By Tara Innes and Peter Sciciliano

Throughout the recent economic downturn, retail REITs have continued to deliver strong operating results. Aided by the strength of consumer demand, companies like Regency Centers Corporation (NYSE: REG) and Developers Diversified Realty Corporation (NYSE: DDR) have enjoyed the defensive characteristics of their high-quality retail portfolios and the earnings lift provided by new and redeveloped assets.

At a time when other property sectors were experiencing declining occupancy and rents magnified by increased operating costs and capital expenditures, retail REITs have generated respectable property level net operating income (NOI) increases. Healthy property operating fundamentals have contributed to solid equity returns and stable credit profiles attracting a variety of new investors.

Retail Demand

What is driving the demand for retail space? In 2003, on a comparable-store basis, chain stores managed a respectable 3.2 percent growth rate. Much of this improvement can be attributed to resilient consumer spending. The low interest rate environment over the last few years combined with a late 2003 stock market rally and the promise of employment gains bolstered consumer confidence, resulting in a particularly good second half for retailers.

Retailers, eager to meet consumer appetites, have been rolling out new concepts spurring much of the increased demand. The remainder of the demand stems from a need to serve continued new household formation (albeit at lower levels than in prior years) and shifting demographic patterns.

While demand has been observed for both mall and strip-center retailers alike, it has been particularly acute for certain big-box discounters and specialty retailers, including Target Corporation, Wal-Mart Stores, Inc., Dollar General Corporation, Kohl’s Corporation and Best Buy Co. Inc. The better performing regional grocery chains, including Albertson’s Inc., Kroger Co. and Safeway Inc., have also contributed to this source of resilient demand.

One other noteworthy trend has been the strong performance of luxury retailers. Positive sales momentum during the holiday season posted by the high-end department stores, namely Neiman Marcus Group Inc., Nordstrom Inc. and Saks Incorporated, as well as several luxury specialty shops, reflected consumer spending patterns tied more to gains in stock market and housing valuations than employment or wage income.

However, Fitch Ratings regards the superior performance of the upscale department stores as an anomaly to the broader department store segment, which has suffered significant losses to market share over the past 10 years—dropping to a current 40 percent market share of soft good sales from 60 percent.

Retail Supply

From a supply standpoint, however, aggregate retail square footage is pushing the limits of saturation. Recent national census data indicates 20.2 square feet of gross leasable area (GLA) for every U.S. customer, up a remarkable 37 percent from 1986 and far in excess of any other developed country. Unfortunately, much of the existing supply of retail space fails to meet the requirements of modern retailers.

The sector is best described as under-demolished rather than oversupplied. Consequently, a clear bifurcation in property quality exists between the newer and/or better located segment of the existing stock and the less desirable assets. Because REIT portfolios generally invest in the former category of assets, they offer better protection for additions to supply than their non-REIT counterparts.

Nonetheless, Fitch continues to monitor the pace of new retail development, which at an expected 2.5 percent over the next year is occurring nearly twice as fast as other REIT property types. Strong retail property performance continues to attract capital and significant supply pressure is likely to continue.

Retail
# of REITs	35
Market Cap. (in thousands)	$62,798,018
Industry Market Cap. (in thousands)	$238,832,627
% of industry	26.3%
Yield	5.2%
YTD Total Return	4.2%
One-Year Return	31.3%
Three-Year Return	28.3%
Five-Year Return	19.6%
Ten-Year Return	14.3%
Average Monthly Trading Volume (shares)	8,851,595
Weighted FFo Growth (2002-2003)	4.68%
Source: NAREIT. Data as of May 28, 2004

An additional source of supply over recent periods has been the result of a number of store closings from such established retailers as Kmart, Lord & Taylor, Toys “R” Us, Inc. and Eddie Bauer. During 2003, these closings created significant hiccups in the functioning of certain geographic markets. Although these closings (and the resulting lease terminations, bankruptcy rejections and non-renewals) have been fundamentally digested already, the potential for more store closings is reason for concern. The recent chapter 11 filing of KB Toys Inc.’s is an example.

For all of this discussion of demand, supply and future development, national vacancy rates now stand at 12.7 percent. Although regional trouble spots exist in the Southeast and parts of the Midwest, national vacancy rates are far below the 19.0 percent rates reached during the trough of the last cycle. Among the REITs in the sector, occupancy rates were affected only marginally and, at worst, deteriorated less than 100 basis points. Rental rates have also remained flat and continue to reflect significant re-leasing spreads of new and renewal leases over expiring rental rates, as low base rents signed in the mid-1990s are converted into current market rates.

Tenant Credit Issues

Though interest rates are up since year-end 2003, many of the favorable conditions bolstering consumer confidence last year are still at play. In addition, anticipated employment gains will likely offset modest interest rate increases, shoring up consumer confidence. Chain-store retailers continue to expect to increase sales at a healthy 4 percent rate in 2004, and improvements in gross margins are expected, as cost efficiencies in distribution are achieved. Though continued expense pressures related to rising labor, health care and insurance costs are expected to offset some of these gains, Fitch’s retail ratings group anticipates a stabilization in the retail industry’s credit profile, with fewer negative rating actions than were recorded in 2001, 2002 and 2003.

Despite the generally stable view on the retail environment, the performance of underlying retail tenants in REIT portfolios will remain important to the sector’s overall earnings stability. Retail companies with smaller portfolios are more vulnerable to tenant bankruptcies and wide-scale store closings. Areas of concern also include specialty retailers (other than luxury) who are facing continued pressure from the big-box discounters, as Wal-Mart, Target and the warehouse clubs squeeze them based on price.

Capital Availability and Investment Activity

The relatively solid performances of retail tenants and their favorable influence on property fundamentals have contributed to a very active acquisition market. Fueled by the low interest rates and the availability of capital to the sector, capitalization rates for stabilized retail properties with strong grocery anchors have dipped into the high 6 percent to low 7 percent range. Certain trophy assets like the retail space at the Venetian Hotel in Las Vegas will reportedly trade at a cap rate in the high 5 percent range. In spite of the low capitalization rates, one reason that REITs have remained such active buyers of retail property is that access to capital remains plentiful.

Fitch expects the pace of acquisitions, joint-venture formation and internal redevelopment to continue as retail REITs seek out investments capable of maintaining the impressive NOI gains recorded over recent periods. As this happens, the investment sales environment will remain active, and capitalization rates will stabilize at these historically low levels. Nevertheless, further increases in interest rates could sharply curb property valuations as leveraged buyers face higher costs of capital.

While the more traditional sources of capital including debt, preferred equity and common equity are readily available, high asset valuations have prompted a prodigious use of capital recycling programs, wherein sales of non-core and low-growth assets are used to fund new purchases. In order to replace the higher book yields of the assets being sold, retail REITs are seeking out more value-added properties, oftentimes with additional leasing or redevelopment risks.

A second reason for the acquisitions pace, as well as the likelihood of more merger activity, has been the realization that certain lease negotiating leverage benefits accrue to larger operating portfolios. As lease negotiations have shifted from the one-off, property-level discussion format toward the national portfolio review model, larger landlords can improve their capacity to draw in multi-store tenants by offering more widespread national footprints. This argument has also pushed many retail REITs toward increased joint-venture and third-party management activities, which can increase the market presence of a landlord, albeit artificially, even more. On top of the improved lease negotiating position, certain cost efficiencies also exist with regard to centralized corporate activities, including leasing, construction, development and accounting.

Aside from external opportunities, several retail REITs have also refocused their efforts internally on growing their redevelopment programs in order to ramp up returns. Because management teams are most familiar with their own assets, this use of incremental capital is among the safest. Furthermore, they ensure that the proper amount of recurring capital expenditures continues to flow to existing properties, thereby addressing any deferred maintenance items and preserving recovery values for bondholders. Interestingly, many retail REIT management teams have also found this use of proceeds to offer the highest returns, primarily because of the relatively small amount of capital outlays needed.

As mentioned previously, development activity continues at a higher rate than any other property type, but still at a scaled-back pace from a few years ago. As traditional mall development has slowed to a near standstill, the real driver has been the weakened sales climate, perceived market saturation of the department stores, concern about anchor credit quality, the lengthy entitlement process, size of the capital investment and relatively modest risk-adjusted returns. Consequently, the little development that has occurred on the part of the mall operators has been targeted to open-air concepts that neglect the historical “four-anchors-at-the-corners” concept.

Mall REITs are therefore looking to drive NOI by increasing specialty leasing, gift card and sponsorship initiatives. For some companies, these ancillary sources have proven extremely meaningful and now account for as much as 10 percent of total revenues.

Strip-center operators, on the other hand, have remained active but cautious developers, primarily pursuing deals with pre-leased or pre-sold anchor pads. Particularly encouraging to their efforts has been the vast amount of private capital flowing to them through institutional joint-venture programs.

Looking forward, the demand for retail space, driven by consumer sales, suggests a favorable outlook for retail REITs. While new supply continues to pressure less functional retail product, most retail REIT portfolios are well positioned to compete. There is potential for modest cash flow volatility resulting from tenant bankruptcies and store closings though Fitch does not anticipate significant disruption. The credit profiles of retail REITs are stable with solid balance sheet protections and good cash flow coverage of debt service obligations. On balance, retail REITs are good quality merchandise.