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Queasy Rider

Fasten your seat belts. It's about to be a bumpy year

Real estate developers have been operating on cruise control for five years, raking in money without trying very hard. But next year, owners will really have to work to earn it.

Although fundamentals will likely remain strong in 2006, don't expect another year of 15 percent asset appreciation — the gimme that has made double-digit returns in retail real estate the norm over the past five years. “While the investment market remains strong, it appears to have peaked,” says Gwen McKenzie, vice president of retail investment for Sperry Van Ness. “Not only has sales volume calmed, but cap rates have stabilized and even increased slightly for strip centers in the third quarter.”

Already there are signs that expectations should be lowered. Net occupancy income and funds from operation growth slowed in 2005, the pace of acquisitions diminished by 30 percent in the third quarter, interest rates ticked up a notch and construction costs have skyrocketed.

To make money, developers will have to take more chances. Even now, the development pipeline is bursting. As investors look for new sources of growth, many owners are entering uncharted territory, exploring the mixed-use market or moving into new geographic areas, including tertiary markets.

Making matters worse, all this is happening at a time of instability around the globe. Mix volatile energy prices, looming inflation and the reality that the housing bubble, which has played a huge role in sustaining economic growth, has finally sprung a leak — and you have a recipe for a consumer slowdown.

Fact is, most REITs won't be able to drive FFO gains simply by adding properties to their portfolios. And rising energy expenses have partially offset gains from increased rents and high occupancy rates. There could be some “plateauing” in pricing and volumes says Bernie Haddigan, national director of Marcus & Millichap's Real Estate Investment Brokerage Inc.'s retail group. “I don't think we'll have the valuation growth of the past, unless there's more aggressive rental growth.” Pricing on retail assets already reflects premiums paid for future rental bumps. Unless rental growth starts surpassing expectations, pricing will remain stable.

For early signs of trouble, look no further than Mills Corp., which missed its third-quarter earnings forecast due to a rash of one-time costs and accounting adjustments (see story on page 10). Analysts expected some bumps given the company's ambitious — and risky — development pipeline, but those have been exacerbated by the general industry trend toward more risk. Specifically, it has spent millions on the proposed The Piers project in San Francisco and Meadowlands Xanadu in New Jersey, both of which face significant hurdles.

Third-quarter earnings could be a harbinger of things to come. REITs “tested the hypothesis that accelerating fundamentals will save the sector in a rising interest rate environment,” wrote Morgan Stanley REIT analyst Gregory White. The results were not encouraging: “Our analysis suggests that many more REITs than usual [40 percent] missed earnings.” But, he notes, “consensus estimates going forward have barely budged. This suggests there may be more pain ahead.” (For its part, Morgan Stanley has lowered estimates on several of the retail REITs it covers. For example, it recently lowered 2005 and 2006 FFO estimates on Developers Diversified Realty to $3.19 and $3.43 from $3.25 and $3.50.)

In the wake of third-quarter announcements, retail REIT stocks that reported shortfalls took a beating, many dropping in price by up to 2 percent. The market reacted more strongly to the negative news than it had at any time since December 2002, according to Morgan Stanley research.

Indeed, rather than reflecting improved fundamentals, the third quarter showed deterioration. Third-quarter NOI growth slowed after nine straight quarters of year-over-year improvements. While revenue continued to rise due to higher occupancies and rents, rising expenses cut into NOI expansion — a trend that is expected to continue in 2006. So while there is growth, it is happening at a slower pace. REIT investors have also become more wary — reacting more sharply to negative news by dumping REIT issues.

Factoring in risk

Rising risk is beginning to be factored into the CMBS market. According to John B. Levy & Associates, there is more concern for retail “than there has been in many years.” The company points to rising interest rates and energy costs, in addition to concerns about the continued risk Wal-Mart represents to the strip center segment. Another cause for concern is that some recent CMBS offerings have come in with extremely high leverage levels. The pool of loans in a recent securitization from Bank of America, for example, had an average loan-to-value ratio of 102 percent, according to Moody's Investors Service. Moreover, interest-only loans have now become prevalent in CMBS pools. During the third quarter, 65.6 percent of CMBS loans were partially or fully interest-only while a year ago the figure was only 19.2 percent.

For REITs, however, rating agencies Moody's Investors Service, Standard & Poors, and Fitch Ratings have maintained, or even upgraded, ratings on retail REIT debt issuance in 2005. Fitch points to the fact that REITs typically have higher-quality properties than CMBS pools as part of the reason they aren't as concerned, yet.

Investors have reason to be cautious, amid signs that valuations and cap rates on retail properties have peaked, and begun to flatten. On strip centers, cap rates even began to rise a little after hitting record lows. The cap rate figures also reflect that more recent sales have occurred in tertiary markets, indicating the risk of playing in cities where projects aren't as insulated from competition from new construction. High asking prices in major markets have also slowed the pace of activity.

Most experts expect cap rates on retail real estate to remain stable and possibly rise slightly in 2006, although most don't think they will ever rise back to the 8 percent or 12 percent range they were at before the boom began.

Transaction volume also has to slow. In the retail sector, it rose 240 percent since 2000, according to Marcus & Millichap. Moreover, as transaction volume has soared, holding periods have contracted, indicating that speculation is driving deals. Some properties have changed hands two or three times in just 36 months, the kind of flipping more prevalent in the overheated single-family housing market. All told, almost 10 percent of recent sales have been on properties held for less than three years, according to Real Capital Analytics.

Composite REIT Index 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005*
Overall Retail 3.19% 5.10% 34.65% 16.99% -4.94% -11.77% 17.97% 30.42% 21.07% 46.77% 40.23% 10.05%
Strip Centers 1.75 7.36 33.55 21.44 -6.99 -10.71 15.10 29.89 17.72 43.12 36.25 6.56
Regional Malls 8.77 3.00 45.27 13.69 -2.62 -14.58 23.50 31.88 24.56 52.24 45.01 15.04
Free Standing -5.49 31.59 30.77 17.77 -6.25 -4.89 8.95 23.95 21.76 35.91 32.87 1.52
* Through Nov. 18
Source: NAREIT

For example, the 165,000-square-foot Warner Marketplace in Canoga Park, Calif., sold for $37.5 million in December 2003 and then was resold in November 2005 for $52 million, for a 38.7 percent price increase in less than two years. The 85,000-square-foot Newbury Oaks Marketplace in Newbury Park, Calif., sold for $18.9 million in December 2003 and then was flipped for $23.6 million this July, for a 24.9 percent increase. In neither case did the property's fundamentals change.

“We're not going to see that anymore,” says Greg Maloney, president and CEO of Jones Lang LaSalle's Americas retail group. “Investors that have purchased now are going to hunker down, increase the NOI and then sell when they feel the market is right. … The availability of product in the last three to four months has slowed.”

Even though retail transactions are on track for another record year — sales are up 14 percent more than 2004's total through nine months — volume is slowing. In the third quarter, sales volume dropped to $9.6 billion after being at $14 billion in the second quarter, according to Real Capital Analytics. Retail is also exhibiting the smallest increase in sales volume of any property type — trailing behind apartments (up 90 percent), industrial (up 83 percent) and office (up 42 percent). Overall, retail accounted for 17.1 percent of commercial property sales in the first nine months of the year, compared with 22.8 percent during the same period in 2004.

Prices on acquisitions have largely gotten too rich for REITs, which made a killing in recent years by growing FFO through purchases and mergers. They've been priced out of the market, as private and foreign investors swooped in and raised the stakes. So REITs are turning to development to drive gains in their portfolios.

“REITs don't have anywhere else to go now,” Maloney says. “There are very few possible portfolio plays. There may be one or two consolidations. But the big growth opportunities are few and far between. Ground up development is their opportunity now.”

This is inherently more risky. Moreover, development activity is being accelerated by the quick rise in cost of materials. Developers want to get projects in the ground now, rather than in six months, to help save costs.

As a result, General Growth Properties is investing $2.1 billion in its portfolio; Regency Centers is spending $1.2 billion. and Simon Property Group is spending $840 million.

And it's not just the big boys who are out there spending heavily.

“You're actually seeing rookie developers or speculators vying for retail development sites and competing with experienced retail developers in the market,” says Michael Dee, senior vice president and national director of retail for Grubb & Ellis Inc. “These rookie developers are much more willing to take risk on because they feel like they can get them leased up in a reasonable period of time and they like the returns they are going to get.”

This has also fueled the mixed-use trend that most retail companies have jumped on. “We're certainly not going to see much in terms of traditional mall development,” Dee says. “That lends itself to this emphasis on mixed-use, open-air type projects.”

The answer, for some, has also been to stray from known formulas and look for offbeat acquisitions in search of higher returns. For now, the gamble to diversify is paying off, but the strategy entails more risk.

Kimco Realty Corp., for example, has shied away from its core property type of strip shopping centers. In early November, Kimco paid $55 million to acquire a 50 percent interest in 57 net-lease industrial and distribution buildings in Mexico. The company said the cap rate for the properties is in the low double digits versus 7 percent for a comparable portfolio in the U.S.

“We believe there continues to be an attractive arbitrage opportunity between property yields in Mexico versus the United States for net-lease buildings to strong credit tenants on U.S. dollar net leases,” David Henry, chief investment officer, said in a call with investors. But down the line, does it make sense for Kimco to be operating international industrial properties when its expertise is in retail?

Kimco has also invested in Canadian car dealerships and is working with Vestar Development Co. to make over the Tustin Marine Air Base in California into a $140 million lifestyle center. And it acquired a downtown Houston office building for $14 million.

Similarly, the Inland Real Estate Group of Companies has been all over the map in 2005. It has ramped up its mortgage business (which provides 100 percent financing). It has acquired not only retail assets, but also offices. And its Inland Western REIT, ostensibly focused on retail properties west of the Mississippi, this year has purchased properties in New York, Alabama, Georgia and other eastern states.

And although Vornado Realty Trust acquired a few traditional mall assets in 2005, it made some unconventional plays by participating in the acquisition of Toys ‘R’ Us Inc., and more recently, the purchase of $500 million of McDonald's Inc. stock.

Interest rate pressure and alternative investments with similar yields represent more of a challenge. There are also now more alternatives to real estate for investors seeking yield. Things like CDs and the 10-year Treasuries have risen, so the spread between them and real estate cap rates has closed. Cap rates were almost 150 basis points above the 10-year Treasury. Now the spread is almost zero. The question for investors has become whether they want to take on the risk of property ownership, or sit back and buy insured, guaranteed returns. More are opting for the latter. Many traded funds are turning away from real estate and toward treasuries. In fact, such funds have been flowing out of real estate since mid-August.

Another reason for concern is that the much-ballyhooed housing bubble is at its end. Some markets have seen housing valuations begin to contract. If housing sales and starts slow down, so too will the string of mortgage refinancings. Homeowners will stop tapping in to the equity of their ever-appreciating homes, and cut back on spending. New homes also bring along a spur of retail spending — an average of $10,000. If home sales slow, so too will retail sales.

While the supply of houses on sales in October in Washington, D.C. ballooned, the number of sales plummeted, causing price contraction. According to the Metropolitan Regional Information Systems Inc. in Northern Virginia, more than twice as many homes were available in October 2005 than in 2004, but sales were off 28 percent. In the city, listings were up 62 percent and sales were down 28 percent. In Montgomery County, Md., listings were up 49 percent and sales down 8 percent. Similarly, in California, the median price of a home was up 14.9 percent in a year-on-year basis — the smallest spread since June 2003. And the median price actually fell from September as did the total number of homes sold.

Meanwhile, the Commerce Department reported that construction of new homes and apartments fell by 5.6 percent in October, the largest decline in seven months. Applications for building permits fell by 6.7 percent, the biggest decline in six years.

Although there is no direct correlation between single-family sales and commercial real estate, analysts say there is a psychological link. If the single-family market sends a signal that real estate is cooling, that will likely have an impact on the commercial market.

Given all the storm clouds gathering, retail real estate companies should expect 2006 to bring challenges they haven't faced in a while. Ultimately, the sector's fundamentals and landlords' ability to continue to raise rents will keep things moving. But it's not going to be all fun and games anymore.

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