Guest column by Paul Fisher
The US real estate market has been through great stress for investors, property owners, tenants and lenders. One of the key questions in wading through the data on the market is what metrics we should be focusing on in determining where opportunity exists and where danger may lie ahead. We also need to ask how the market is changing in ways that might not be covered by the reports on the metrics. Those changes are sometimes based on business changes and sometimes based on legal issues.
Each property sector has its own key metrics, some of which are constant across the sectors. In today’s column, I’m focusing on the retail sector. The factors that most affect the retail sector are jobs and family income, the amount of retail space available and vacancy level and rental rates. Construction levels also have a significant impact on the retail vacancy rate and indirectly on rental rates. There are also geographical disparities, as well as disparities between urban, suburban and rural markets and between the large malls, neighborhood (or community) shopping centers and single-tenant freestanding retail buildings. To understand the disparities, we have to look beyond raw numbers to see which retailers are growing and which are contracting or going out of business.
Store openings announced by retailers for 2011 are stronger than they have been since 2007. The retailers announcing the most openings planned in 2011 are Dollar General (625), Dunkin Donuts (350), Family Dollar (300), Quizno’s (300), CVS Pharmacy (275) and Walgreens (225).
Store closings announced by retailers have been declining. The retailers announcing the most closings are Blockbuster (405), Borders (228), f.y.e (160), Anchor Blue (117), Foot Locker (117) and Talbot’s (100).
Note that none of the retailers leading the list in store openings is a big box retailer and none is typically near the top of the charts in their rental rates. The vast majority of the planned openings announced by these retailers are in urban and close-in suburban markets. Note also that the vast majority of the planned closings announced by these retailers are in sectors heavily affected by Internet sales competition. Finally, the retailers leading in planned closed sales tend be larger stores.
According to the 2007 Economic Census, there were more than 1.12 million retail establishments in the United States with 14.2 billion square feet of space. That’s 46.6 square feet per capita. By comparison, in India this number stood at 2 square feet per capita, in Canada 13 square feet per capita and in Australia 6.5 square feet per capita.
With unemployment now at 9 percent in the United States and not expected to fall below 8.5 percent in 2011, and family income levels declining for six consecutive quarters, the pressure on retail rents will continue to be strong. One positive factor is that there has been almost no new retail construction in recent years. However, we have been seeing some large big-box stores, notably Walmart, moving into urban centers more aggressively, often with a smaller store size.
Most of the new store openings, as a result of the paucity of new construction, have been retailers taking space vacated by other tenants. Discount retailers such as Dollar General and Family Dollar generally will not pay the rental rates of the vacating tenants. An example of this phenomenon is Five Below (another discounter pricing everything at $5 or below) which has opened 10 stores in the Chicago area and has taken part of a closed Circuit City in Woodfield Mall in Schaumburg, Ill. The rental rate declined from nearly $30 a square foot to under $10 a square foot.
One of the legal issues that has a great impact on whether property owners will be able to capture the tenants opening new stores or even merely deciding whether to stay is the availability of tenant-improvement funding. Landlords and tenants alike know that most large tenants expect to get a non-disturbance agreement from the landlord’s lender, assuring them that if the mortgage financing goes into default, the lease and occupancy of the tenant will not be disturbed. Most lenders are agreeable to the request; however it’s what’s in the agreement that can have an adverse effect on the landlord and tenant. Many lenders will insist that the non-disturbance agreement say that the lender does not have to honor lease provisions requiring landlord construction of improvements or funding tenant improvements.
So a careful tenant will want any promised landlord improvement and promised tenant improvements (or funding for the cost) to be guaranteed in some way, whether by cash in escrow, a guarantee from a credit party, a letter of credit or a right of setoff (acknowledged by the mortgage lender) for these particular promised improvements. Of course, large national landlords are far more likely than most landlords to be able to deliver these types of assurances.
Vacancy rates in retail markets are still quite high. Reis, Inc., a New York-based research firm reported that the vacancy rate in United States regional malls climbed to 9.1 percent in the first quarter of 2011 from 8.7 percent in the fourth quarter of 2010.
The firm also reported that the asking rents of mall landlords fell from $38.79 per square foot in the fourth quarter of 2010 to $38.75 in the first quarter of 2011.
Similar trends were reported with neighborhood shopping centers. Vacancy levels rose from 10.7 percent in the fourth quarter of 2010 to 10.9 percent in the first quarter of 2011. Overall retail vacancy rates are higher than in these two sectors. But the vacancy rates are not uniform geographically. The Pension Real Estate Association reports that in the Midwest, overall retail vacancy rate is 18 percent compared to below 16 percent in the Mid Atlantic region, more than 20 percent in the Mountain region, just more than 14 percent in the Northeast region, just under 14 percent in the Pacific region, more than 22 percent in the Southeast region and more than 20 percent in the Southwest region. They also report rental rate declines in the first quarter of 2011 in all regions but with the rate of decline slowing in the Midwest to 2 percent.
So where is the opportunity? Discounters are the fastest-growing retailers, but they tend to have lower rents than the tenants they replace. They are generally expanding in urban and near-in suburban markets. Walmart and a few other big-box retailers are building smaller stores. In areas where the political landscape is favorable, this is a real opportunity.
Lenders, having gotten more conservative in their underwriting, are looking for steady and predictable rental streams. Many of the middle-market lenders have suffered the greatest stress (a subject for a future column) so property owners with a strong balance sheet or strong and predictable rent rolls have a great advantage giving strong tenants great leverage in negotiating with property owners. Buying properties which fit this profile should continue to be an opportunity. Property owners with the ability and foresight to subdivide the big-box stores have a great opportunity unless they’re burdened by too much debt.
Where are the dangers? We all know about the rising price of gas (although perhaps moderating slightly in the next few months) and lurking inflation and cash-strapped cities that may not be able to maintain roads and other infrastructure (another factor for investors to watch). The greatest danger comes from seeing overall trends toward lower vacancy without looking behind the numbers to see the geographic regions without recovering family income and improving employment levels. There’s danger, too, in failing to differentiate between properties with retail tenants that are growing and those that are stagnant or declining.
Paul Fisher is a partner at Chicago law firm McGuireWoods. He can be reached at 312-849-8244.
