National Economy: Spending Strong, Needs Reinforcement Soon
by Marcus & Millichap Research Services

Consumption has remained strong throughout this recovery, but on balance most of the growth in spending power has come from rising home equity and massive fiscal stimulus. As a result, both consumer debt levels and the federal budget deficit have ballooned, while the dearth of new jobs has kept income growth to a minimum. At some point consumers will have to rely less on onetime windfalls and will be forced to live within the confines of their recurring income.

Consumption growth will be constrained by income growth, which in turn is limited to wage increases and job formation. With companies still trying to boost profits, wages will rise slowly in the near term. Fortunately, it appears households will receive some relief in the form of more jobs in 2004. With the inventory-to-sales ratio at an all-time low, GDP advancing smartly and businesses beginning to spend in earnest, it is only a matter of time before firms will be forced to hire additional worker just to keep inventories from falling further.

Dangers loom, however. The budget and trade deficits represent imbalances that will have to be reconciled at some point. One method of doing so would be to devalue the dollar. A sharp drop in the dollar could force the Fed’s hand, however, driving up interest rates prematurely and snuffing out both the housing boom and the budding recovery. In addition, energy supplies remain tight, and gas prices are expected to reach record levels during the summer driving season, which will reduce discretionary income.

Capital Markets: Reaching for Yield

Low yields on alternative investments, especially bonds, are encouraging lenders to compete aggressively for all types of retail loans, including lesser-quality deals that may not have generated a quote only two or three years ago. Due to stock market volatility and economic uncertainty, life insurance companies and pension funds are under considerable pressure to put money to work in real estate, where relatively stable, attractive returns can help diversify portfolios. CMBS lenders, on the other hand, are hard pressed to keep up with the seemingly insatiable demand for new issues. The result is a highly competitive environment in which lenders are often willing to consider deal that many not fit easily in the box. We believe now may be a good time for borrowers, especially those with lesser-quality or storied properties and floating-rate debt, to consider locking in longer-term fixed-rate financing. While the rates are not expected to spike, they have bottomed and terms for borrowers are unlikely to improve materially from current levels.

Spreads on larger unanchored retail centers with 70 percent to 75 percent loan-to-value (LTV) ratios range from 190 to 220 bps over 10-year Treasuries, while anchored centers with similar LTVs are commanding spreads as low as 130 to 150 bps. LTVs of 80 percent are not uncommon, but the higher risk will push the spread to 160 bps. Construction financing is available at 300 to 400 bps over LIBOR for most retail property types, but lenders continue to exhibit a strong preference for grocery-anchored projects.

Retail Overview: Vacancy to Drop Despite Rising Construction

Consumers are seeking convenience and low prices, which is supporting the development of lifestyle centers and also the rapid expansion of discount retailers. These trends, however, are threatening smaller retailers and mall-based department stores. Many traditional malls have experienced a deceleration in revenue growth or even a decline, leading to the closure of some and the renovation and/or re-tenanting of others. Investor demand for mall properties is strong due to the slimmed-down and updated mall inventory and a surge in demand from traditionally non-mall tenants.

Closures continue, but unlike the past few years, the majority and small-scale formats such as toy stores and music shops. The expansion of Wal-Mart’s Neighborhood Market is also a looming threat, as the loss of market share to the retail giant will likely push at least a few secondary or tertiary grocers out of business. There are options emerging for centers with vacant anchor space, however, including niche grocers that market to a specific ethnic group or health-conscious consumers. Properties with space left dark by Kmart are not only receiving the attention of major chains, such as Home Depot, Kohl’s and Target, but are also attracting some nonretail tenants, including schools, offices and churches. In spite of closures, retail prices have not been negatively affected, and in most cases are up thanks to low interest rates and strong investor demand. High prices have prompted many owners to renovate older centers in close-in areas, particularly those that are in jeopardy of losing quality tenants to new centers.

Investment Outlook: Improving Fundamentals to Support Retail Values

As the economy improves, fundamentals firm in other real estate sectors, the stock market posts consistent gains and interest rates rise, retail price appreciation is likely to slow from its frenzied pace of the past few years. We do not, however, expect downward pressure on prices. Improving fundamentals will offset increased debt-service payments for most properties, through 2004 may be the time to shed under performing properties or those acquired over the past few years that may not be as attractive when economic recovery gains traction. While there is substantial demand for turnaround opportunities, investors with longer-term hold strategies should shift their focus to quality, tenant credit and location. As Wal-Mart’s grocery arm expands and competition from within the industry heats up, investors considering the purchase of a groceryanchored center must scrutinize the anchor’s potential to maintain market share long term. Strip centers are also vulnerable, but values will continue to climb for properties with a favorable tenant mix and convenient location. Properties with specialty grocers or upscale merchandisers may also yield strong returns.

It has become increasing difficult for developers to get large-scale multi-tenant properties permitted in infill locations; therefore, we expect existing properties in close-in areas to appreciate at a more rapid pace than their newly constructed counterparts in far-reaching suburbs. These properties will likely come at a high price that will exclude many private investors. First-time retail buyers may want to focus their attention on wellperforming fast-food or restaurant properties, which offer steady returns and require little to no maintenance.

With 38 offices and more than 800 investment professionals nationwide, Encino, Californiabased Marcus & Millichap is the largest commercial real estate brokerage in the nation focusing exclusively on real estate investments. Founded in 1971, the firm has perfected a powerful system for marketing properties that combines product specialization; local market expertise; the industry’s most comprehensive research and analysis capabilities; state-of the- art technology; and established relationships with the largest pool of qualified investors nationally.

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