Capital In 2012 - A Continuing Path Of Slow But Incremental Growth
As we have done each of the last three years, we will once again take on the daunting task of forecasting what will happen to the retail industry and, in particular, the capital markets in 2012. However, before doing so, we can not resist reciting the immortal words of Yogi Berra: “It’s tough to make predictions – especially about the future.”
2011 turned out to be a very volatile year for the economy. The first half of the year showed signs of recovery and increased consumer confidence. The stock market surged and job creation, although not great, showed some signs of life. This led to a small but incremental increase in retail sales, consumer spending and lending. However, by the summer, the economy faltered significantly. The fight in Congress over an increase in the U.S. debt ceiling (which ultimately led to a lowering of the credit rating of the U.S. by Standard & Poor’s), a downturn in the U.S. jobs market, and the European debt crises, resulted in a significant loss of confidence in the U.S. economy, along with a major drop in the stock market. These events also led the media and economists to speculate about a possible “double-dip” recession. On the heels of all of this, one would have been hard pressed to predict a strong rebound in the economy in the last two months of 2011. However, that is exactly what happened.
The two main factors causing the turnaround were the European Central Bank stepping in with loans to banks in the 17 nations of the European Union and calming sovereign debt default fears in Europe (for the moment), and a reduction in the unemployment rate in the U.S. from 9.1% in August to 8.5% in December. As a result, retailers had a very respectable holiday season in 2012. To illustrate this, the 22 retailers tracked by Thomson Reuters showed a 3.4% gain in December sales at stores open at least a year.
This bodes well for some optimism entering 2012. However, the economy still remains fragile and can be easily derailed by any one of a number of events ranging from a further weakening of the global economy by more European unrest in its debt markets to political unrest in the Middle East. In addition, in the best of circumstances, economists do not expect anything other than the possibility of slow incremental growth in the U.S. economy during 2012 considering the housing foreclosure problems, the lackluster job market and local, state and federal government “belt tightening” and grid lock.
With respect to the retail industry, 2012 should continue to reflect the larger economic picture. Very little new development is expected other than in urban infill locations, and retailers continue to remain cautious about store expansions, with the possible exception of the discount-oriented retailers such as Ross, Marshalls, Family Dollar and General Dollar, grocery store chains, and fast casual restaurant chains. In addition, some larger box retailers and health clubs have shown a desire for more growth. Target, Wal-Mart, LA Fitness, 24 Hour Fitness and Dick’s, to name a few, have all shown a propensity for expansion as compared to the past few years.
Turning to the capital markets, they increased slightly in 2011, as compared to 2010, notwithstanding a significant tightening during the third quarter when the U.S. economy faltered. Investor demand was strong, which resulted in slightly higher loan originations amid varied financing options. The balance sheets of most lenders strengthened during 2011 due to loan modifications and extensions and fewer write-offs, made possible through the “amend and extend” strategy. However, this strategy is gradually losing steam as lenders focus on permanent resolutions of troubled loans resulting from a pick-up in commercial real estate investment activity. 2011 also saw lower delinquency and default rates and better loan quality. In the coming years, however, the commercial real estate debt markets still remain challenging with nearly $1.8 trillion due during 2011-2015, with approximately 60.0% of this amount estimated to be “underwater.”
Although CMBS originations were stronger than 2010, the market faltered along with the economy in the third quarter due to market volatility, which saw investor appetite switch to treasuries and away from the perceived risks associated with CMBS. This caused CMBS spreads to widen, which created problems for those lenders sitting on loan inventory that had yet to be securitized. As a result, CMBS originations in 2011 hovered around $20 billion, well below the predicted $40 to $50 billion. A more robust CMBS market in 2012 and beyond will be central to a more sustained commercial real estate recovery.
The volume of Bank loans continued to slowly increase in 2011, although banks continue to remain cautious about underwriting standards and sponsors. Most new loans continue to chase “core” properties in top tier geographic regions. With no secondary market, banks making larger loans will be looking to lay off some of the risk by bringing in participating banks or co-lenders. Banks are still in no rush to sell distressed assets and take losses. They will continue their preferred strategy of extending many loans with modifications rather than refinancing or disposing of them. They would rather wait for more promising opportunities and avoid balance-sheet issues until markets approve. Much like in 2011, typical loan to value ratios for both bank permanent and construction loans will range from 50% to 65%, maybe higher for recourse loans with higher reserves. Terms will be short – typically in the 3 to 5 year range, interest rates will remain low, but do not necessarily follow the historically low 10 year treasury rates, and interest rate swaps will be often required of borrowers as a hedge against significant interest rate fluctuations.
As they did in 2010 and 2011, life insurance companies will continue to lend in 2012, and with higher allocations. As with banks, the underwriting of life insurance companies will remain very strict since they have plenty of options available to them because of their limited allocations. They will lend to the “best-breed” borrowers who own class-A properties. They will continue to underwrite at values well below past peaks with reasonable loan-to-values in the 60% to 65% range and on projects providing good debt-service coverage and solid net operating incomes. Life company loans will continue to be predominantly permanent loans with terms between 5 and 10 years. They will be non-recourse loans with fixed interest rates between 3% and 5%, and with amortizations over 25 to 30 years. Life companies have made a significant dent in filling the void left by the collapse of the CMBS markets, but unfortunately are not able to provide the smaller loans previously available when the CMBS markets were robust.
Mezzanine debt and preferred equity are available to borrowers in need of meeting the stringent equity requirements of lenders and for refinancing or restructuring existing debt. However, this capital comes at a high cost – projected “equity-like returns” at 15% and up. These lenders orient more to preferred equity positions and desire significant control over the direction of projects to allow them exiting strategies.
We wish we could predict that 2012 will be the year when the economy and the retail markets improve significantly. However, it would be hard for anyone, other than “Pollyanna,” to take this view. As we stated in last year’s forecast, “[t]he profound events of 2007 and 2008 were neither bumps in the road nor an accentuated dip in the financial and business cycles we have come to expect in a free market economic system. This was a fundamental disruption – a financial upheaval, if you will – that wreaked havoc in communities and neighborhoods across this country.” It is going to take years for the U.S. economy and retail and capital markets to fully recover. We are still at the very beginning of this fragile recovery. As was seen in the third quarter of 2011, many factors can derail sustained and continued recovery. As was the case in 2009, 2010 and 2011, we continue to see positive signs of recovery, but the recovery will be one of slow incremental non-linear gains. We expect 2012 to exceed the “recovery benchmarks” seen in 2011, but gains in 2012 will be a part of the longer term five to ten year recovery continuum necessary to return the retail industry to something close to the ten year real estate “boom” experienced prior to 2007.