Suddenly, development doesn't seem like quite the safe bet that it did at the beginning of the year for retail REITs.

As the downturn in the housing market spills into other industries, development yields are declining, from the high double-digits at the beginning of 2007 to less than 10 percent in the past three months, says David Lynn, managing director for research and strategy with ING Clarion.

A combination of factors is conspiring against building from the ground up. Consumers are pulling back. This in turn is altering retailers' expectations. Many are scaling back on formerly grandiose expansion plans, while existing store closings are also up. These factors are lowering demand for both existing and proposed shopping center space. That means that developments that looked like they would lease up quickly six months ago may take a lot more work to fill up today. The net result: declining development yields.

On the consumption front, weary consumers are spending less, which has led to anemic same store sales growth of 2.3 percent year to date, compared to 3.6 percent in 2006, according to ICSC. In September, same store sales grew a measly 1.7 percent.

And the amount of bad news coming from retailers is increasing. On Oct. 15, furniture seller Bombay Company, Inc., which filed for Chapter 11 bankruptcy in September, announced that it plans to close all 384 of its U.S.-based stores. A day later, Movie Gallery, the second largest movie rental chain in the country, with 4,368 stores, filed for Chapter 11 as well. The company had already announced plans to close 520 under-performing Movie Gallery and Hollywood Video stores back in September. Even firms that aren't closing stores are scaling back expansion plans.

This shift in the development climate comes at a time when many REITs are sitting on huge development portfolios. Regency Centers Corp., based in Jacksonville, Fla., has $929 million of new projects under construction, according to SNL Financial. Houston-based Weingarten Realty Investors is working on $373 million of retail properties, while Indianapolis-based Kite Realty Group Trust has plans for at least $200 million worth of new projects. Regional mall REITs, such as General Growth Properties, Simon Property Group and Taubman Centers, meanwhile, have pipelines worth billions of dollars each. It will take a while to build out--or wind down--that space.

It's not impossible that REITs may choose to abandon and write down some of these new developments, says Stephannie Mower, executive vice president and managing director of investment services for PM Realty Group, which advises REITs. "We will see people rethink the size or rethink the launch of developments all across the country, especially in markets with low barriers to entry," Mower says.

As it stands, even if developers pull back on centers with planned opening dates in 2008 or 2009, tens of millions of square feet of new space are coming on line right now. Overall, there will be 188.2 million square feet of retail space delivered this year, according to CoStar--the largest amount in at least the past 25 years.

At the same time, Colliers International forecasts that national retail vacancy rate will rise 0.3 percentage points to 7.4 percent for the 12-month period between December 2006 and December 2007. That's in line with the statistics compiled by REIS, Inc.

"While that increase is modest, it is nonetheless the case that fundamentals are softening, and if there is a significant downturn in 2008, it would undoubtedly affect the performance of retail space," says Sam Chandan, chief economist with REIS, Inc.

All of these factors have conspired to drive down development yields. At the same time, credit markets have become more conservative and that's changing the investment climate. Buyers that relied on debt and drove cap rates down to record low levels have stepped back from the market. Cap rates reached a low of 6.9 percent in 2006, according to Real Capital Analytics, down from 7.4 percent in 2005. Now cap rates are on the rise--anywhere from 50 to 100 points above their lowest level, according to estimates from brokers and investors. As a result, many REITs may change tack and look for more acquisition opportunities while slowing development activity.

That will reverse the dynamic that has been at play for the past couple of years. During the early stages of retail real estate's bull run, which began in earnest in 2002, REITs were achieving growth targets by snatching up mall and shopping center portfolios left and right. There were also a series of outright REIT mergers and acquisitions. Overall, REITs typically accounted for more than 40 percent of all retail acquisitions, Mower estimates. In the past two years, the share has dropped to approximately 20 percent. Other buyers entered the fray--including many that could afford to pay higher premiums for properties.

What's another reason that development yields are decreasing? This year's projected rent increases did not come to fruition, notes Scott Kaplan, senior managing director of retail services for the Western region at global brokerage firm CB Richard Ellis. Kaplan estimates that over the past decade, annual retail rent growth in most U.S. markets topped 10 percent each year. "This year, it just stopped," he says.

Retailers leasing space at new centers also insist on discounts and concessions, lengthening the negotiation process to more than 12 months, Kaplan added. Last year, developers moved from conception to groundbreaking in as little as six months.

Lenders have tightened the reins as well. Last year, they underwrote projects that had zero percent equity, according to Kaplan. However, this year, they insist on an equity contribution from 10 percent to 20 percent.

"There is still capital out there, but the capital is much more selective on where it's going," Kaplan says. "The lenders want to see a signed agreement with the anchor tenant, they want to see that there is hard money on the table."

For a development to be economically feasible, a builder needs yields of at least 7 percent to 8 percent. In the past couple of yeas, yields far exceeded those thresholds. Now, many developers face projections hitting right up against those numbers. This change in market fundamentals has taken its toll on privately held developers, who have less liquidity than the REITs. Kaplan cited a Phoenix-based builder who dismissed his entire leasing staff in order to retain the eight centers he has under construction. REITs counter by partnering with cash-flush institutional investors, says Kaplan, but they too are scrutinizing their pipelines.

Meanwhile, the cap rate decompression that began this summer has not translated to lower acquisition prices for Class A retail properties, says Brad Case, vice president of research and industry information with NAREIT. Therefore, REITs can't shift gears from development to acquisition just yet. And while entry into overseas markets remains an option for larger firms, including Developers Diversified Realty and Kimco Realty Corp., smaller players lack the capital to go abroad, says Jason Lail, senior research analyst with SNL Financial.

For her part, Mower expects more acquisitions to be announced in coming months. "I know of portfolio acquisitions that may have been a mixed bag a year ago that REITs may be in a 'move ahead' position on today," she says.

So what will REITs do as they wait for the market to sort itself out? Over the next two years, they are likely to focus on raising returns on their existing properties through re-merchandising strategies and aggressive leasing campaigns, Chandan says. However, don't look for them to scrap their development pipelines completely, says Case. They are more likely to scale down the amount of new space they plan to put on the market.

--Elaine Misonzhnik