MDOT Office of Real Estate

News Article

Sharp Drop in New Supply Has Broad Impact for Retail Property Sector

(10/7/2009) The degree to which new retail development has slowed across the country is quite remarkable. The level of retail property under construction in nearly every market across the country is well below historical averages and CoStar is forecasting that the amount of new retail space completed this year will set a record low. One area where this decrease in new supply is clearly visible is the plunge in the number of large retail projects being built.

According to CoStar Property data, 15 shopping centers that are 500,000 square feet or larger have delivered so far this year, and another six are on tap to open sometime this quarter. Compare this to the 48 shopping centers (500,000 sq. ft.+) that delivered during 2008 and 51 centers that opened in 2007; and these statistics show that even if the six large retail centers still under construction deliver as planned this year, large retail center deliveries will be down more than 50% compared to activity in the prior two years.

CB Richard Ellis economist, Abigail Marks, sees the pullback in deliveries of major centers as a positive for the market, "since oversupply is always a concern during a downturn and we don't expect demand for retail space to begin recovering until the end of 2010."

Walter Bialis, vice president of research for Madison Marquette at the national level, agreed with that assessment, saying, “From a broad view, it’s a good thing that construction and deliveries of these large centers are down because that's going to help existing space get absorbed, as well as help the retailers opening up in these newer centers be profitable.”

OCCUPANCY

While most large retail centers delivering this year likely secured their key anchor tenants a year ago or longer, developers across the nation have found it challenging to fill available small-shop and junior-anchor spaces in light of retailer expansion pullback. Additionally, retailers have cancelled agreements to open at new centers for various reasons, ranging from bankruptcy to the firm deciding a project no longer fits into its business plan.

In some cases, the pullout of an anchor tenant can result in a domino effect leading to the delay or cancellation of the center as lenders generally require that a new project meet and maintain a minimum level of pre-leasing in order to secure its construction financing. However, it is not always the case that projects that have successfully delivered enjoy a high level of preleasing.

CoStar data found that slightly more than half of the major centers (12 of 21) that either already delivered or are on track to deliver by the end of 2009, are 85% leased or better, while about one-third are less than 60% leased.

“While in the old days, I said 85% occupancy is pretty good for a recently-delivered center," said Bialis. "Today, I scratch my head at that. I still use it as a bellwether, but there's other dynamics that are shaping those numbers." Even the centers better than 85% leased are at risk, he said.

That's because, while developers may have managed to keep getting leases signed, in this today’s tenant’s market many have had to settle for significantly lower rental rates than they may have originally planned, increasing the likelihood that a new center may not be able to meet its pro forma net operating income (NOI).

"If a center isn't coming close to generating the income it was supposed to be generating, in the finance world, that property is underwater - It is likely not covering debt service and its loan to value ratio is out of whack,” said Bialis.

Additionally, said Bialis, even if a developer delivers a project at 90% to 95% leased, its ability to maintain the tenant lineup in the short-term remains at risk. As retailers continue to fight lackluster sales performance across the country, they also face the risk of whether or not that specific new store in a center will be met with what Bialis dubs, “shopper acceptance,” or the ability to meet sales goals. If that sales goal isn’t met, the retailer may choose to shut that new store.

This, combined with ongoing bankruptcy risk, has developers of these large centers delivering in 2009 facing the reality that they still may have a few tenants drop out of their centers before the retail recovery begins.

Bialis said banks are aware of this risk and therefore, many developers are challenged in finding permanent financing for a center once its complete. Lenders are being very cautious with new centers that may be 85% or 87% leased over fears that the property will be able to achieve pro forma rent, or maintain that occupancy, much less attain the level needed to have the property considered stabilized at 93% - 95% occupancy.

However, if the property has already secured financing, Bialis explained that lenders have been willing to extend loans. "Banks don't want to foreclose on the developer because they can't lease it either in this economy, so they just give an extension on the loan and hope that 85% occupancy turns into 95% within the next year or two."

CENTER SIZE

CoStar's research also shows that the size of the large shopping centers delivering this year has shrunk. The median size of retail centers (500,000 sq. ft.+) that have opened so far this year is 540,000 square feet and the largest center delivered was 760,000 square feet. During 2008, the median size of a center delivered was 681,000 square feet and there were at least 18 centers that opened that were 800,000 to 1.4 million square feet -- the statistics for 2007 are pretty similar.

Marks said that the size of these large centers is shrinking in part due to the "resizing of individual stores," as many retailers have made the decision to downsize store formats in this recession. Additionally, developers are responding to the reality that their centers aren't filling up as quickly as they hoped by downsizing the entire project size, or delivering it in phases, said Marks.

That isn’t necessarily a good thing, explained Bialis.

"I think a lot of developers are in this position, which is not necessarily good because they acquired the land, they may have had a lot of money in approvals, and the overall profitability of the project is based on the entire project, not necessarily the first and second phases, so there may be some value lost or value they have to for due to this," Bialis said. He added that we'll see the latter phases of many of these projects later, rather than sooner, if at all, as developers deal with the challenge of keeping that first phase of the project viable.

PIPELINE STATUS

As far as large shopping centers in the pipeline, CoStar Property data shows at least 33 are currently in proposed status, with developers aiming for delivery by the end of 2010; another 21 large centers are projected to deliver by the end of 2011; and more than 100 large centers on the drawing board without a delivery date scheduled.

Regarding the likelihood of these pipeline projects coming to fruition, Marks said, "Our new construction data shows that the major retail center types will have historically low completion rates over the next four quarters. I am not sure if many of these projects will ever leave the planning stage over the next couple of years. The market would have to rebound a lot earlier than we are projecting and the recent behavior of the consumer is not supporting a fast recovery."

Regarding the large centers in the pipeline that are on the back burner, Bialis pointed that approvals on these projects can become an issue.

"In some cases, approvals can run out on projects if they're sitting for a very long time, which forces the developer to go back through the process, spending more time and money, which raises development costs in a world where rents are compressed," he said.

Due to the lack of ability to secure the right tenants a developer may have planned on, many developers are having to reconfigure their plans for these large centers (for instance, maybe that glitzy town center that is a combination of a power center and lifestyle center combined has to be downgraded to a big box project only) into something more basic, and often they face backlash from communities that expected something better, which sometimes results in these projects being rejected. There are many developers in a position today of deciding what to do with land, no longer viable for a large shopping center, that is sitting in their portfolios, said Bialis.

OVERSUPPLY OR UNDERSUPPLY?

Bialis said that whether or not the delivery activity involving large centers being cut in half this year should be considered an issue of oversupply or undersupply, is a localized issue.

"A lot of these large centers may be perfectly timed in their market and as they open, their tenants will generate good sales, because they're filling a niche in that market. However, some of these large centers that started during the heyday. They may have had their leasing done and opened and the market's just not there for them. They may have been wagering on continued residential growth that hasn't happened, or be in an infill location where there's a competitive center too close by, for example. So there's some that are probably fitting in very nicely, but then there are others that are pushing the limits of oversupply, and I'm sure that's the same case for centers in the pipeline."

Will the few large centers delivering in 2009 have a leg up when tenants are back on the prowl for new space when the market recovers? Bialis agreed it's a possibility, considering there will be fewer competing centers of the same age. "The centers that opened in 2008 and 2009, if they can survive and hold on and weather the storm through 2010, they will likely grow into themselves when the market recovers," he added.

Marks, however, was slightly less optimistic, saying that while large retail centers delivering this year may eventually benefit from there being fewer rival centers to compete with when demand for retail space does return, she does not expect that retailers are going to be in a position to expand over the coming years.

By Sasha M Pardy

Copyright © 1997-2009 CoStar Realty Information, Inc. All rights reserved.

Link to the article: Sharp Drop in New Supply Has Broad Impact for Retail Property Sector

Source: CoStar Realty Information, Inc.