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The retail property sector is undergoing a rapid contraction in demand for space in the wake of a fairly large construction wave in the past few years. Retail sales in the first quarter of 2009 were down 9% from a year ago. Adding to the retail sector's woes is an abundance of new shopping centers built to serve housing developments, which sit largely vacant or never came to fruition. Further price corrections are expected, leading to strong buying opportunities. As market conditions soften, however, the urgency to sell retail assets will intensify and the bid-ask gap will narrow. Government attempts to remove toxic securities from the balance sheets of financial institutions are encouraging.

Copyright Penton Business Media, Inc. and Penton Media, Inc. May 2009

The retail property sector is undergoing a rapid contraction in demand for space in the wake of a fairly large construction wave in the past few years. Compounding the problem is today's global credit crunch, which has constrained the availability of financing for commercial real estate.

During the first quarter of 2009, the U.S. retail vacancy rate reached an estimated 9%, its highest level since the early 1990s. Further increases are expected this year as job losses mount, and both consumers and retailers remain cautious.

In 2008, household wealth declined by 18%, largely the result of sliding home and stock prices. Consumer spending has taken a hit. Retail sales in the first quarter of 2009 were down 9% from a year ago.

Adding to the retail sector's woes is an abundance of new shopping centers built to serve housing developments, which sit largely vacant or never came to fruition.

Lenders today are more cautious when underwriting new retail loans. Loan-to-values have declined dramatically from a few years ago and lender spreads reflect the heightened risks. The average term for newly originated retail loans is five years, with fewer lenders willing to make a 10-year commitment. Lenders are scrutinizing borrowers' and tenants' credit quality and avoiding secondary or tertiary markets.

A Darwinian environment

These pressure points are resulting in a growing inventory of properties for sale, as well as an increase in the distressed component of the retail marketplace. The net effect is a heightened urgency to sell retail assets this year. Further price corrections are expected, leading to strong buying opportunities. The degree of price adjustment and distress varies significantly across retail subsectors and is heavily influenced by local market conditions.

Well-stabilized shopping centers that provide consumer staples in supply-constrained markets or infill areas are experiencing the least price correction. Assets in secondary and tertiary markets are seeing the largest price correction, as are older malls and new retail developments that trailed the overbuilt housing market.

The retail investment market has endured a disconnect between buyer and seller expectations and constrained capital markets since 2007. Retail investment fell nearly 65% in 2008 compared with the previous year. Data for the first quarter of 2009 reflects further declines.

Deal volume in the higher price range has decreased the most Sales of properties priced at less than $20 million comprised approximately 96% of all activity over the past year, compared with 90% during the previous 12-month period.

Tight credit markets have made it difficult to finance large deals, and many major owners have remained hesitant to offer properties at significantly discounted prices. As market conditions soften, however, the urgency to sell retail assets will intensify and the bid-ask gap will narrow. Factors such as maturing debt, deteriorating net operating income or the need for owners to raise capital will spark attractive buying opportunities.

Government remains a wildcard

Approximately $4.7 billion in retail properties is distressed, with another $23.5 billion at risk. Investors waiting for a central clearinghouse for troubled assets to be established - like the Resolution Trust Corp. in the early 1990s - may miss out on attractive opportunities.

Unlike the early '90s, the loan structures of a substantial portion of the mortgages securing retail properties are far more complex due to the role of securitization over the past decade. In addition, battered financial institutions are avoiding commercial foreclosures to stem further losses, which postpones the disposition of troubled assets.

Government attempts to remove toxic securities from the balance sheets of financial institutions are encouraging. But questions remain about how these assets, including mortgage-backed securities, will be priced and sold off through a private sector partnership.

Expectations that a massive inventory of deeply discounted retail properties will become available through a single clearinghouse is unrealistic in the near term. Instead, investors should focus on the markets and types of retail that fit their value-creation goals.

The U.S. economy is expected to bottom in 2009 and begin to recover in 2010. Although job growth will be modest compared with past recoveries, rising incomes should help move a substantial volume of capital off the sidelines.