After posting stellar returns of nearly 30% in 2006, retail REITs have taken it on the chin. Total returns year-to-date through Oct. 24 were a negative 2.15%. But the good news is that the retail sector is somewhat healthier than the office and residential sectors.

Regional malls are performing better than community shopping centers, but free-standing properties are outdoing malls, with year-to-date returns coming in relatively strong at 3.86%, compared with a negative 5.61% for shopping centers and a relatively flat 0.2% for regional malls, according to the National Association of Real Estate Investment Trusts.

In contrast, apartment REITs posted returns of negative 13.16% in the same period, down from a whopping 39.95% in 2006. Office REITs, meanwhile, plunged to a negative 9.9% through Oct. 24, down from a glowing 45.22% for all of 2006.

“In general, retail has been the least overbuilt product type in the last 20 years,” says Bernard Haddigan, senior vice president and managing director of Marcus & Millichap's retail group. “Office has been more of a gamble — you may make more money in the long run but I think there's less risk in retail.” Upscale malls are thriving, he says, and will expand in the Southwest and growing states.

However, the International Council of Shopping Centers reported in September that same-store sales grew only 1.7%, down 19 basis points from 2006 growth of 3.6%. ICSC projects 2.5% growth through the end of the year.

Why retail fares better

Retail REITs haven't suffered major damage, some analysts say, because their revenue is tied more to long-term rent cycles than to the economy. When regional job losses occur, they are somewhat insulated by leases, which average 10 years.

Mall performance has more to do with asset quality and the demographics of nearby residents than with short-term economic cycles, experts say. While secondary malls with lower ratings have lost traffic recently, luxury malls such as Simon Property Group's Lenox Square in Atlanta or Taubman Centers' Mall at Short Hills, N.J. are doing quite well.

“In the higher-quality mall there seems to be almost a nonstop demand for space. If one concept fails, there seems to be two or three more waiting in the wings,” says Barry Vinocur, editor of REIT Zone Publications in Novato, Calif. Investors tolerate higher leverage with malls than with office space, since they have demonstrated stable cash flows and earnings over decades, he says.

Modest growth ahead?

Investors can expect modest growth among retail REITs, particularly in January as mature leases expire and some rents rise, says Beth Campbell, director of the real estate companies group at Standard & Poor's in New York. S&P is cautious because of concern about consumer spending and energy costs. Of the 13 powerful retail REITs it examines, S&P rates 11 as “stable” and two as “positive outlook.” The 13 account for more than a fourth of S&P's rated securities, or $32 billion, Campbell says. November and December will be vital for retail, since a high percentage of earnings are generated during the holiday season.

Some regions can expect significant growth. In Las Vegas over the next five years, twice as many shopping centers are expected to be built as have been built in the last 15 years, says Haddigan.

Chris Lucas, senior REIT analyst at Robert W. Baird in McLean, Va. says established retail centers in mature locations will weather the turbulence without difficulty. But new projects located farther from cities could encounter problems.

“I'm sure we'll see anchors postpone their plans; we'll see some developers have to delay projects. We'll see projects get downsized or at least truncated,” Lucas says. It will provide opportunities for deep-pocket investors, and pain for merchant developers unable to sell their projects at a profit, he adds.

While strip malls anchored by supermarkets or “big-box” stores pop up frequently, regional malls are rare because of the cost, the shortage of land near major cities and the complicated entitlement process.

In late October, Taubman debuted the $155 million, 640,000 sq. ft. open-air Mall at Partridge Creek about 20 miles northeast of Detroit. Thousands of shoppers coursed toward the mall's 70 stores and its bocce courts, outdoor TVs and 30-foot fireplace, a gratifying response for the developer, who anticipates a 10% return on investment.

Rich Moore, managing director of Cleveland-based RBC Capital Markets foresees a healthy market. “Basically the demand is extremely high. That's not going to change just because consumers have a bad quarter or two.”
— Denise Kalette is senior editor.