COVER STORY, MAY 2009

ADAPTING TO CHANGE
Losing a little of its luster, Southern California's retail market learns to deal with new economic realities.
Jereme Snyder

Snyder

Desperate times call for desperate measures, even in Southern California, one of the most desirable retail investment markets in the country. Experts agree that the commercial real estate industry as a whole will experience a tough and lengthy correction and it appears that the retail sector will be one of the hardest hit and could be the last to turn around.

The daily news headlines tell of the troubled retail market: retailers closing non-performing store locations or filing for bankruptcy, vacancy rates nearing the double digit range in Southern California, sale transactions down 80 percent from last year, financing being completely unavailable to investors.

The mood of the investment community has changed and most everyone has accepted our current market state and where it appears to be heading. As the investment community and all of its members are faced with the burdens of leasing up a vacancy, selling an investment or attempting to obtain financing, they quickly learn that demand has dropped off a cliff and, subsequently, are forced to decrease their expectations. 

Investor Activity

Investment activity, like all else in the retail real estate sector, has slowed. A more cautious lending environment and expectations of decreasing values have translated into fewer transactions. There are, however, many investors with plenty of cash who are waiting on the sidelines for the market to turn. A good majority of the properties that are transacting today are those under $5 million and/or properties with existing debt with good terms remaining.

In the last year a large number of the deals that traded have been all-cash transactions with private investors. According to Real Capital Analytics, approximately 75 percent of Southern California retail investors within the last year have been from the private sector.

Smart investors that are capitalizing on the investment market right now are looking for deals with good solid intrinsic value - properties with irreplaceable locations and below-market rents. For example, a single-tenant 7-Eleven in Anaheim recently traded for a 4.9 percent cap rate to an all-cash investor. The lease had seven years remaining and the rent was arguably 60 percent of the current market. The buyer commented that he had minimum downside risk and he could look forward to an upside in the rent.

Lending Environment

One of the most common objections from investors and the marketplace is that there is no financing available. Jeff Chambers, senior loan officer with Westcap Corp. in Irvine, Calif., disputes this claim.

“I believe the perception of many property owners is that lenders are not willing to lend in today’s environment, which is not the case. Lenders are comfortable to lend in this environment, noting that some of the best loans made in past years were made between 1992 and 1997 when the overall real estate market was struggling,” stated Chambers.

According to Chambers, “The high loan to value ratios benefiting borrowers during the past five plus years have been replaced by more prudent underwriting covering the risks lenders have been subjected to these past few years. With cap rates increasing 200 plus basis points these past few months, and expectations for further declines in real estate values, lenders are limiting new loans to a range of 50 percent to 65 percent loan to value, with cap rates at 8 percent and higher.”

Westcap Corp. recently secured a loan on a grocery-anchored retail center in Los Angeles County. The $8.9 million loan had a loan to value of 55 percent, interest rate of 6.25 percent and a 30-year amortization 10-year loan term with a 5-year rate adjustment.

Retailer Activity

Retailers in certain areas of Southern California are faring better than others for a variety of reasons. For example, the Inland Empire, is struggling more than surrounding regions because it has less population density and less disposable income. Infill areas, such as Los Angeles, Orange and San Diego Counties, are more stable during tough times due to a denser population and the fact that there is less availability of space, therefore lower likelihood of new retail centers entering the market.

According to CoStar, retail vacancies in the Inland Empire were at 7 percent at the end of 2008 compared to 6.4 percent at the end of the third quarter. Those numbers are expected to climb with 1.7 million square feet of retail space still planned for delivery to the region. Vacancy rates in surrounding regions of Inland Empire remain historically low but are increasing. Vacancy rates in Los Angeles are at 3.9 percent compared to 3.5 percent the previous quarter; and in San Diego vacancy is 3.6 percent, up from 3.4 percent the previous quarter.

According to Terry Bortnick, principal of Argent Retail Advisors, an Orange County based leasing and consulting firm, “Higher vacancies mean tenants are in the driver’s seat. Landlords are offering more concessions to retain and secure tenants and tenants are achieving aggressive lease terms. Existing tenants are renegotiating their leases in an effort to reduce rents and landlords are obliging in an effort to maintain occupancy in their centers.”

With consumer spending estimated to comprise nearly 70 percent of the US economy and unemployment at more than 10 percent in Southern California the average consumer is spending less and, consequently, retailers are struggling. However, not all retailers are suffering. Consumers are still shopping and spending, but they are focusing on necessities and staying closer to home.

According to Bortnick, “retailers that are faring best now and into the foreseeable future are those that offer day-to-day necessity items such as Grocers and Pharmacies, and value retailers that capitalize on the trend that most consumers are now ‘Shopping Down’. The retailers at most risk are luxury goods and “lifestyle” tenants.

Discount retailers such as Big Lots and 99 Cents Only are in a good position. In fact discount retailer, Dollar General, is looking to open 100 new store locations in Southern California over the next three years.

There is hope for a rise in sales by the end of the year. Sales were up slightly in January for the first time in six months, by 1 percent.  According to ICSC, total retail sales are forecast to decline 5.3 percent in the first half of the year and rise 2.7 percent in the second half.

Facing these challenging and dynamic times, each retail participant is required to roll up his or her sleeves and become even more proactive in every aspect of prospective business.

Jereme Snyder is a vice president in Colliers International’s Irvine, California, office.

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