Retail Development – The Times They Are A-Changin'

Just a few years ago, when shopping centers were relatively easy to value and credit was easy to obtain, many retail developers were able to expand their portfolios at rapid rates, finding properties at cap rates that encouraged growth. Additionally, those developers who were not in expansion modes at the time were nonetheless able to charge high rents to shopping center tenants who were themselves expanding and interested in opening as many stores as possible.

Times have changed, however, and, so long as the credit and stock markets continue on an uncertain and, some might argue, unprecedented path, retail developers are left in a difficult position. Those developers who had recently been in an acquisition mode are finding it difficult to assess the fair market value of existing shopping centers because of a dearth of transactions. In addition, developers with existing centers who are not currently looking to expand are finding themselves scrambling to keep struggling tenants, and some are trying to fill vacant space with categories of tenants that would have been unthinkable a few years ago.

For the retail developer who views the current economic climate as an opportunity to expand its portfolio, the lack of transactions in the market place has resulted in significant uncertainty regarding property values. Neither sellers nor buyers of shopping centers have many comparable sales upon which to value existing product because transactions simply are not happening; in addition, it is arguable that the hyper liquidity in the credit markets prior to 2008 artificially drove up prices. The result is that owners of shopping centers are valuing their products at much higher prices than potential buyers, and the bid-ask spread is substantial enough to prevent most transactions from moving past initial inquiries and due diligence. Thus, while sellers may get several bids for a property, in many cases they do not get a valuation that is acceptable to them, so they elect to hold onto the property. Consequently, both sellers and buyers are left in a waiting game, with neither side currently willing to budge.

The problems for retail developers are not limited to existing centers – land development has also been severely impacted, due to the crash in the housing markets, which has resulted in retail tenants drastically scaling back their expansion plans. This retrenchment has brought the construction of new shopping centers to a grinding halt, as with no new housing, retailers cannot justify opening new stores, making it virtually impossible for many retail developers to grow their portfolios in the manner to which they had become accustomed over the past decade – buying relatively inexpensive raw land on the outskirts of cities, confident that newly constructed residential subdivisions would quickly fill up and provide customers for their new centers.

In addition, a lack of available funds to developers in need of capital has caused the market to stagnate. It is estimated that the two major sources of debt, banks and commercial mortgage backed securities (CMBS), represent a combined ownership of 80% of all commercial real estate debt. However, banks are experiencing significantly stricter regulatory oversight, making it much more difficult to lend, and the CMBS market has all but shut down. Indeed, CMBS originations, estimated to be $230 billion in 2007, dropped to a mere $12 billion in 2008. The credit market is clearly locked up, and it remains to be seen whether TARP (Toxic Asset Relief Program), TALF (Term Asset-Backed Securities Lending Facility) and the other stimulus packages making their way through the nation’s capital will have much of an effect on relieving the blockage.

Another market-driven difference that may affect a potential buyer is that, just a few years ago, a buyer could acquire a shopping center with several vacancies with little worry about being able to lease it up with creditworthy tenants willing to pay high rental rates, as those tenants (particularly publicly traded ones) were also in expansion modes and eager to find spaces and open as many stores as possible. The shopping center acquisition could be underwritten with optimistic numbers for rental income, as opposed to the uncertainty that plagues the current market. Potential buyers now only view vacant space with skepticism, as deals with creditworthy tenants are currently much more difficult to find.

With cap rates on the rise, some developers who are looking to expand are shifting their focus to in-fill locations or single tenant deals where the former tenant has vacated. For example, spaces formerly occupied by Circuit City, Linens ‘N’ Things, Mervyn’s and Home Depot Expo are hitting the market, and are attractive options for some developers with capital to spend. Such spaces can be relet to big box users or demised into smaller spaces and leased to some of the retail tenants who are currently active and looking to make deals, although even those retailers are seeking to benefit from the downturn by paying significantly lower rates than were achievable just 18 months ago.

Even developers who are not in an expansion mode likely will find themselves with plenty of issues regarding the properties in their portfolios. Of primary concern is retaining existing tenants. To do so, developers are being forced to offer rent relief or other concessions to tenants who are having a difficult time staying in business. While reducing the cash flow of a project is likely to have a negative effect on a developer’s ability to refinance or obtain a take-out loan when the credit markets open up, many developers believe that it is more important to keep tenants open and shopping centers as full as possible in the short term.

In addition to keeping existing tenants open and operating, some developers are being forced to consider alternative uses to fill vacant space. Uses which up until recently had been anathema to shopping center owners are now being viewed as possibilities – discount stores, thrift stores, governmental offices, schools and churches are just some of the uses which developers are considering to “bridge the gap” until the market turns. Of course, in allowing those uses, there may be issues with existing CC&Rs or leases with major tenants that a developer needs to consider. Such documents may expressly prohibit such uses or, in the alternative, require the consent of one or more of the existing occupants of the shopping center.

Unfortunately, there is no crystal ball that definitively sets forth the date the current recession will end and retail development will begin to rebound. It is, in many ways, an unprecedented time in retail real estate, and most developers are doing their best to use techniques and information gleaned from the past to keep their heads above water and ride out the storm. The majority of analysts seem to think that it will be early 2010 before there will be a modest rebound, and that it might be early 2011 before a stronger recovery occurs. However, that storm may be clearing sooner than later, as recent reports indicate that consumer spending is trending up, housing starts have increased, the stock market has improved, and there is an expectation that 2009 holiday sales will increase over 2008 (albeit modestly).