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The rise and fallout of interest rates

The right deals will get done despite rising interest rates, some say. Others, citing larger economic issues, aren't so sure.

A delicate balance is emerging between those interest rates shopping center developers can digest and those that can knock smaller developers and weaker tenants out of the retail ballpark. That delicate balance may be starting to tip.

"The last 50 to 100 basis points' swing in interest rates has taken most of the juice out of shopping centers for us and other developers who finance acquisition, construction and development," says Milton Smith, president of Birmingham, Ala.-based AIG Baker Development LLC.

AIG maintains a portfolio of 5.4 million sq. ft. of GLA in grocery-anchored neighborhood centers and big-box power centers.

A smaller industry player at roughly one-fifth the size of Regency Realty Corp., AIG ranked 15th on SCW's 2000 survey of the top 75 shopping center owners.

The Federal Reserve elected, on Aug. 22, not to raise interest rates, leading some economists to conclude that the Fed's 14-month string of rate hikes to ward off inflation is close to an end.

Fed Chairman Alan Greenspan and his colleagues opted to leave short-term interest rates unchanged. They cited a moderating economy and strong productivity growth, which could help keep inflation down.

Some economists say the Fed used more positive language in its latest decision, prompting the optimistic to predict that - provided there are no sudden increases in economic growth or inflation - the central bank will let interest rates be for some time. The current cycle of rate hikes began in June 1999.

"We believe that the Fed is finished tightening," Merrill Lynch's chief economist Bruce Steinberg told the Associated Press. Others were more cautious.

"For now, it sounds as if the Fed is uncertain that it will have to tighten again, in contrast to the certainty it felt in the second half of 1999 and early 2000," David Orr, First Union's chief economist, told the news service. "Bottom line - less likelihood of further rate hikes this year."

One more increase? Other analysts say they expect at least one more increase, probably at the Nov. 15 or Dec. 19 meeting. But no experts feel there will be a rate increase at the Oct. 3 meeting. The Fed prefers a hands-off approach in the closing weeks of a presidential campaign. (The presidential election is Nov. 7.) In the past 14 months, the Fed has raised rates six times, pushing its target for the federal funds rate, the interest that banks charge on loans to each other, up to 6.5%, including a half-point increase on May 16.

Everything, not just interest rates, has been moving up - Treasury bills, LIBOR and spreads from insurance companies and conduits. LIBOR, the London InterBank Offered Rate, is the base interest rate paid on dollar-denominated deposits traded between banks in London in the Eurodollar market.

A damper on projects In this climate, notes Andrew S. Oliver, managing director of national retail for New York-based Sonnenblick-Goldman Co., "It's difficult to do a deal under 200 basis points. Anybody who wants full leverage will pay 220 to 250 basis points, depending on the type of property and how much leverage is involved. With interest spreads at 200 basis points plus over LIBOR, the rate is approaching 9%, which puts a damper on projects."

Financing is still readily available, Oliver notes, for a well-conceived project, with anchor spots pre-leased, especially to a major grocery, and other tenants in place. But it's not a slam-dunk for all types of projects. "Power centers will be difficult to finance," Oliver says, "regardless of the interest rates because a lot of lenders and investors think they're overbuilt."

They're also nervous about some of the credits of the big box retailers - smaller regional movie theater and sporting goods chains, for example - that go into them. "It's hard to find investment-grade credits in those two big-box businesses in particular and that's of great concern to lenders," Oliver notes.

Projects that aren't investment grade are harder to finance, says Jay D. Stein, partner with Indianapolis-based Sandor Development Co., which maintains a portfolio of 5.2 million sq. ft. of GLA, mainly strip shopping centers, in 17 states.

Money is available for the "right deals" and at less than 8%, especially on a 20-year loan term, Stein says. However, "If the rates keep rising you'll get less proceeds when you close your loan, so you'll have to get more rent, which is harder to do because they're typically market rents."

According to Oliver, the right deal calls for "the right developer, with some equity in the project, tenants likely to be around for the life of a long-term lease, and the right location," not necessarily in that order.

"If yields on bonds increase, yields on real estate go up as well," Oliver continues. "If somebody is willing to buy something at a 9% return and interest rates go up 100 basis points or 1%, then the price of the real estate has to go up to maybe a 10% return or 10 cap. So sale proceeds are affected by interest rates as well." And worthwhile deals will not abound.

AIG's Smith says, "we've probably passed over 25% to 30% of the projects we've looked at over the past year because yields weren't there, and rates had a lot do to with it."

AIG is looking for yields above 11%. "But each deal has its own set of risks. If we're doing 800,000 sq. ft. of big boxes and have 600,000 sq. ft. leased before we break ground, we may accept a lower yield because of a lower risk. If we have to lease a lot of space we expect a higher yield."

Regional and local developers are finding it tougher to get money, with banks requiring more equity and interest rates going up, Smith continues, so instead AIG is doing more joint ventures.

"Developers may have the land and tenants, but need the financial power to get started. We're seeing more of those opportunities in the past six months than over the past two years."

Narrowing spreads Mark E. Zalatoris, CFO of Chicago-based Inland Real Estate Corp., a REIT with 19.8 million sq. ft. of GLA in its neighborhood and community shopping center portfolio, says there is a disincentive for his company to acquire property.

"Our spreads have narrowed between return on the property over our cost of funds. We don't view this period as a good buying opportunity. Sellers still expect to get a higher price and we're not interested in buying at that price."

Moreover, higher interest rates curtail tenants' access to inventory. If they sell less they earn less and are hard put to pay rent.

"We're concerned about that even if we haven't experienced it to any degree," says Zalatoris.

50% loan-to-value ratio Money isn't harder to get, just more costly. "There may be a small contraction in availability of funds, but it's at higher leverage levels," Zalatoris says. "There's plenty of money available if it isn't a high loan-to-value ratio. We do 50% and lenders knock themselves out to get those types of loans."

So far, rising interest rates have hurt the smaller players, Zalatoris notes, because they're typically borrowing at higher loan-to-value ratios and don't have the collateral of larger companies.

AIG's Smith expects competition in the industry to dwindle if interest rates keep creeping up and an economic downturn grinds under consumers' spending power, in which case he figures only the best financed 10 to 20 developers will be able to keep shopping centers in development.

Meanwhile, he says, "I can't remember what a down cycle looks like after a 10-year run up. It can't get any better than we have it today. It can only go down at some point, and with it - employment and discretionary spending."

There is more to the looming predicament than interest rates, according to Sidney D. Eskenazi, Sandor Development's president.

"Interest rates are just part of your costs, like the rising price of cement," Eskenazi says. "You have to show tenants how your costs are increasing, to get them to pay higher rents."

But if the economy generally and household incomes specifically keep on the current roll, wouldn't consumers' buying power offset some of those higher costs? "That would make a difference only if the tenant believes it does. If a tenant can actually generate more sales at a profitable margin, then he's willing to pay more rent, but if he doesn't, he can't pay the rent," Eskenazi says. "It's not a big secret that tenants who have to pay more for goods have to charge more."

Joe Milanowski, president of Las Vegas-based USA Capital LLC, a privately held financial services company, says online shopping, jobs, population and household income growth have a greater impact than rising interest rates, as long as the rate increase remains within certain limits.

"Las Vegas has seen a tremendous amount of retail development, driven by job growth, population and visitor volume, which are bigger factors than prevailing interest rate," he says. "Although, if the rates affect job growth, household formation and income, that will in turn affect the general economy and create less demand for shopping center space."

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