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Don't Count on These High Prices to Hold

The retail industry has been a mixed bag over the last 18 months. Despite a weak job market, declining confidence and falling stock prices, 2002 consumer spending increased by a healthy 3.8 percent (excluding cars).

The pace of consumer spending was sluggish toward the end of the year, however, and it is projected to slow to 2 percent in 2003 — a 12-year low. Kmart, Ames, Jacobson's and several well known smaller retailers filed for protection under the bankruptcy code, and announcements of store closings by other retailers have raised vacancy rates.

Despite signs of weakening fundamentals in the retail sector — and across other property types as well — conditions in the capital markets are favorable. Total acquisitions among the four main commercial property types rose to nearly $100 billion in 2002, an increase of roughly 30 percent. Retail transactions, which had been out of favor among investors, more than doubled — exceeding $25 billion. The flow of equity into commercial real estate has driven prices up and capitalization rates down to historic lows.

To explain the disconnect between weak fundamentals and low cap rates, look to low interest rates. With the 1-month LIBOR rate below 1.5 percent and the 10-year Treasury below 4 percent, low yields in the credit markets result in low mortgage spreads, providing positive leverage on invested capital. Also, many funds are pouring mezzanine debt and preferred equity into ownership capital structures. The flow of capital fuels acquisitions, and low rates ease the strain on property cash flows brought about by tenant defaults. This helps borrowers weather troubled times and keeps loan default rates low.

If history is any guide, these trends will be short-lived, and the retail real estate industry will face significant challenges in the near term. Assuming the economy stabilizes and corporations sustain earnings growth, investors will return to the stock market, causing equity to flow out of real estate. Real estate fundamentals typically lag behind the general economy, and vacancy rates are likely to continue rising for a time even after the economy turns. Rents probably will not rise until vacant space is absorbed and increases in retail sales can offset high occupancy cost ratios. Interest rates will likely increase to more typical levels.

Simultaneously, real estate cap rates will rise and market values will fall, causing erosion of equity value and “stress situations” as loans mature. Lenders that provided short-term loans based on 80 percent of purchase price or appraised value at sub-7-percent cap rates will find themselves overleveraged when these loans mature two or three years after cap rates return to traditional levels. Borrowers with stabilized properties — rent rolls with solid tenants under long-term leases at market rents — should lock in long-term fixed rate financing, notwithstanding the appeal of the 250-basis-point differential between LIBOR and 10-year Treasuries.

While we haven't tightened our underwriting standards, we emphasize analysis of sustainable rents and market values. Among the factors we consider: tenant mix; co-tenancy and exclusivity clauses; tenant credit quality; tenant sales and the occupancy costs of tenants; ratio of local and non-credit space and income to total space and income; site plan/floor plan layouts; area demographics; supply constraints; sponsorship expertise and track record

The company remains firmly committed to the retail industry, no matter the market conditions. Sound fundamentals are what count.

Who Thomas P. MacManus
President of GMAC Commercial Mortgage Corp. and head of the North American Operations of GMAC Commercial Holding Corp.

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