At the beginning of 2009, we looked at the retail industry (and the commercial real estate markets in general) and attempted to predict how they would fare over the coming year, and when traditional capital would return to the real estate industry.
On the heels of a horrible 2008 fourth quarter for the United States economy and the real estate industry, predictions for 2009 were bleak. One thing that was certain was the need for the Federal Government to take very definitive action to prevent another Great Depression. And that they did. As reported by us last year, the United States Government invested heavily in the banking system, the car industry, the insurance industry and the housing industry.
Although these Government investments were unable to spur the sale of distressed or “toxic” assets by financial institutions, and the first half of 2009 brought on the loss of jobs at an alarming rate, it appears that the “second” Great Depression has been averted. The economy is now starting to normalize. Job losses have finally stabilized (although it will take years for the economy to recover the over 8 million jobs lost), GDP has begun to grow again, retail sales are up slightly, consumer confidence is starting to return, and the stock market has recovered a significant portion of its losses from the last 18 months.
This is good news for the retail industry. However, despite this good news, the value of retail properties has dropped significantly due to retailer bankruptcies, the precipitous drop in rental rates, the lack of retailer interest in new stores, retail rent re-sets and a dearth of shop tenant demand. Investment sales were still anemic in 2009, although the bid-ask differential seemingly did start to narrow. With respect to new retail development, most retail experts do not expect any significant new development (except some rare in-fill locations and large box single store phased developments) for 3 to 5 years.
With respect to the capital markets, over the last year, banks have chosen to work with their borrowers to avoid foreclosures. In many cases, they have either re-worked existing loans (usually in cases where cash flow continues to cover debt service) or, in the case of maturing loans, chosen the path of extending the maturity dates knowing that their borrowers could not refinance under the current stricter underwriting standards (the practice commonly referred to as “pretend and extend!”). For the most part, banks have not wanted to acquire and sell distressed assets, determining that their balance sheets would be vastly superior by avoiding foreclosures and sales at distressed prices. At the same time, most of the large banks have slowly returned to health by de-leveraging and stabilizing their portfolios, and by earning profits through investment strategies made possible by the minimal cost of funds available to them through the Federal Reserve.
However, despite the posture of banks over the last year, many real estate pundits continue to believe that the commercial real estate industry is a disaster waiting to happen. It has been reported that approximately $1.2 trillion in commercial debt is due to mature by 2013, a large percentage of which are CMBS loans. A vast number of these loans would not qualify for re-financing under today’s stricter bank underwriting standards. What happens with these loans will significantly affect the capital markets, as well as the retail industry, over the coming year.
Two possible scenarios exist.
In the first scenario, banks and special servicers will work with borrowers to extend and “work-out” troubled loans as they have been doing over the last year; they may foreclose on select assets, but will only do so in limited circumstances and over a longer period of time – well beyond 2010. The banks seem to have learned some valuable lessons from the early ‘90s when, through the RTC, banks disposed of distressed assets at bargain prices, took significant balance sheet losses, and allowed developers and private equity groups to prosper mightily off of these assets as the economy recovered and the assets were enhanced and sold.
The second scenario is one in which the banks and special servicers become much more aggressive with problem loans. If this happens, it will be very difficult for many retail developers to survive. Some will file bankruptcy as a defensive measure to attempt to force their banks to work with them on re-structuring problem loans. However, if this scenario occurs, the investment markets will more quickly become “unclogged”. Many more assets will be sold, prices will stabilize (albeit at lower values), and transaction activity will significantly increase. There is currently a tremendous amount of capital sitting on the sidelines. The public markets (and other capital sources) have provided numerous investment vehicles with money to buy these distressed assets. Will this be good for retail? For some, the answer is yes. However, for retail developers, this scenario will create a situation in which only the strong survive.
What will most likely happen will be a hybrid of actions by financial institutions under both of the scenarios set forth above. We believe these actions will cause the retail markets to slowly recover. However, a return to fundamentals will occur for retailers, developers and banks.
Retailers will be more cautious; they will not look to locate across the street from direct competitors. Already, the number of retailers in any one category has been significantly reduced through bankruptcies or consolidations. Retailers will be less likely to locate in areas where housing is expected, as opposed to existing, and they will merchandise more prudently.
With respect to developers, they will attempt to avoid building or buying in secondary and tertiary markets. They will only buy raw land when significant pre-leasing has occurred. They will preserve capital knowing that it will take more equity to borrow.
In the lending community, underwriting standards will get tougher. Lenders will discount rents in anticipation of turnovers, they will underwrite taking into account troubled retailers, they will require 35% to 40% equity, and their loans will be recourse. However, liquidity will return, as was the case in 2009 in a very limited fashion (i.e., loans were available for high-quality assets in top markets with strong and reputable borrowers). CMBS deals will begin to slowly make some sense, if underwritten better with structures that are not as complicated and which create a better means for dealing with troubled assets. A few new CMBS deals were consummated in 2009, and more will occur in 2010.
In summary, the retail industry will show incremental signs of recovery in 2010. However, we believe that a significant recovery in both the capital markets and the retail industry, although begun in 2010, will really take a more measurable hold in 2011.