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UH-OH … IS THIS A ‘NEW ECONOMY’ FOR REAL ESTATE?

Patrick Beach

Roddy O’Neal

Mark Strauss

For two years now the U.S. retail real estate market has remained strong, defying the overall economy. But anyone who thinks there is such a thing as a new retail real estate economy could end up as disappointed as the believers in the “new economy” of a few years ago, experts warn.

Despite economic sluggishness, spendthrift consumers are keeping stores in business and helping landlords stay profitable. Retail REIT stocks continue to shine, and the sector is a financing magnet. Cap rates remain low, as real estate buyers snatch up prize properties to take advantage of low interest rates.

In its first-quarter assessment of returns for the retail real estate sector, the National Council of Real Estate Investment Fiduciaries reported that retail properties had an average cap rate of slightly less than 8.5 percent.

But make no mistake: The basic rules of retail real estate funding are unchanged, lenders say.

“Is this the ‘new’ real estate economy? I don’t think so,” said Patrick Beach, the chairman and CEO of Cape Financial Group, Ann Arbor, Mich., at a panel at this year’s ICSC Spring Convention.

Some developers might be content with low returns on their projects and with the fees they get for building and managing them, but not Cape Financial. The company will not finance any property that doesn’t generate double-digit returns on its cost, added Beach. Developers should seek to get a 200-basis-point difference, at minimum, between the cost of the project and its market value at sale.

Performance notwithstanding, retail real estate has not gotten any less risky, although the cost of financing has fallen significantly, said Jay C. Hart, managing director of FleetBoston Financial’s real estate finance group, which specializes in mezzanine lending.

Neither has the sector broken away from the broader economy, whatever some may believe. Retail real estate financiers still watch job market statistics closely, says Mark Strauss, a director of capital markets at Cohen Financial, Newport Beach, Calif., noting that the U.S. workforce has lost about 2 million jobs in the past few years.

Jobs drive real estate, and that will always be so, says Roddy O’Neal, co-CEO of Irving, Texas-based Archon Financial.

So why has retail real estate done so well in spite of the gloom? The sector has been relatively insulated from job-market and economic weakness because consumers are using cash obtained through home equity loans to buy more retail goods, said Hart. But there’s a drawback: Just as retail hasn’t borne the brunt of the recession, neither will it ride particularly high when the economy revives.

“Retail is not going to see a rapid improvement in values or occupancy as we come out of the recession,” Hart said in an interview with SCT.

Meanwhile, lenders are being particularly cautious about the balance between supply and demand in some retail real estate markets. Beach said the Southwest and the Southeast are slightly overbuilt, while sales at central Florida’s newer malls have been disappointing.

“The Southeast makes me nervous,” said Hart, who adds that he prefers markets with a high entry barrier.

The panelists agreed that Southern California, which has such barriers, remains one of the most popular markets with lenders.

As for the properties themselves, unanchored centers and property types with no proven track record for sales growth are out, according to William McPadden, senior investment officer at the John Hancock Real Estate Investment Group, Boston. But grocery-anchored community centers and solid power centers are strong favorites.

Because of the short supply of desirable real estate, and perhaps also because of lenders’ choosiness, retail real estate lending has been down in the first half of 2003.

“We are slightly behind where we want to be,” said Hart. Retail lending for the period was off about 15 percent against last year’s first half, he added. “But we are not far behind, so there is no fire sale on mezzanine debt.”

NCREIF property index: Total quarterly returns
	The National Council of Real Estate Investment Fiduciaries (NCREIF) property index tracks capital appreciation and net operating income returns for commercial properties. Both numbers are combined for a total return. The major retail property sectors switched roles as far as total returns go. Returns for malls and neighborhood and community centers fell significantly, in contrast to their performances in previous quarters. Power centers were up slightly in the first quarter of this year, after dipping in the fourth quarter of 2002. First-quarter preliminary returns on malls were 2.63 percent, down from an adjusted 5.74 percent; community and neighborhood centers were 3.21 percent, down from 4.06 percent; and power center returns were 3.79 percent, up from 3.41 percent. Source: National Council of Real Estate Investment Fiduciaries

 

MARKET SCANNER The U.S. House of Representatives is looking at tweaking REIT tax rules through the REIT Improvement Act of 2003, which is designed to clarify and correct issues arising from the REIT Modernization Act of 1999 and to make foreign investment in publicly traded U.S. REITs easier. Proponents also want to allow the Internal Revenue Service to fine companies making errors that jeopardize their REIT status, rather than having them stripped of the designation outright. • Mortgage bankers made $18.9 billion in commercial and multifamily property loans during the first quarter of 2003, a 38 percent increase over the same period last year, according to the Mortgage Bankers Association of America. Capital inflow from commercial-mortgage-backed securities conduits and commercial banks helped buoy the activity. New loans in the retail property sector were up 75 percent for the quarter from a year earlier, the biggest jump among the major property sectors. • The U.S. economy may be ready to turn a corner, or so experts hope, if the release of revised unemployment figures is any indication. No workers were cut in April, a revision from the 48,000 that the Labor Department had initially reported, according to Reuters. In May the labor market shed some 17,000 jobs, much lower than the expected 39,000 cuts. Despite the careful optimism, however, some note that May’s job losses brought the country’s unemployment rate to a nine-year high of 6.1 percent. • Contrary to predictions, investors didn’t unload REIT shares during a recent rally, and they may be rewarded for not doing so, says a Morgan Stanley report. Continued economic uncertainty and another interest rate cut would help improve REIT yield spreads and maintain the value of the stocks, the report says. But what could threaten REIT values is an economic recovery, which would make other kinds of stocks more attractive, Morgan Stanley says. The reason is that REIT fundamentals don’t respond as quickly as those of other companies.

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