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Mind Reading

<em>Consumers are thinking about returning to malls. But they face obstacles to spending. What it means for retail real estate.</em>

On the morning of Apr. 3, when Apple’s new iPad tablet officially went on sale, the lines in front of Apple’s four New York City stores snaked around street corners. At the company’s shops from coast to coast, people turned out in droves to take the new gadget for a spin and many ended up shelling out $500 to $700 for units of their own.

By the end of the day, Apple had sold 300,000 iPads.

By the end of the week, the number had jumped to 500,000.

And by mid-April, Apple was forced to delay the international release of the product by about a month because of the overwhelming domestic demand.

Things got so crazy that in late April one shopper in Denver lost a part of his pinky finger when an overzealous thief violently ripped the plastic bag he was carrying the device in out of his hands.

Before the iPad hit the market, the company expected to sell 1.2 million units in the second quarter of 2010. After the release, analysts upped the projection by 50 percent to 1.8 million because of its smashing sales.

It would be hard to classify the iPad as a necessity. The device fills the gap between smart phones and laptops and one of its main purposes is to compete with Amazon’s Kindle in the burgeoning e-reader market. (In that first day of sales, iPad owners downloaded 250,000 iBook titles.)

Yet a healthy number of beleaguered U.S. consumers were willing to fork over hundreds of dollars for what is essentially a luxury gadget, even as they continue to deal with limited credit availability, stagnant housing prices and the worst job market in decades. The iPad is not the kind of item that should be a hit, given the levels of frugality that have gripped U.S. consumers during the past 18 months. Could its success be a sign that the U.S. is en route to the same levels of consumer spending the country saw before the recession hit?

Not quite, experts say. While consumers are recovering some of their buying prowess, buoyed by positive news about the economy, spending power is nowhere near what it was in 2006 and 2007. Back then, the housing bubble and a booming stock market helped fuel Americans’ shopping trips in the absence of real income growth. With those crutches gone, going forward U.S. consumers will likely return to their pre-boom shopping habits. That means there will be less room in the sector for all the mid-price chain retailers and less demand for retail space. One real estate professional describes the situation this way: while the worst of the retail industry reshuffling may be over, the game of musical chairs will go on for some time.

Misleading picture

In March, same-store sales for U.S. chain stores rose 9.0 percent year over year according to ICSC—the sixth month out of the last seven with positive results. It was the biggest year over year gain in 10 years. More interestingly, sales gains were strongest at luxury chains, which posted a 14.2 percent increase. Discount stores saw sales increase 10.7 percent.

Similarly, the U.S. Commerce Department recorded a 1.6 percent gain in consumer spending, marking seven straight months of increases. The Deloitte Consumer Spending Index, which looks at consumer cash flow as an indicator of future spending, rose to 4.47 percent from 4.21 percent in February.

Yet most economists caution that the March retail numbers come with a lot of caveats. The comparisons are with March 2009, one of the worst months for retail on record, notes Mary Delk, director in the retail practice of Deloitte Consulting LLP. In addition, the shift in the date of Easter skewed sales related to the holiday much earlier than they were last year. As a result, April numbers will be much more modest and a more accurate picture will emerge when sales can be viewed in their totality compared with 2009’s figures.

“We are up against very easy comparisons against last year and the other thing is that whenever there is a recession, we get this puritanical behavior from consumers and then people pull out their wallets and they spend again,” Delk says. “Sometimes it’s because of [pent-up] needs, other times it’s because of the emotional factor. But I believe there will be a period of time when that will start to taper off again.”

In fact, while Americans have begun feeling more hopeful about the future and are gradually coming back to malls, the economic indicators that determine a sustainable level of consumer spending have not been strong.

As of March, the unemployment rate remained at 9.7 percent in official estimates, the same level as in January and February. and not far from October’s 10.2 percent peak. In addition, when discouraged job seekers and part-time workers looking for a full-time job are added in, the rate jumps to 16.9 percent.

That rate continues to be a source of concern not only to those Americans looking for a job, but also to those in the workforce, as they worry about their job security and potential salary cuts, notes Robert Bach, senior vice president and chief economist with real estate services firm Grubb & Ellis. And when people worry about losing their jobs, they remain conservative spenders.

Moreover, the average length of unemployment stands at more than 26 weeks—the highest number on record. There were more than 8 million jobs lost during the recession—dwarfing what the economy experienced in any other recent downturn. While firms have begun hiring again, the pace of job creation remains anemic. And the number of job openings per applicant remains at depressed levels. All of this paints a gruesome employment picture for some time to come.

There has also been a slow decline in real disposable incomes in recent years and consumer credit remains tight, as banks have adjusted their lending criteria to fit a more risk-averse model. But perhaps the biggest obstacle to strong growth in consumer spending is the housing market.

While the housing sector seems to be on the mend in many parts of the country, with a rising number of sales, foreclosures keep trending upward and prices are either flat or going down. Moody’s Investors Service predicts it might take a decade for the U.S. housing market to fully recover the 30 percent to 40 percent in value it lost during the crisis.

It was the unsustainable rise in home values that drove unprecedented levels of consumer spending in the mid-2000s, more so than steady employment or credit cards, notes Jay McIntosh, president of Consumer Foresight LLC, a Chicago-based consulting firm. In those years, Americans came to rely on their home equity to finance their shopping sprees. In 2005, for example, U.S. consumers extracted $750 billion of equity from their homes through home equity lines of credit. In 2009, the figure fell to a negative $214 billion.

“One of the fallacies that I think exists in many people’s mind is this focus on the negative savings rate we had for many years,” McIntosh says. “But [during that time], the home values were going up and many consumers were focused on their homes as a source of their net worth. At a time when housing prices are flat or falling, consumers are going to scale back spending because they need to replace that wealth creation with savings.”

As of fourth quarter 2009, the U.S. personal savings rate as a percentage of disposable income stood at 3.9 percent, according to the Commerce Department. The figure represents a 240 basis point increase from a savings rate of 1.5 percent in fourth quarter of 2007, but is off its recent peak of 5.4 percent, which occurred in the second quarter of 2009. Since home values are not likely to recover any time soon, Americans, especially baby boomers who are now approaching retirement, will continue to put at least a portion of their income into savings, McIntosh notes.

What that means for the retail industry...Continue reading on the next page. that the 9 percent same-store sales increase in March was a fluke. Going forward, sales growth will be more measured—in the low single digits, says Hessam Nadji, managing director of research services with Marcus & Millichap Real Estate Services, an Encino, Calif.-based brokerage firm.

In fact, the U.S. might never return to the level of consumer spending experienced in 2005, 2006 and 2007, when retail sales totaled $4 trillion a year. But that may not necessarily be a bad thing, in Nadji’s view. He notes that a better comparison would be to the period between 1997 and 2002, which encompassed the stock market bubble, the 9/11 attacks and a recession of its own. In those years, total retail sales in the U.S. unadjusted for inflation rose 38 percent, to $3.1 trillion a year from $2.07 trillion a year. And same-store sales growth ranged from 0.5 percent to 5.4 percent, according to ICSC data.

“If we could come back to that [level of spending], I would say it’s a healthy consumer environment,” Nadji says.

It won’t be enough, however, to support more than 7 billion square feet of retail GLA the country has accumulated. With fewer dollars to go around, some retailers will continue to disappear from the landscape, while others may shrink their real estate portfolios for more efficient operations. In addition, even when sales growth resumes, more and more activity will shift online—taking a bite out of the ultimate upside for brick-and-mortar operations.

As a result, in the months and years ahead, retail property owners will have to pay close attention to their tenant rosters because properties that don’t attract market leading tenants will ultimately fail.

Five easy pieces

Most economists say consumer spending is determined by employment, income growth, housing prices, consumer credit and peoples’ outlook on the future. So far, employment, the most important of these factors, has not shown much improvement. While the unemployment rate has declined from its peak, some caution that it may rise again and be around 10.5 percent later this year, says Abigail Marks, economist with CBRE Econometric Advisors, a Boston-based research firm.

Jobs are beginning to be created: in three of the previous five months, the Bureau of Labor Statistics recorded a net jobs gain. But the gains have been modest compared to the millions of jobs lost. Based on preliminary statistics, there were 162,000 jobs created in March. Yet, economists estimate that businesses need to add 125,000 jobs a month just to keep up with the pace of population growth. In reality, the pace of job growth will need to accelerate greatly before it begins to truly shift the employment picture.

As talk of recovery intensifies, more of those Americans who have given up looking for a job might also come back into the labor force, negating job gains, says Bach. Plus, each year there is a number of first time job seekers who enter into the fray. Given those factors, the pace of job creation won’t catch up with the size of the labor force until approximately 2020, even if the U.S. economy sees 200,000 to 300,000 jobs added a month—matching the pace in the 2000s boom, Bach notes. As a result, it will likely take up to a decade before the unemployment rate comes back to 5 percent, he predicts.

Partly as a result of this imbalance in the labor market, and partly as a result of widespread salary cuts U.S. employers had to institute in 2009 to keep their companies out of Chapter 11, consumers’ real disposable incomes have been falling.

In the fourth quarter of 2009, the Commerce Department estimated Americans’ real disposable personal income per capita at $35,747. The figure represents a 0.76 percent drop from the $36,022 in real disposable personal income per capita recorded in the second quarter of 2008.

There is unlikely to be long-term growth in real incomes, due to a combination of job outsourcing, the likelihood of tax increases for highest earners and the possibility of inflation as a result of huge government debt, says David J. Lynn, managing director of research with ING Clarion Partners, a real estate management firm. “We will have growth in nominal incomes [as employment improves], but I am not really optimistic about real incomes rising,” he notes.

U.S. consumers can also no longer use their homes to finance their purchases. It’s true that the worst of the housing crisis may be in the past—in March, the National Association of Realtors reported that home sales have posted increases over year-ago levels for eight straight months. In February, the volume of existing home sales rose 7 percent over February 2009, to a seasonally adjusted rate of 5.02 million units.

The problem is that foreclosure notices keep piling up. In the first quarter of 2010, the number of foreclosure filings, including default notices, scheduled auctions and bank repossessions, was up 7 percent compared to the fourth quarter of 2009 and 16 percent compared to the same period a year ago, according to RealtyTrac, an online marketplace. That translates to a total of 932,234 properties, or one in every 138 housing units. By the end of 2010, the U.S. might see up to 3.5 million foreclosures, according to the Housing Predictor, an independent online research provider.

And though declines in housing values have become more palatable than those experienced in 2008 and 2009, the economy is a long way off from seeing any gains, Bach says. In January, the most recent month for which data is available, Standard & Poor’s Case-Shiller Home Price Indices 20-City Composite, which tracks the housing market in 20 metropolitan regions, stood at 145.32. The figure represents a 0.7 percent decline from January 2009. And that was the most positive reading in three years.

Nor can Americans rely on credit cards the way they once did. While many banks have recapitalized (in some cases with the help of government aid) and are in a position to lend, they remain focused on improving the health of their balance sheets and are lending only to the most credit-worthy borrowers, says Nadji.

In February, the overall volume of revolving debt in the U.S., which includes credit cards, declined at an annual rate of 13.1 percent, to $858 billion, according to the Federal Reserve. At the end of 2007, the overall volume of revolving debt stood at approximately $943 billion.

Of course, none of the actual statistics matter as much as consumers’ view of the market, Bach points out. He brings up an April Newsweek cover that proclaimed “America is Back,” as an example of the kind of media coverage that could fuel a surge in consumer spending in spite of lackluster market fundamentals. In March, the Conference Board Consumer Confidence Index rose to 52.5 on a scale where 100 equals average consumer sentiment in 1985. In index reached a cyclical low of 25.3 in February 2009

“It’s psychological. People are reading this and that alone will help consumer confidence,” Bach says. He adds, “I think the recovery is real and it seems like the surge in consumer spending is real.”

Slow and steady

The good news is that U.S. consumers love to shop too much to kick the habit completely, says Nadji. He expects that over the next 18 months, as corporate America creates more jobs and incomes stop declining, people will gradually return to stores.

“In the short-term, I think we are going to see a continued strength in retail sales—not so much month-over-month increases, but a return to stability and a sigh of relief that the worst is over,” Nadji notes. “The consumer really doesn’t have a reason to go on a spending binge, but I think we now have much healthier consumption, much healthier retail sales than before.”

The resurgence in consumer demand, coupled with greater availability of corporate credit, means the cycle of retail bankruptcies and liquidations that hit the industry in late 2008 is largely over. Store closings, however, will continue for some time, albeit at a much slower pace, says Marks.

Retailers that will have a good shot at succeeding will be ...Continue reading on the next page.

...those that focus on necessities, as well as those that promote value, according to Lynn. Luxury chains have been posting strong sales in recent months, but there might not be enough luxury shoppers in the U.S. to support their expanded store fleets.

“A lot of people were aspirational retail buyers [during the boom] and they really didn’t have the money,” Lynn notes. In the future, there will be “less total spending and it will be different spending. I think discount boxes and grocery-anchored neighborhood centers will do better” than everything else.

Most economists believe that even prior to the recession, the U.S. was over-retailed, with more than 20 square feet of retail space per person, more than any other country in the world. With consumers reining in their spending, there won’t be enough demand to support the same number of stores as before.

The current down cycle will offer the retail industry a chance to witness the principles of natural selection at work, adds Delk. With less market share to go around, the most successful retailers will be those who stay innovative, either through product offering or though unique customer experience.

In addition, as mobile and digital shopping venues gain in importance, smart retailers will switch more of their operations to those channels and shrink the size of their brick-and-mortar portfolios. After all, a mobile Web site costs a lot less than building a fleet of new stores, Delk says.

Apple is a good example of an early adapter that’s likely to survive this cycle. It continues to offer innovative products consumers have to have, like the iPad. Plus it has been running a very efficient real estate portfolio, with stores that go into just the right markets and devote very little space to excess inventory. It has a healthy Web presence to support all its mobile devices. In 2010, Apple plans to add 40 to 50 new stores to its existing fleet of 283 stores. In the economists’ view, other examples of long-term survivors include Best Buy, Whole Foods Market and Walmart.

“There is going to continue to be a bigger gap between the leaders and the laggers in the retail industry,” says Delk. “The leaders excel at innovation, they excel at customer interaction and retention. They will get bigger, and as a result, you will see some additional failings with people leaving the industry.”

What it means for owners

For retail center owners, that translates into both good news and bad news. Thriving retailers will likely view the downturn as the perfect opportunity for expansion, says Andrew Florance, CEO of CoStar Group, a Bethesda, M.D.-based real estate research firm. As rents continue to fall, tenants can reduce their operating expenses while grabbing better spaces. CoStar has already noticed an emerging trend of retailers upgrading from class-C locations to class-B locations, and from class-B locations to class-A centers.

In spite of negative absorption of 121,906 square feet, the preliminary figure for total leases signed during first quarter of 2010 has shot up to 34.6 million square feet, the highest level in four or five years, according to CoStar data. During normal times, total leasing activity does not show much fluctuation, says Florence. He expects that the number will be revised upward when the results are finalized. “I think folks have adjusted their businesses,” Florence notes. “Some retailers face a lot less competition now and have been able to opportunistically move into better locations.”

That means class-A and class-B centers in primary markets will remain open for business, though they will have to be extra careful about which tenants they sign leases with, according to Nadji.

He discourages landlords with stable assets from signing leases with any tenant, at any price, as long as a vacant space becomes filled. Most lease agreements last for 10 years and it’s important that the tenant that goes into the center today not only has a good chance to survive this decade, but drives new customers to the property.

When contemplating new leasing transactions, landlords should pay close attention to the prospective tenants’ balance sheets and growth strategies, as well as their possible competition within the center’s trade area, Nadji says. Going forward, having a diverse tenant base in your center will be one of the keys to success, adds Lynn. He notes that during the boom years, retail developers tended not only to put shopping centers on every street intersection, but also to fill those centers with the same list of national chains.

“I think we don’t need that much retail, particularly in suburban areas,” Lynn notes. “Every suburb had some kind of lifestyle center or power center, and it wasn’t really necessary. And it was the same retail formats—five mid-segment retail stores in the same development.”

In consequence, the lifestyle centers and power centers that were built on suburban fringe in the mid-2000s will take a long time to reach full occupancy, according to the experts—trailing class-A and class-B centers by several years. However, most of those centers will likely be kept as retail in the long term. A much more uncertain fate awaits older class-C centers in suburban markets. With too much retail space and not enough tenants to go around, the older unanchored malls and shopping centers might end up demolished and turned into other uses, including schools, churches and health care facilities.

“There are some centers that are simply too old or obsolete and they are better served through other uses,” Nadji says. “That kind of recycling is now going to happen more than ever.”

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