The Real Estate Retail Market Q1-2010

April 19, 2010

National

Unprecedented government stimulus and intervention prevented the worst case scenario for the U.S. economy and may have helped bring the great recession to an end but over time, the conduct of the U.S. monetary and fiscal policy has also prompted an imbalance between supply and demand for U.S. Treasury notes and is causing the potential for interest rates to rise suddenly. China is the largest foreign holder of U.S. treasury notes followed by Japan and there are indicators that the balance between U.S. debt issuance and Chinese purchases is teetering. The Chinese government recently expressed concerns over their huge investment in American debt and as commercial real estate investors we can all attest that when lenders are weary of their borrowers spending practices, that relationship may sour… The 10 year rate recently closed at  3.9% which is the highest level since last June.

On a positive note, March indicators show that retail sales exceeded expectations and the job creation is the most meaningful since late 2007. Although the odds for a double-dip reception continues to decline the rate of growth in retail sales will likely be limited given record consumer debt and high unemployment that will persist through the end of 2010. The key to the next phase of recovery is corporate spending.

The Great Recession has accelerated a wave of retail failures such as Linens-n-Things, Circuit City, KB Toys and Mervyns and thousands of regional and national retailers have also shuttered their doors. Other chains are adjusting their franchise offerings and business models, closing stores, online retailers are growing at lightning speed and consumer confidence and spending plunging in the wake of the housing and financial crisis. Consumer changing habits and lifestyle will dictate where the sales transactions are going to take place and more often than before, it is not the suburban mall or strip center. In addition, there is simply too much unoccupied shopping space with too few legitimate retailers to occupy it. Redeveloped downtowns and suburban villages with urban like amenities are proven to be a successful model. All these trends will result in negative rental growth and vacancies continue to rise in shopping centers across the country for all but class A and In-fill urban locations for the foreseeable future.

Distress levels are rising but the expectation for a flood of REO has faded for now.  Quality properties have not hit the market due to the lenders avoiding foreclosures on performing assets that have reasonable prospects of stabilizing but the distress levels are expected to increase this year as occupancy and rents continue to weaken in most major markets.

Giving the fact that approximately 1.4 Trillion Dollars of commercial real estate loans are coming due over the next three years and about half of these loans were originated between 2005 and 2007 when prices were near peak levels and high leverage loans were commonplace and  therefore,  the owners owe more than the properties are worth. This situation combined with tighter lending criteria with a minimum of 1.3 debt coverage ratio will make it very difficult for owners to refinance maturing debt or even meet debt service obligations. If banks are forced to take major write downs on these loans many of them will fail which will further harm the nation’s financial system but on the other hand, until billions of dollars of these loans are written down no meaningful recovery can begin.  

Another risk is the inevitable inflationary pressure that will result from doubling of the money supply in the U.S. This will significantly pressure the lenders to increase mortgage rates which will push cap rate higher. Any savvy investor will demand a minimum spread between the cost of money and the immediate return on investment regardless any value added potential a certain property may offer. When cap rate move higher and are expected to remain high for the foreseeable future while lower rents and higher vacancies push NOI downwards, property values cannot go anywhere but down.

In addition to financial distress there are several concerns for this year’s economy that cause owners to sell such as the lack of confidence in our economy due to government spending, the national deficit, weakness in our currency, anticipated increase of capital gains tax to 20-30% , the possible effects of the healthcare reform and more. Several other properties have been maxed out and sustain a diminishing return on investment (ROI) every year that goes by. Other owners see 2010 and 2011 as the best buying opportunity since the great depression and want to release their equity. During 2010 supply of distressed properties is expected to increase and when it does it will exert significant downward pressure on values. After all, the key to successful commercial real estate investing is the ability to buy low, lock in long term low interest, fixed rate debt and hold on until the next cycle kicks in. As inflation kicks in it will drive up the value of the asset and the advantageous debt terms will create an even better performing asset. Another key point to remember is that we entered this cycle without the massive speculative construction that we had during the previous Savings and Loan crisis and the fundamentals were in a better shape going into this current crisis compared to the previous crisis. When the market does recover (when?) it is expected to reach new heights.

Development is reaching an all time low as it responds to softened demand for space. This decrease in supply will result in a far less volatile year for property performance; vacancy is expected to increase to 10.6% while effective rents will drop 4%. A few successful debt reorganizations and loan restructuring such as Developers Diversified Realty, Inland Western Retail and General Growth effort to emerge from bankruptcy thanks to a 6.55 Billion Dollars of new equity investment by Brookfield, Pershing Square and Faiholme Capital eased concerns that greater than expected losses were in store for the CMBS market and is seen as a template that will be replicated in many other situations. Thus, many defaults and asset sales anticipated by a tsunami of upcoming maturing debt can be avoided or at least deferred for a few years.

Investment activity is poised to begin recuperation in the second half of 2010 as investors realize that the flood of REO properties is unlikely to hit the market and a reported $75 Billions of equity has been raised by opportunistic funds and REITs and very little of it has been deployed. These investors are getting anxious and are ready to execute on their investment strategies. Long-term investors are attracted to top tier properties and opportunistic buyers will focus on limited volume of distressed properties sold by financial institutions but those institutions have favored workouts and extensions to allow owners additional time and flexibility to help them recover. Demand for small and mid-size retail centers is expected to move off the bottom as the confidence in the economy grows over the course of 2010.

Foreign interest in U.S. properties is high and will continue to grow in 2010 as Asian investors will provide new capital mostly to the west coast whereas European investors tend to prefer the east coast. Potential changes to the Foreign Investment in Real Property Tax Act (FIRPTA) could remove more barriers from foreign investors. U.S. assets are particularly attractive to foreign investors since prices in Asia, Europe and Israel are already rising and the Dollar remains weak.

The credit crunch is starting to ease and financing for quality assets is becoming more available. The market has already priced in the poor outlook for fundamentals expecting the worst, thus there is only upside since the expectations were so low. Core buyers of top tier stabilized, cash flowing assets are advised to move quickly while cap rates are high and interest rates are low. Cap rates on highest quality assets in core markets are already beginning to fall. Opportunistic buyers targeting value add and distressed assets do not need to move so fast. Very few distressed sales have actually occurred and there are plenty that must be sold and recapitalized. Finding debt for these distressed assets remains tough, serving to keep prices down for a while but opportunistic buyers need to realize that the RTC like fire sales and huge discounts they hoped for are not likely to materialize.

On a positive note, The Health care reform may have positive effects on the medical office market due to the addition of 32 Million Americans to the ranks of the insured. The formula calculating the need for medical space holds that a healthcare system requires 1.9 square feet of medical space per patient which equates to the potential demand for 64 Million square feet of medical space.

March’s job gains of 162,000 are the strongest monthly gain since 2007 and the latest indication that the choppy economic recovery continues to make headway although some sectors, such as financial and information, continue to decline. The unemployment rate remains high and unchanged at 9.7%. A total of 2.3 million jobs have been lost since February 2009.

The Consumer Confidence Index rebounded to 52.5 in March after falling sharply to 46.4 in February from January’s 56.5, the highest index reported since September 2008. February retail sales were up very slightly—a 0.3 percent increase, following a 0.5 percent increase in January. February’s retail sales are the highest monthly sales since September 2008.

Overall, many economic indicators are improving or stabilizing, but until job growth presents consistently positive monthly numbers and is based on permanent full-time jobs, it will still feel like a recession for many.

Capitalization rates in general remained steady at 7.77 percent in February. Cap rates are well above the 6.39 percent of June 2007 and just above the historic norm of 7.6 percent (since 2001).

Retail vacancy rates stood at 19.2 percent in the fourth quarter of 2009, up from 18.6 percent in the third quarter.
Forecast; muted recovery is expected in 2010 and upside surprise is expected for second half of 2011. Commercial property sales volume dropped back to the lower levels of the past eight months after one month’s sharp increase. However, other bright spots continue to appear, continuing the pattern of mixed signals that we have experienced for some time now—REIT and S&P returns, retail sales and housing starts.

Real estate capital markets remain in poor condition but are showing improvement and signs of increasing stability. The REIT sector provided solid performance again in February, CMBS issuance in January continued to show signs of life and capitalization rates remained steady at 7.92 % in January.

Orlando

The Orlando retail market did not experience much change in market conditions in the last quarter. High profile vacancies created by Linens N’ Things and Circuit City have created market entry opportunities for several retailers at current rental rates. Fast food and casual dining restaurants are also actively looking at new sites, albeit at greatly reduced rates.

 

Vacancy. Vacancies will rise again in 2010 partly as a result of significant blocks of vacant space in properties built in the past few years and  the lingering effects of retailer bankruptcies and weak consumer spending weigh on the retail sector shopping centers recently constructed topped over 20% last year and general retail vacancy is expected to reach 12.4%. Vacant subleased space increased by 9,667 square feet.

 

Rental Rates.  Market wide effective rents slipped to levels last recorder in 2005 and additional decline is expected in 2010. Quoted rental rates decreased from third quarter 2009 levels, ending at $16.59 per square foot per year. That compares to $16.63 per square foot in the third quarter 2009 and $17.23 per square foot at the end of the first quarter 2009.

 

Effective Rents. Effective rents dropped to $14.04 per square foot. The largest lease signings occurring in 2009 included: the 51,250-square-foot deal signed by West Oak Charter School at Former Service Merchandise; and the 45,000-square-foot lease signed by Publix Super Markets at University Plaza.

 

Unemployment. Orlando’s unemployment rate increased last year from 7.8% to 10.8%.

 

Distressed Properties. Distress level in Orlando’s retail market is approximately $41.8 Billion which is the highest of all property types. During the past 12 months, eight transactions worth $72MM closed with an average price of $118 per square foot. Fourteen properties were offered with an average price of $203 per square foot and an average cap rate of 7.9%.

 

Construction. Construction completions will drop from 900,000 square feet in 2009 to 300,000 square feet in 2010 and low construction levels may persist for several years due to lower rents and higher vacancy rate.

Equity Pricing. Investors are seeking best in class assets and are underwriting accordingly for anything that falls short. Cap rates are being driven by positive leverage and most investors are focused on the current cash-on-cash yields rather than internal rates of return (IRR); Cap rates for core assets: 9% -11%, Value Add assets: 12% -15%, Opportunistic: 15% – 20%.

Debt Pricing.  Loan to Value: 60-75% spreads over 10 Year Treasury: +/- 350 bps with a minimum implied loan constants of 8.4% to 8.9%. Debt coverage ratio is 1.3 – 1.4.

 

Orlando’s Economy. Orlando is considered to be the most stable economy in Florida with a wealth of attractions for visitors and residents alike and consistently ranks as a leading place to conduct business. This Central Florida city has a number of significant new projects underway in addition to being the tourist capital of the world, having the nation’s leading research park that includes many international, simulation, training and imaging industries. Projects like the new medical city at Lake Nona featuring the UCF College of Medicine and Burnham Institute for Medical Research. This 600-acre site will also be home to the $656 million Orlando VA Medical Center, UCF’s Medical School, Nemours Children’s Hospital, MD Anderson’s Orlando Research Institute, Burnett School of Biomedical Science and a UCF Research Center. The project is projected to be one of the largest medical cities in the world and have an impact of billions of dollars to the local economy as well as generate thousands of jobs. Orlando is home to the University of Central Florida, the third largest university in the United States and the fastest growing university in the country. The Sun rail project that was approved and funded in December 2009 will turn 61 miles of the existing CSX rail tracks into a commuter rail system running from Deland, north of Orlando to Poinciana south of Kissimmee. Service is expected to begin in 2012 just as the Department of Transportation starts a major I-4 reconstruction project through the area. Orange County is offering incentive to developers that would focus on several Infill Master Plan Development, the City of Orlando is planning an expansion of the successful Lynx system and a major redevelopment project of the new Creative Village that will be created in the old Amway Arena surroundings, Seminole County is offering to fund up to 20% of any new or renovated project cost as a part of their U.S.17-92 CRA Grant Program and additional 75% of any environmental cleaning costs and more.

 

Forecast. The Orlando retail sector is likely to emerge from the current recession without widespread bankruptcies or closures. This coupled with Florida’s population growth prospects, which are stronger than ever given the renewed housing affordability, continued quality of life attributes and a lack of recent or planned new development, should provide stability to Florida’s retail market in the coming years. Sales of single tenant assets will dominate activity in 2010 with buyer’s conservative return objectives sustaining interest in national brands of drugstores, fast food restaurants and discount stores. Transaction volume will likely pick up in early 2010 driven by greater visibility in fundamentals and more available financing. Additional ‘distress’ will cause sellers to close the bid-ask gap, and buyers will have more confidence that the current rent rolls already reflect tenant failures and rent reductions. As always, the sector will recover and it will turn quickly when it does. Once the Florida and broader economy awakens, fueled by unprecedented stimulus, the supply / demand dynamic in 2012-2015 will be favorable. Cap rates will moderate once transaction volume stabilizes, but will not fall to the aggressive leverage fueled levels of 2006 and 2007. Cap rates will fluctuate with changes in financing costs, but will be driven by positive leverage and will reflect more historical risk premium spreads over US Treasuries.

 Sources:           ULI, ICSC, M&M, Costar, NREI, CPN, RCA, and more.

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 Sean Glickman is a real estate investment expert and a strategic advisor with Marcus & Millichap, the largest real estate investment brokerage services firm in America. Glickman represents institutional and private owners, lenders and investors and provides decision analysis services to help the client determine and execute the best strategy for each property while maximizing the value for the owner. Our commitment is to help our clients create and preserve wealth through real estate investments by providing them with the best real estate investment analysis, financing, research and advisory services available. Glickman is exclusively representing several of the largest developers in Central Florida with over $120 Million worth of real estate, has over 10 years of experience as an international real estate investor and has owned and developed projects such his latest, a $100 Million golf course community in Louisiana.         Since 1971, Marcus & Millichap Real Estate Investment Services has been the premier provider of investment real estate services. In 2008, Marcus & Millichap closed over $13.1 Billion worth of transactions for private and institutional investors and has established itself as the number one investment real estate company in the U.S. both in volume and number of transaction. 1,400 experts in 72 offices specialize 100% in investment real estate with a specific property type and local market expertise, therefore proving the client with superior market knowledge and transaction expertise targeted specifically to the unique requirements of each client.

 Sean Glickman

Marcus & Millichap Real Estate Investment Services

Phone:  407-557-3821, Email: sean.glickman@marcusmillichap.com

www.marcusmillichap.com  http://www.zacharybusiness.net/pdf/2007/july/July2007CS.pdf

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