With retail construction starts totaling approximately 301 million sq. ft. nationally in 2007, the shopping center industry is reporting robust development activity. That volume will be tough to match in 2008 as slower economic growth, slumping consumer spending and capital constraints join forces to curtail new development.

Still, developers remain confident in the long-term stability of the retail sector. A survey conducted jointly this fall by National Real Estate Investor and Retail Traffic magazines reveals that 91% of respondents who are active in retail or mixed-use real estate indicate they have plans to either develop new retail properties or redevelop, renovate and expand existing properties in the next 12 months.

Among the 77 survey respondents, 90% are currently active in retail and/or mixed-use properties, and 70% are active in two or more property types [Figure 1]. Opus Corp. is a case in point. The Minnetonka, Minn.-based developer has 30 different retail projects under way or planned totaling 15 million sq. ft., a 60% increase in volume since 2005.

“We are still bullish and optimistic on retail development for 2008, but we also are keenly aware of concerns retailers have as they relate to consumer spending,” says Tim Murnane, senior vice president and general manager of real estate development at Opus Northwest. “We are closely watching earnings reports from all of our retail clients, and studying patterns of where they are growing, or more importantly, pulling back.”

What is likely to have the greatest impact on development activity in the coming year? Some 48% of respondents cite the overall health of the economy, while 44% believe retail sales will have the biggest impact, the study shows. And 42% of respondents point to the availability of capital.

Those concerns represent a stark contrast from last year's results when 52% of respondents indicated that land costs were the biggest factor followed by overall health of the economy (45%) and availability of land (40%). A year ago, availability of capital ranked lowest in the survey at 27% [Figure 2].

In fact, economic and financial concerns are already taking a toll on construction activity. The U.S. construction market is expected to continue to weaken in 2008 due in large part to the slumping housing market, tighter lending conditions and weaker job growth, according to industry sources.

In a report titled “The Construction Outlook 2008” by McGraw-Hill, researchers write that total starts are expected to decline 2% to $614 billion, which follows on the heels of an 8% decline that was predicted for 2007. Construction starts on stores and shopping centers are expected to drop 10% to 270 million sq. ft. in 2008 down from 301 million sq. ft. in 2007, according to the McGraw-Hill report.

“The retail industry has enjoyed a wonderful 10-year period,” says James Ratner, chairman and CEO at Cleveland-based Forest City Commercial Group. “But no business goes up forever. I expect there will be some slowing in the retail industry.”

That confidence is likely due to the sector's solid track record in the past decade in terms of occupancies, rental growth and returns, though that's slipping some. In the third quarter of 2007, the vacancy rate at community and power centers reached 7.4% — the 10th straight quarterly decline and the highest level in half a decade, according to New York-based real estate research firm Reis Inc. Year-over-year, vacancies increased by 40 basis points.

The downturn will likely have the harshest effect on those “marginal” projects that don't exhibit strong demographics or sufficient demand to support them, Ratner notes. “But my assumption for others in the business — as it is for us — is that we're building to what we believe is real, existing demand,” Ratner adds.

Forest City has more than $2 billion in development, redevelopment and renovation projects either underway or planned. In fact, the firm plans to open three new shopping centers in 2008, which is a sizable increase compared with the one center it opened in 2007. Forest City opened the 715,000-sq.-ft. Promenade Bolingbrook in suburban Chicago last April.

Cash-strapped consumers

The slumping housing market — characterized in many parts of the country by a decline in home sales, plummeting prices and a drop in construction starts — is creating a drag on the overall economy. The question is how deeply those residential woes will shake the retail sector in terms of retail sales and new store expansion plans.

Respondents are less confident in the economy than they were a year ago. In fact, 36% of respondents expect a moderate decline in the U.S. economy over the next 12 months compared with 29% in last year's survey [Figure 3]. No one expects strong economic growth in 2008, and the 38% predicting moderate growth marks a significant drop from the 47% response in the 2006 survey.

Real GDP achieved an annualized growth rate of 3.9% in the third quarter, which is an improvement over the 1.1% growth rate the same quarter in 2006. However, some economists are predicting slower growth ahead with a 2.1% pace in the fourth quarter. Overall, expectations are for 2007 GDP growth to come in at 2.3%, followed by a 2.2% to 2.3% in 2008, according to San Francisco-based Wells Fargo & Co.

Consumers have continued to defy experts with their unflappable spending, but many retail market watchers are wondering if consumers have finally run out of steam — and financial resources. “I think consumers are getting close to the end of their financial rope,” says Scott Anderson, Ph.D., a vice president and senior economist with Wells Fargo.

Respondents appear to agree with that assessment. Nearly half (48%) expect consumer spending to decrease over the next year. By comparison, 31% of respondents last year predicted a decline in consumer spending [Figure 4].

“We do think the housing market downturn will have more important spillover effects on consumer spending next year,” Anderson says. The impact could start to materialize in the fourth quarter of 2007, in what some predict will be a tough season for holiday shopping sales.

“What happened in August with the liquidity crisis appears to be turning into a credit crunch for consumers, which will weigh further on consumers' ability to spend,” Anderson adds. The concern is that lower profit margins for retailers could translate to a pullback in store expansion plans.

Capital constraints grow

The crisis in the subprime residential market that began emerging in February moved into the commercial real estate sector in July. Credit concerns sparked a liquidity crisis among commercial lenders and led to tougher underwriting practices, higher equity commitments and increased borrowing costs.

The majority of respondents expect the current volatility in capital markets to have some impact on the shopping center industry. Most respondents (70%) expect to see higher equity requirements, 52% predict there will be fewer sources of capital, and another 44% predict higher interest rates [Figure 5].

At this point, the cost of capital has not changed dramatically. Higher spreads have been offset by a decline in the yield on the 10-year Treasury. As of November 12, the yield on the long bond was 4.21% — down 38 basis points from last year's level of 4.59%. “So when you're looking at the actual coupon that a borrower is paying, it is very close to where it was prior to the volatility occurring earlier this summer,” says Thor Orndahl, managing director at Prudential Mortgage Capital Co. in Newark, N.J.

Commercial mortgage-backed securities (CMBS) have been hit the hardest. Floating-rate CMBS have almost disappeared, while fixed-rate conduit loans still exist, albeit at a diminished and more expensive capacity. In addition, underwriting has become more conservative, and borrowers can expect to find lower-leverage deals.

Loan-to-value ratios of 70% to 75% are likely to be the norm on stabilized properties compared with 75% to 85% just a few months ago. In addition, the interest-only, full-leverage loans have disappeared. “The lending landscape has changed,” Orndahl says. “And that is going to change borrowers' investment strategy somewhat because they won't be able to invest with as little equity as they have in the past.”

Respondents vary on which property types will be most affected by volatility in the debt market. Most respondents (44%) expect multifamily to be most affected, followed closely by office (42%) and hotel (39%). Some 38% of respondents also predict that mixed-use will be significantly affected followed by retail at 35% [Figure 6].

Capital constraints haven't slowed development plans for Beachwood, Ohio-based Developers Diversified Realty Corp. In fact, the reverse is true. Because the REIT is able to finance its projects internally, the public company is actually looking at more opportunities as the financial reins tighten for many of its private competitors.

The firm currently has close to $4 billion in retail projects in various stages of planning and development, including 18 new projects under way and nine that were scheduled to begin construction by the end of 2007. “Our activity has been very consistent because we develop a variety of centers,” says Daniel Herman, a senior vice president of development at the firm.

The company is actively building mixed-use projects, discounter- and grocery-anchored community centers and lifestyle centers. “From our perspective, we will continue to develop retail properties, but we might be more selective simply because we have more opportunities to choose from,” Herman says.

Penchant for mixed-use

Despite financing and economic challenges, the retail development pipeline in the coming year remains active as retailers continue to expand. Target and Kohl's, for example, both announced this year that they plan to open 500 new U.S. stores over the next five years.

“Retailers are still looking to open new stores in quality developments,” says Gar Herring, president of the Dallas-based MGHerring Group. Those developments that stick to the fundamentals of securing quality locations in growth areas with strong demographics and co-tenancy will continue to land tenants, he adds.

Similar to last year, the favored property type for many respondents continues to be mixed-use. More than one-third of respondents (38%) say they are most likely to plan new development of mixed-use properties within the next 12 months compared with 37% in last year's survey. Other property types that scored high among likely development plans in the coming year include freestanding/single tenant retail at 29% and lifestyle centers at 25% [Figure 7].

The real driver behind mixed-use projects is tenant demand. The first question prospective tenants ask is about co-tenants, and the second question is always “what's the environment?” Herring says. “Customers like to be in an environment where there is more than one purpose with housing, entertainment, hotels, office and other park-like amenities,” he adds.

The MGHerring Group is developing the 500,000-sq.-ft. Village at Fairview and the one-million-sq.-ft. Village at Allen in neighboring Fairview and Allen, Texas. The two retail centers are part of a 400-acre mixed-use development that will also include 700,000 sq. ft. of office space, two hotels, more than 1,000 multifamily units, a cinema and a 7,500-seat event center.

The Village at Fairview is a lifestyle center anchored by Dillard's, Macy's and JCPenney, while the Village at Allen is a power center that will include a variety of big-box tenants, restaurants and specialty shops. Both will open in fall 2008.

Keeping it fresh

Redevelopment and renovation remains a key focus as shopping center owners strive to meet the needs of an ever-changing industry. Among those respondents who are active in retail or mixed-use properties, 52% have plans to renovate, redevelop or expand existing properties in the coming year, while 61% indicate that they have already done so during the past 12 months. “A good property only gets better over time, provided that you spend a lot of effort and time making sure that it remains responsive to market demand,” Ratner says.

Forest City is in the midst of a major renovation and expansion at its Promenade in Temecula, a one-million-sq.-ft. enclosed mall located in Southern California. The expansion will create 126,000 sq. ft. of shopping and entertainment space in an outdoor lifestyle component, as well as build additional parking decks.

“We're bringing in the kind of tenancy, restaurants and other retailers that we could not accommodate in the existing center,” Ratner says. “At the same time, we're renovating the existing shopping center. So when we open the center we will have, effectively, a new center.” The grand opening of the expansion is planned for March 2009.

Among those respondents that plan to redevelop, renovate or expand existing retail properties in the coming 12 months, grocery-anchored strip centers, non-grocery-anchored strip centers and downtown/urban centers are the most active property types. One in five respondents plans to renovate, redevelop or expand those types of properties in the coming year.

Feeding investor appetite

Developers remain confident in the stability of the retail sector — despite the formidable economic and capital challenges ahead. Part of that confidence stems from bottom-line results.

More than $58.4 billion in retail properties have sold this year through October at an average cap rate of 6.6%, according to Real Capital Analytics. Not only is that pace ahead of the $52.9 billion in retail properties that changed hands during the same period last year, but competition from buyers has pushed cap rates down

Cap rates have dropped 300 basis points since the 9.6% average in 2001, according to RCA. “I think the retail development business has always had relatively good returns, and that is because the demand for the product among institutional investors has been enormously high,” Ratner says. Even if sale prices have peaked — as some experts predict — and cap rates begin to rise, returns are still favorable.

Among respondents invested in retail properties and one or more other property types, 77% rate retail in the top three for returns. Lifestyle centers and grocery-anchored strip centers are thought to yield the highest returns, while mixed-use centers rank third. Combined, 49% of respondents rank lifestyle centers as their first, second or third choice, while grocery-anchored strip centers follow closely at 48% and mixed-use scored 40% [Figure 8].

True, the close relationship between new store construction and housing starts does not bode well for retail development in light of the current residential slump. That said, retail development may be propped up by demand created by shifting demographics in some parts of the country, as well as changing shopping patterns that fuel demand for more mixed-use and outdoor-oriented retail projects.

Ultimately, industry experts believe that well-conceived and well-located retail developments will continue to thrive despite the market constraints. Demand among institutional investors for retail properties is expected to remain strong as long as new shopping centers continue to perform well in terms of occupancies, sales and rents.

“If those projects don't do well, it will be a less desirable product type, and the values will reflect that,” Ratner says. “So it behooves Forest City, and everybody else in the business, to be very, very sure that what we're building is built for real market demand.”

Snapshot of Survey Respondents

Data for the second annual Retail Development Survey was collected between Oct. 4 and Oct. 22. E-mail surveys were sent to National Real Estate Investor and Retail Traffic subscribers who listed their firms in either the builder/developer or owner/manager categories.

The purpose of the survey was to analyze respondents' plans for development activity by volume and property type and to measure their expectations for the U.S. economy over the next year. Additionally, the editors sought to compare this year's findings with the results of the 2006 study. A total of 77 usable surveys were collected.

The majority of respondents are executives, with about half holding a top-level position. An additional 41% either carry the title of vice president or director. Three out of four are active in development or redevelopment. On average, respondents hold properties in their portfolios for 10 years.

The survey group has a median 95,000 sq. ft. of new retail property under development. Additionally, the group is currently redeveloping, renovating or expanding a median 100,000 sq. ft. of retail property. In 2008, respondents plan to begin construction on a median 225,000 sq. ft. of new retail space.