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By Michael Havdala

Senior Vice President – HSA Commercial

By most estimates, 2009 was the one of the worst on record for Chicago’s retail merchants and for many landlords. Halfway into 2010, current market reports are confusing and sometimes contradictory.

Retail property mortgage delinquencies are continuing as the result of retailer retrenchment, according to research firm Trepp LLC. Yet such retailers as Aldi, Food 4 Less, Dollar General, Advance Auto Parts and Five Guys Burgers and Fries are maintaining their growth goals in Chicago and Illinois, according to research firm CoStar Group. Unemployment increased in June across Illinois, but decreased to 10.6 percent in Chicago, down from 10.9% a year ago.

Consumer sentiment was trending positive in May, according to a Reuters/University of Michigan index, but the U.S. Dept. of Commerce showed consumer spending was flat last month.

What do these smoke signals mean, and how will we know when sustained improvement is on the way?

More capital on the market

Money makes the market go ’round, of course—and it hasn’t been flowing in a positive direction lately.

The percentage of past-due Chicago CMBS loans fell to 7.5% in June, down from 7.7% in May but more than double the 3.2% in June 2009, according to Trepp LLC, a New York-based research firm. Nationwide CMBS delinquencies also fell to 7.5% in June, but rose again to 8.6%–higher than Chicago’s.

Portfolio lenders continue to “extend and pretend,” preferring to retain a borrower and their property than add to their REO portfolios, and are shying away from properties perceived as high risk—including lifestyle centers and retail properties near half-empty new housing development. Owners seeking to refinance often must either come up with significant equity to meet lender requirements, or face a workout.

Yet, mortgage delinquencies are not telling the whole story. Already, some capital sources are beginning to emerge from the sidelines. According to a recent Investment Quarterly report published by CCIM and Real Estate Research Corp., community and regional banks, individual investor funds, owner/users, credit unions and insurance companies are stepping up.

Even the beleaguered CMBS market is showing signs of life. Retail REITs Ramco-Gershenson Properties Trust and Glimcher Realty Trust both have closed CMBS transactions recently, the former on a Class-B retail property portfolio that would not necessarily appeal to a portfolio lender facing rising delinquencies.

Cash buyers are starting to take advantage of depressed property prices to acquire well-stabilized properties with consistent cash flows. Private funds, whether domestic or international in origin, are today’s most likely buyers, in light of the still-tight credit markets. A few major investors, including Kimco Realty Corp. and Inland Real Estate Acquisitions Inc., have been engaging in acquisitions and joint-venture agreements on the premise that now is an opportune moment in which to buy high-quality, well-located retail properties. The recent competition for control of Chicago’s bankrupt General Growth Properties (GGP) shows that investors are still interested in attractive properties.

What other trends might signal a genuine uptick? The end of “pretend and extend” lending, longer lease terms and a sustained uptick in retail loan securitizations.

Stabilizing retail rental rates

Metropolitan Chicago’s retail sector vacancy continued to rise in first quarter 2010 to just over 12 percent. But vacancy is only one indicator of market dynamics. Surprisingly, net asking lease rates have actually risen by a percentage point for the first time in two years—which suggests that landlords are feeling more confident. Also, the drop-off in new retail construction since 2008 will undoubtedly help strengthen existing properties.

Other signals to watch? The winding down of rent relief, less aggressive lease renegotiations on the part of retailers, the decline of “blend and extend” leasing, and the re-emergence of long-term leases.

Tenant expansions, not contractions

Retailer contractions and bankruptcies continue, contributing to the vacancy increase. Yet some tenants are continuing to seek space. Fast-food restaurants, discount stores, auto parts and grocery stores are still active, with Chick-fil-A, Sonic, Burger King, Fashion Bug, Kay Jeweler, 7-Eleven, Aldi, Wal-Mart, Trader Joe’s, Darden, SuperValu and Potbelly Sandwich Works among the retailers currently seeking new or additional Chicago locations.

Chicago’s downtown has defied the odds and retained its vibrancy despite the closings of some stores and restaurants. Retailers who previously were priced out of prime downtown locations are now finding a more favorable environment.

Lakeshore East, now under construction east of Columbus Drive, secured two major leases for Roundy’s grocery chain and a III Forks steak house. The long-awaited opening of MetraMarket earlier this year is another positive development for downtown.

Positive signs? Yes, but what we are all hoping to see is less vacant space coming on the market and a return to income growth among a wider variety of retailers.

A return to long-term leases

While some signals are favorable, landlords and retailers continue to haggle over lease terms. Strong tenants view rising vacancy as an opportunity to aggressively renegotiate better lease terms, while many landlords are pushing for short-term, three- to five-year leases in hopes that rental rates will stabilize by the time such leases are up for renewal.

Signs of real improvement? When landlords have the confidence to resist tenant demands for rent relief and to secure long-term leases.

Employment and consumer spending

Despite the hand-wringing about a permanent change in consumer culture from free-spending to frugal, the emerging evidence suggests otherwise. While we can’t count on cheap credit to drive consumer spending any time soon, luxury goods bellwether Tiffany  reported a 20 percent jump in net sales in first quarter 2010 over the previous three quarters, and nationwide sales of Rolls Royces jumped 60 percent.

That’s a promising smoke signal of pent-up consumer demand at the highest end. However, Chicago has lost more jobs last year than any major metropolitan area in the country, and it will take some time for consumers to feel truly confident about shopping. When unemployment begins to fall at a reliable clip, overall consumer spending will undoubtedly rise (although probably not to its pre-2008 levels).

Job growth and its attendant consumer spending are the most important smoke signals of all—and those are the indicators to watch.

Michael Havdala is a senior vice president in the Retail Brokerage division of HSA Commercial Real Estate.

Tags | Chicago, CMBS, General Growth Properties, HSA Commercial, Retail

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