When the housing market began to seriously falter in 2006, some commentators raised the alarms that retail real estate would be next. After all, it is no secret that millions of Americans spent heavily on goods and services in large part because they pulled billions in equity out of their rapidly appreciating homes for years.

But the industry proved pundits wrong.

Cash registers keep ringing up sales in spite of the bursting housing bubble — even if growth has tapered off a bit in 2007 compared with the past couple of years. (Same-store sales growth has averaged about 2.3 percent per month this year.) More importantly, the sector boasts sterling fundamentals. Property values in markets across the country sit at or near all-time peaks. The development pipeline is also bursting at the seams. Retailers have filled existing centers to the brim and also gobbled up space in both expansions and new developments.

In fact, at the ICSC Spring Convention, developers were more focused on meeting retailer demand for space for expansion plans in 2008 and 2009. They took care of this year a long time ago.… Or so it seemed.

However, new data may suggest the first signs of weakness have emerged.

At the end of the second quarter, vacancy rates at neighborhood and community shopping centers hit their highest level in nearly four years, according to Reis Inc. The vacancy rate climbed 10 basis points to 7.3 percent during the quarter, making it the ninth consecutive three-month period of flat or declining occupancy.

Meanwhile, absorption — or the change in the amount of leased space — dropped to 3.1 million square feet, also its lowest level since 2003.

And the situation isn't likely to improve this year. Developers are slated to deliver more than twice as much new space in the second six months of the year as they did in the first. All together, 26.2 million square feet of new space is slated to hit the market, up from 11.4 million square feet in the first half of the year. While much of this space is leased, Reis Inc. chief economist Sam Chandan predicts it will push the national vacancy rate up even further, to 7.6 percent, its highest level in 12 years.

According to CoStar Group data, developers will deliver 188.1 million square feet of retail space in 2007, the most in a single year in at least the past 25 years. (That's just 13 million square feet less than Indianapolis-based Simon Property Group, the nation's largest owner of retail space, had in its entire portfolio as of Dec. 31, 2006.)

This year's burst of construction is a whopping 53-million-square-foot jump over 2006. And it is 32 million more square feet than the second biggest year on record — 1986.

“The projected imbalance between net absorption and completions will increase the upward pressure on retail vacancy rates, as well as on concession levels for new and renewing tenants,” Chandan says.

Moreover, some retailers are now stepping forward and lowering their store opening projections for 2008 and 2009. This could be particularly worrisome given that there is 209 million square feet of space in development, according to CoStar Group. (Developers delivered 661 centers containing 20.3 million square feet to the market in the second quarter, according to CoStar.)

Still, is this rise in vacancies enough to cause serious worries? The answer coming from brokers and developers so far is “no.”

Even though vacancies have crept upward, landlords retain a strong hand in the lease negotiating process. Deep concessions that predominate in weak environments — such as long stretches of free rent, huge tenant improvement allowances or even rent decreases on renewals — are not on offer. For now, data providers see concessions as remaining stable — about 9 percent of asking rents. And don't expect that to change much in the second half of the year or even into 2008. In fact, rental rates continue to go up. According to CoStar, quoted rents at the end of the second quarter were $17.76 per square foot — a 3.3 percent increase over the end of the first quarter.

Drilling down

Other data providers are seeing similar trends to REIS. In its mid-year review, CoStar Group measured a rise in national vacancy at retail properties to 6.8 percent, up from 6.6 percent at the end of the first quarter. CoStar also measured a rise in sublease space in the market. It sees about 19.5 million square feet of that supply in addition to the 25.8 million square feet of vacant space.

Torto Wheaton Research, CB Richard Ellis' research arm, also confirms the slight uptick in vacancies.

“We feel that the availability rate is rising because consumers have turned circumspect due to the slowdown in the housing market and that their spending is being affected by high gas prices, so retail space absorption is declining,” says Abigail Marks, an economist at Torto Wheaton. Completions are also outpacing demand, compounding the problem.

Experts believe the main culprit is that slowing retail sales are starting to catch up to the industry, especially in some hard-hit sectors where sales growth has turned negative. That performance has altered some firms' plans, causing them to downscale formerly ambitious expansion targets. According to Thomson Financial, specialty retailers saw same-store sales drop 11.4 percent in July — far lower than analysts expected — and apparel retailers didn't fare much better. Same-store sales in that sector fell 2.1 percent, mainly due to poor performance at Gap Inc. Even Wal-Mart Stores Inc. saw its same-store sales rise only 1.9 percent.

“The slowdown in the housing market has certainly caused some consumers to take a step back and reevaluate their spending habits,” Marks explains. “They've become more cautious.”

The lower sales have forced cutbacks in retail employment levels and some retailers have announced plans to slow down their growth. Wal-Mart said in June it would build only 190 to 200 new Supercenters in 2007, down from its initial plans to build 270. Office Depot also recently said it would slow its expansion following softer sales of furniture, supplies and technology items.

No retailer relief

Although retailers have begun to see the effects of the economic slowdown on their sales figures, they haven't had much relief from expenses, including the cost of leasing space. Despite high vacancy rates in a large part of the country, both asking and effective rents are rising.

According to the Reis data, asking rents climbed 0.8 percent to $19.21 per square foot in the second quarter and effective rents also grew 0.8 percent to $17.42 per square foot. In fact, a majority of the 76 markets in the firm's report saw rents rise, even as occupancy rates grew in only 30 of 76 markets and positive net absorption was found in only 47.

Chandan says the high rents are a result of space that was built during a more profitable time and is pre-leased at higher rents. New retail space may also be able to garner higher rents in areas that have been less affected by the downturn. “With a lot of new inventory being completed, some of these places could demand premium rates,” he says.

Bernard J. Haddigan, senior vice president and managing director of Marcus & Millichap's national retail group, says the pre-leased new construction is helping to keep the effects of the consumer environment at bay.

“From an operational point of view, it's been a fairly healthy year so far. In the short term, we're not really seeing a strong impact yet,” he says.

“Much of the new construction is still pre-leased,” Haddigan adds.

Hot markets

California is one area where pre-leasing, combined with an influx of new residents, has helped keep the retail real estate sector healthy. The state — like other Sun Belt states such as Florida and Arizona — has enjoyed massive population growth and a strong economy in recent years.

In Orange County, for example, the vacancy rate was only 2.7 percent in the second quarter according to Reis (and 3.0 percent according to CoStar). A new one-million-square-foot retail project called District at Tustin Legacy, which opened there in May, was virtually entirely pre-leased well before the start of the year. And rents are rising even as deliveries are projected to rise 70 percent in 2007, according to a 2007 Marcus & Millichap national retail report.

In other areas, consumers willing to put aside economic worries and continue to spend are helping to stave off a slowdown. In the Twin Cities, consumers' willingness to spend more on discretionary items like clothing, entertainment and food is helping landlords avoid large concessions, says Tricia Pitchford, senior real estate associate at United Properties in Bloomington, Minn. “We realize the market is a little bit quieter,” she says. “A few years ago, we really could have [retailers] compete against each other.”

A bleaker picture

In the Midwest, particularly in Ohio, the situation is far bleaker. In Cincinnati, the vacancy rate reached 12.3 percent in the second quarter due to a glut of retail space that came on the market in the first half of 2006 and has proved hard to rent. In Columbus, meanwhile, Marcus & Millichap projects more concessions with asking rents outpacing effective rent gains and owners looking to find ways to lease available space.

Nationally, small shops in suburban markets appear to be the hardest hit since consumers are no longer building homes in those areas at the speed at which they did in the late 1990s. Regional and superregional malls, on the other hand, look to be faring well, with a vacancy rate of 5.6 percent in the second quarter, well below the 6.8 percent peak rate recorded in the fourth quarter of 2001, according to Reis.

In those areas that are experiencing some effects of the overall consumer environment, the landscape may begin to look a bit different. In Minneapolis, Pitchford says, the small-shop spaces are increasingly being rented to professional services firms, like doctor's offices and small accounting firms, which have been far less affected by consumer spending issues but are interested in the convenience of a retail location.

Developers may also have to hold onto land and parcels for a longer period of time. Developers looking to build grocery stores and shops for young professionals in newly built downtown condos might never see their stores built as condo sales slide.

But for now, most landlords and retailers aren't too worried.

In the Twin Cities, Pitchford says the slower market has already led to more landlords offering free rent up front or giving a month's free rent every year. But, she added, “I don't feel like landlords are in a panic.”

SECOND QUARTER 2007 MARKET PERFORMANCE
Improving Fundamentals/Flat or Declining Fundamentals
Absorption Occupancy Effective Rent
Declining Improving Declining Improving Declining Improving
Q2 2007 47+ 29 30+ 46 61+ 15
Q1 2007 49+ 27 30+ 46 66+ 10
Q4 2006 56+ 20 34+ 42 59+ 17
Q3 2006 51+ 25 26+ 50 68+ 8
Source: Reis Inc.
TOTAL RETAIL MARKET STATISTICS
VACANCY TRENDS
Period Existing Inventory Total Sq. Ft. Vacancy % Quoted Rates
Q2 2007 6,766,392,208 460,121,839 6.8% $17.76
Q1 2007 6,746,351,867 448,282,500 6.6 17.19
Q4 2006 6,719,513,314 434,211,481 6.5 16.76
Q3 2006 6,679,800,313 426,241,624 6.4 16.45
Q2 2006 6,652,716,880 411,471,379 6.2 16.11
Q1 2006 6,629,361,415 395,031,779 6.0 15.57
DELIVERIES UNDER CONSTRUCTION
Period Buildings Total GLA Buildings GLA
Q2 2007 661 20,338,412 3,214 209,418,791
Q1 2007 738 28,468,913 3,140 193,824,211
Q4 2006 880 40,404,802 2,427 151,143,829
Q3 2006 745 27,459,959 2,584 158,149,918
Q2 2006 770 24,645,614 2,524 146,246,972
Q1 2006 1,060 35,422,838 2,324 123,877,368
Source: CoStar Property