Retail Fundamentals Shaky at Best

The fundamentals in the retail real estate sector eventually boil down to American's propensity to consume. If people are buying, stores will open, vacancy will decrease, rents will rise, developers will build and the world will keep on spinning. If, for any reason, people stop spending this process goes into reverse and can unravel quickly. This reversal can be especially painful when retailers have spent the past decade expanding at breakneck pace and now have to pull-back double-speed to maintain profitability - see Starbucks' recent experience for a prime example.

September's retail sales numbers show only 1% growth year over year, the worst performance since September 2001, mostly attributable to the economy-wide slow-down and financial crisis. This growth hides the fact that while most retailers struggle mightily a few are actually benefiting from the economic hard times. Apparel and luxury goods retailers are being hit hardest with sales at Neiman Marcus, Sak's, and Nordstroms down 15.8%, 10.9%, and 9.6% respectively. The bright spots are warehouse stores and discounters where consumers can stock up on essentials at bargain prices. BJ's and Costco saw sales increase by 10.4% and 7% respectively showing that consumers were still spending in September, they just shifted from the mall to the power-center.

It is yet to be seen how falling gas prices, government bailout packages, and a roller-coaster stock market will affect consumer spending patterns through the crucial holiday season, but it is safe to say that while uncertainty reigns the safest bets are in core markets that haven't taken major hits in terms of housing price declines and job losses.

Retail developers that we've spoken to seem to think conditions are still good for non-luxury retailers selling essential products at good prices. Many also think that the 'near-luxury' retailers will attract those customers who want to be prudent but don't want to go all the way down the scale to shop at the discounters and warehouse store. Another area of optimism has been urban markets in dense, central-city locations, although if financial sector job cuts increase, these CBD markets could lose many of the high-earning consumers that make them so attractive.

One bright spot in the retail sector is that, largely due to high construction costs and the credit crunch of the past year, overbuilding has been contained. Many lenders and equity sources have dropped out of the retail game altogether, and those that remain are keeping LTV's low and raising the cap-rates at which they value properties. In today's environment stricter underwriting should continue to keep speculative building in check and keep all but the strongest projects on the sidelines until the consumers come back.

Llenrock Group