Peter Pays Paul

Here are a couple of items from around the web on commercial real estate:

• Is this a sign of things to come? Mish comments on Commercial Real Estate Mutiny In Downtown LA where retail tenants held a two week “rent strike”, while they demanded their landlord lower rents and stop charging for advertising.
• Square Feet has noticed that January Unemployment Shoots to 10.1% in California.
  
• The Dirt Lawyer  cautions that Before you think there’s no money out there… Blackstone claims to have $12 Billion sitting on the sidelines.
• Ever wonder how to determine a market cap rate? Lucas Rotter Grant Norling has written Scarcity in Capitalization Rate Examples? An In Depth Approach To Find The Right Cap Rate to help answer your question.
• CoStar.com proclaims Market Turmoil Takes Aim at Life Insurers

Chris Rodriguez of Retail Chatr has written on Determining Market CAP Rates. It details how CAP Rates have fallen during this recession and where they could go.

Now we are in a recession and retail property prices are moving as fast as the stock market. It is almost impossible to accurately pinpoint a property’s value as there is no common motivation from the buyers in the marketplace. One buyer is yanking money out of stocks to buy something more “secure” while another is in a 1031 exchange having sold at a great price and is now watching as his purchasing power increase daily. Not to generalize too much, but yesterdays 5.00% – 5.50% CAP Rate single tenant properties are (or should be) trading between 6.25% – 7.25% CAP Rates, depending on the lease terms, strength of the tenant and location.

Retail real estate had a great run up in value and rental rates in the past few years. Fueled by easy consumer credit retailers expanded at a furious pace. This demand spurred development of retail projects across the country.

Now, with consumer spending down and online purchases up, retailers are going under.This decrease in demand for retail space has retail real estate set for a bumpy road in 2009.

Advice for Retail Specialists

The Jacksonville Business Journal has some tips on how to get retail real estate deals done in this tough economic climate from a local ICSC event.

Rent concessions, local government assistance and reduced maintenance costs are going to be the new way to make retail real estate deals stick in 2009, according to panelists at an International Council of Shopping Centers event.

The ICSC Jacksonville Next Generation Program panel discussion on creative deal making strategies attracted nearly 100 young professionals Jan. 22.

Retail real estate pros have to get creative – Jacksonville Business Journal

A Doomsday Forecast

How bad could the situation get? James Quinn at Seeking Alpha has written an article titled Ghost Malls: Coming to Your Town (HT: Transparent Real Estate) that details how bad the situation could get.

The illustration of Old West ghost towns is something that every American can relate to. During the great gold rush of the mid 1800’s in California, Nevada, and Wyoming towns sprung up out of nowhere to support the gold mining efforts of those looking to strike it rich. General stores, bars, hotels, brothels, and jails appeared out of nowhere based on demand from delusional prospectors hoping to hit the jackpot. Thousands of malls emerged throughout suburban America in the last twenty years as delusional shoppers thought they could spend their way to prosperity and achievement. Both delusions will end in the same manner.

James speculates that gone are the days when American consumers attempted to spend their way to prosperity and predicts that this will have a drastic affect on malls.

A permanent psychological change has occurred in American consumers. They have lost $30 trillion in value from their homes and investments in the last few years. No amount of fiscal stimulation will reverse this psychological trauma. The savings rate will increase from 0% to at least 8%.

…

As Americans realize that they don’t “need” a $5 Starbucks latte, IKEA knickknacks, Jimmy Choo shoes, Rolex watches, granite counters, and stainless steel appliances, our mall centric world will end.

Uncertain Future

“Batten down the hatches boys, it’s going to be a wild one.”

Only time will tell how bad the situation will get. If James’ assumptions are true, it could be very bad. If retailers are able to trim their costs and survive, the bottom will be much softer than James predicts.

What are your thoughts? How far down will retail real estate go?

The Contra Costa Times is reporting that Fresh & Easy grocery store is delaying their planned expansion into Northern California and the Bay Area. Fresh & Easy styles itself as a smaller supermarket that insists on fresh food and quality produce.

The article states optimism about the future of the expansion plans for Fresh & Easy. I think that because of public distrust of publicly traded companies, some shoppers may prefer a local, known grocer/shopkeeper to a chain store. This could be a benefit for the smaller Fresh & Easy markets.

However, this may be a sign that people are less willing to spend extra money on “luxury” type food items. Whole Foods has seen a downturn in the present market.

Fresh & Easy delays local expansion – ContraCostaTimes.com.

Imagine that little retail center near your house.You know the one.

It has your favorite coffee shop, the weird home decor shop, a woman’s clothing boutique, the nail shop, and the national auto parts store.

Over the years you’ve seen the stores change. Different shop owners have come and gone. The coffee shop has been there for a while. The woman’s clothing store is only a year old.

As you drive by you notice a “Going Out of Business” sale going on in the home decor shop. You’ve talked with the owner of the woman’s boutique and she is having a rough time making a profit.

If these two stores close their doors, you wonder who is going to fill this space. What is going to happen to the owner of that little retail center? Where will he find tenants?

The Plight of Retail Stores

Americans are spending less money these days. We built our economy upon the model of consumption and borrowed to fuel that consumption.

With the well of cheap financing depleted, spending has come to a screeching halt. Retailers nationwide are taking a hit. The recent headlines have featured the likes of Circuit City, Mervyn’s, Shoe Pavilion, and Linens ‘n Things.

The Pain on Retail Center Owners

When a retail store closes or “goes dark” the landlord will feel the pain of having a vacant store. (Some leases do have a provision that stores can close but while the tenant continues to pay rent.) This means that she does not have as much rental income to pay the bills she faces for owning the property.

How Vacancy and Rental Rates Affect Value

I shared here the most common method to value income producing property. The most important numbers to determine value are Net Operating Income (NOI) and the Capitalization (Cap) Rate.

Rental rates and the assumed vacancy rate will affect the NOI. NOI is then used to calculate the value of the property based on an expected return to the investor, the Cap Rate.

Slight Changes with Devastating Effects

So how would a 10% decrease in rents, a 5% increase in vacancy, and a 1% increase in Cap Rate affect a properties value?

Notice that the value decreases by 26%.

Also notice that the change in the maximum loan amount decreases by $1.08 million. If the borrower needs to refinance under these new assumptions, the borrower will need to come up with over a $1 million to close the loan. The foreclosure process and bankruptcy are not far away.

The Current Credit Crisis

Currently, some institutional lenders have begun to underwrite retail loans along the lines of this scenario. They are forecasting decreasing rents and higher vacancy rates.

Some lenders are incorporating a higher cap rate as well. (One developer I know said that he hasn’t started a retail project unless it underwrote at a 8% cap rate or higher because of historical cap rates, even during the boom times.)

Unless, a retail property absolutely must be refinanced now, the wise real estate investor would be best served to hold off until cooler heads prevail.