in Manhattan. Expected to open in October 2009, it will be anchored by a Target store and provide parking for 1,248 cars. A similar mall in the suburbs might cover 40 acres, but the Manhattan project will be compressed into six acres.

Despite the new malls, much of New York's retail space remains located on the first floors of office and apartment buildings, where retail rents have increased faster than the cost of space on higher floors. That has encouraged owners to sell the retail space as commercial condos.

Choice condos may offer financial security since they can be leased to national chains with solid credit. Even if a tenant goes bankrupt, a busy Manhattan location remains desirable to competitors. Many investors find condos easy to manage, says Jeffrey Baker, executive managing director of New York-based Savills US, a real estate investment banker. “It's not like owning a shopping mall where you have to renew 100 leases a year.”

Cap rates for New York condos run in the 5% to 6% range, Baker says. The deal flow has slowed lately, but it has not stopped, he says. Investors in recent years include pensions and REITs, such as Vornado Realty Trust and SL Green Realty, both based in New York.

Wealthy individuals also are drawn to condos, sometimes as vehicles for 1031 tax-deferred exchanges or for estate planning. And some entrepreneurs who made a retail fortune overseas are attracted to the idea of owning a store site in Manhattan.

Inside the condo deal

Manhattan condo prices start at around $4 million. “A condo can be a nice bite-size deal,” says Edward Jordan of Marcus & Millichap. “An investor can pay all cash and lock in solid cash flow.”

In April, Acadia Realty Trust, a shopping center REIT, paid $4.9 million for 10,213 sq. ft. on East 17th St., which houses a single tenant — Barnes & Noble.

The biggest retail condo deal to date came in July when private equity giant Carlyle Group led a venture that paid $525 million for a 90,000 sq. ft. commercial condominium. The space, at 666 Fifth Avenue, houses not only Abercrombie & Fitch, but also Hickey Freeman and The NBA Store. Kushner Cos., a New York landlord that owns 8 million sq. ft. of office and retail space, sold the space.

Kushner made a series of deals for the transaction. In early 2007, Kushner bought the 1.5 million sq. ft. 666 Fifth Avenue for $1.8 billion, one of the highest prices ever paid for an office building. The price was inflated partly by the high value of the retail space.

At the time of Kushner's acquisition, Brooks Brothers occupied 40,000 sq. ft. of the retail space, paying $850 per sq. ft. Kushner bought out Brooks Brothers' lease and rented part of the space to Abercrombie & Fitch for $2,500 per sq. ft. With the new tenant locked into an expensive lease, Kushner set aside the retail space as a condo and sold it.

Along with the big condo deals, there has been a flurry of costly leases recently for prime locations. In the past year, Gucci, Diesel and Tommy Hilfiger took space in the most expensive part of Fifth Avenue between 49th and 59th streets where space costs from $1,200 to $2,500 per sq. ft. A half-dozen new luxury stores are under construction on Madison Avenue. Topshop, a London mainstay, is opening its first U.S. outlet in Manhattan's trendy shopping district of Soho.

Signs of trouble

For all the excitement in the high-rent districts, brokers see signs of recession. “Landlords are not giving away the store, but they are beginning to offer tenants more enticing deals,” says Faith Hope Consolo, chair of the retail leasing and sales division at Prudential Douglas Elliman. “Landlords are starting to offer four or five months of free rent. You can get a 15-year lease instead of a 10-year.”

In the past, investors and underwriters appraised buildings by assuming that rents would keep rising. But those days are over, brokers say. While rents have not yet dropped, they are no longer climbing. A possible sign of things to come appeared recently on Broadway between 80th and 100th streets, a residential area where stores cater to local traffic. In recent months, a dozen retail vacancies have appeared, Goldfarb says.

Figuring that the good times would continue, landlords bought out leases or refused to renew them for delis and other small businesses so the empty stores could be combined into big spaces and marketed to deep-pocketed chain outlets. The landlords hoped to double their rents, but the moves proved ill-timed. “The big-box retailers are not interested now,” says Goldfarb.

He believes the vacancy problem will worsen early in 2009. Troubled retailers usually hang on during the Christmas holiday, hoping that sales will stimulate business. “This Christmas is probably going to be bad, so we will see closings in January and February,” Goldfarb says.

The economic winds could prove particularly harsh in the financial district on Manhattan's southern tip. Luxury outlets, including Hermes and Brooks Brothers, opened near the crowds of Wall Street brokers and investment bankers who in the recent past eagerly spent big bonuses.

But layoffs at Merrill Lynch and Lehman Brothers are taking a toll. “There has been a pause in leasing activity in the financial district,” says Andrew Goldberg, executive vice president of CB Richard Ellis. “People are waiting to see how the economy holds up.”

Stan Luxenberg is a New York-based writer.

NEW YORK - BY THE NUMBERS

LARGEST PRIVATE EMPLOYERS

  1. New York-Presbyterian Healthcare
    28,090 employees

  2. Citigroup
    26,809 employees

  3. JPMorgan Chase
    20,883 employees
    Source: Crain's New York Business, October 2008

CITY POPULATION

8.3 million
Source: U.S. Census Bureau

METRO AREA VITAL SIGNS

Manhattan Office:

7.4% vacancy, 3Q 2008

5.7% vacancy, 3Q 2007

$72.97 rent per sq. ft., 3Q 2008

$62.91 rent per sq. ft., 3Q 2007
Source: Cushman & Wakefield

Multifamily:

2.3% vacancy, 2Q 2008

2.4% vacancy, 2Q 2007

$2,847 effective rent, 2Q 2008

$2,634 effective rent 2Q 2007
Source: Reis

Manhattan Retail:

12% vacancy, 3Q 2008

7% vacancy, 3Q 2007

$200 rent per sq. ft., 2Q 2008

$220 rent per sq. ft., 2Q 2007
Source: Prudential Douglas Elliman

Industrial:

6.3% vacancy, 3Q 2008

3.7% vacancy, 3Q 2007

$43.19 rent per sq. ft., 3Q 2008

$38.45 rent per sq. ft., 3Q 2007
Source: Marcus & Millichap

Hotel:

89.2% occupancy, 2Q 2008

88% occupancy, 2Q 2007

$256.05 average daily rate, 2Q 2008

$234.47 average daily rate, 2Q 2007
Source: Smith Travel Research

UNEMPLOYMENT RATE:

5.8%
Source: New York State Department of Labor

MAJOR PROJECTS

Freedom Tower: The 1,776-ft. main structure of the new World Trade Center is part of a four-building complex that will surround the World Trade Center Memorial. The tower will house office and retail space. Designed at the site of the towers destroyed on Sept. 11, 2001, the building features an architectural twist at the top. The observation deck will stand at 1,362 ft. Developer Larry Silverstein previously completed Seven World Trade Center nearby.

Developer: Silverstein Properties

Completion: 2013

Cost: $2 billion

11 Times Square: The 1.1 million sq. ft. office and retail tower at Eighth Avenue and 42nd Street sits at the western gateway to the Times Square entertainment district and the nearby business corridor. The 40-story high-rise is the largest speculative development under construction in Manhattan. Energy-saving features include exterior sunshades to reduce glare, and 90% of its spaces are designed to use natural lighting.

Developer: SJP Properties

Completion: 2010

Cost: $1.2 billion