Retail Development - Hold On To What You Got
In last year’s forecast for retail developers, the overriding theme was “change” – change in the way retail developers were valuing their portfolios from prior years, change in their approach to leasing vacant space, and change in their overall operating strategy. And while the economy appears to have improved modestly as we turn the calendar to 2010, many retail developers are clinging to the tactics that got them through a rough 2009. Indeed, in what may seem like an oxymoron, a popular strategy of retail developers at the current time is not to develop at all. Rather, the focus appears to be on trying to maintain existing occupancy levels and improving the quality of assets, to the extent existing capital is available. Also, some retail developers with debt are being forced to raise capital to pay down their loans to meet existing loan-to-value covenants as property values continue to drop.
Many of the issues that contributed to the slowing of new retail development beginning in 2008 and continuing through 2009 are still present, and may continue to serve as impediments to new development for some time. Housing starts, while up modestly in California and the western United States, are still relatively stagnant, so there are no new housing projects or residential neighborhoods for retail development to service. Unemployment continues to plod along at dangerously high levels, resulting in fewer consumer dollars being spent – both because of a lack of income from the recently unemployed, as well as trepidation from those who fear that they might soon lose their jobs and, therefore, are more prudent with their spending habits. For others with seemingly solid job security, the emphasis for the family budget has shifted from spending to debt reduction and increased savings, all of which impacts retailers. Indeed, while retail sales for December 2009 rose by 5.4% over December 2008, they were actually down 0.3% from the prior month, as some question the extent to which consumer spending is gaining traction.
Without retailers to fill new product, there is no need for retail developers to even contemplate new projects. As such, with little to no new development forecast for 2010, retail developers are left to take a lay of the (developed) land, and what they are seeing is somewhat disconcerting. A lack of consumer spending has impacted virtually all sectors of retail, forcing some retailers to close their stores, and others into bankruptcy. Not surprisingly, vacancy rates for malls and shopping centers were up in 2010, reaching an 8.3% vacancy rate in the 76 largest U.S. markets, according to The Wall Street Journal. And, for those retailers who continue to keep their doors open, many are finding the need to seek rent relief or other concessions from their landlords. While retail developers with centers in the most desirable locations may be able to reject such requests (figuring that, if a tenant leaves the center, there will be another right behind it willing to pay comparable rent), most landlords are in the position of seriously considering granting such relief or other concessions to keep tenants open and centers as vibrant as possible.
At the same time, the need to fill vacant space has resulted in some retail developers doing deals at rental rates that would have been inconceivable only a few years ago. Indeed, some analysts predict that underlying rents will continue to drop for at least another two years. This climate has resulted in good growth opportunities for retailers with capital and/or a desire to expand even in tough economic times. Since many of the “reduced rent” deals are being struck with terms in the 10 to 20 year range, these retailers will likely find themselves sitting on below market rents when the economy ultimately improves. This is good news for the retailer, but it will likely have a negative effect on a developer’s ability to refinance or obtain a take-out loan when the credit markets open up, as operating income (and hence, center value) may be driven down by below-market rental rates.
As was the case in 2009, some retail developers are also being forced to consider alternative uses to fill vacant space, or are offering special events at their centers. Operators of deep discount stores, thrift stores, governmental offices, schools and churches are in some cases finding themselves with landlords willing to do deals in centers where doors would have been firmly slammed shut just a few years ago. In addition, some retail developers are introducing special events at their centers, like farmers markets and free visits with Santa Claus, in an effort to increase customer traffic.
Some retail developers have decided to use the current climate to attempt to raise capital by selling off portions of centers which are occupied by credit tenants in triple-net deals. Coupled with a trickle of increased liquidity in the capital markets toward the end of 2009 (as some life insurance companies and commercial banks returned to the commercial real estate market), and a slight uptick in commercial mortgage backed securities, the new inventory on the market resulted in approximately $45 billion in such transactions in 2009, with some analysts predicting a total of twice as much in 2010. Some retail developers who raised money through such triple-net “pad” sales used the proceeds to pay down debt (in an attempt to stabilize loan-to-value ratios), while others were able to use the money to refurbish or otherwise renovate existing centers. By spending money on improving existing product during “down” times, these developers are hoping to be able to attract new tenants when the market turns around, and charge comparably higher rents, because of improved buildings, common areas and other shopping center amenities.
Retail developers who have raised capital and who do not need to use the proceeds to pay down debt or refurbish existing product, but instead would like to acquire existing centers, are finding a dearth of product on the market, as was the case in 2009. Indeed, those developers, including many public REITs, with capital to spend who were waiting for a flood of distressed centers to enter the market because of defaulting owners and foreclosing lenders have found the landscape relatively barren. Instead of foreclosing on problem loans, banks have been willing to extend the terms of such loans so the product is not hitting the market, at least not yet. In addition, the bid-ask spread that began in 2008 and widened in 2009 has only closed somewhat, as owners of shopping centers continue to value their assets at much higher prices than potential buyers. The lack of activity has left some retail developers flush with capital, but with little choice but to hold it until there is inventory on the market that is reasonably priced, in their opinion.
As retailer developers move into the second quarter of 2010, there appears to be a bit more optimism than was present at this time in 2009. However, the forecast of large brokerage firms and other analysts seems to indicate that there will be little recovery in retail in 2010, but that it may begin to generate momentum in 2011. For 2010 then, retail developers appear to be focusing on doing whatever possible to hold onto existing tenants (including offering rent relief and other concessions), spending some money (to the extent available) on improving existing centers, and doing what is necessary to placate lenders and make sure they are meeting the terms of existing loans.