By Peter Kozel, director of real estate research, Standard & Poor's Ratings Group
Of all the major property types, both the near- and long-term outlooks for the retail property sector are the most ambivalent. This uncertainty is the result of three distinct but also partially related factors. First, a detailed analysis of the supply/demand balance of retail property space in a substantial number of the major metropolitan statistical areas (MSAs) indicates that a slow down in the national economy would tip these markets into a condition of over-supply fairly quickly.
Second, during the last few years, individuals have increased their retail spending faster than their incomes have grown. With individuals saving virtually nothing out of current income, it is difficult to project how long the recent rapid growth in retail sales will continue.
Third, it is now generally conceded that the impact of the Internet on consumer spending patterns will be massive. Because of a massive infusion of venture capital, technological advances, and a business model that promotes sales growth rather than profitability, the challenge posed by silicon versus bricks-and-mortar will probably be felt this holiday season.
Regional Supply/Demand Balance
Assuming a continuation of recent growth rates for the next two years, there are only a few MSAs in which the net new supply of retail space significantly exceeds the incremental demand for space. However, even for these markets, the amount of excess supply relative to the total stock of retail space is relatively modest, and a moderation in construction activity should result in an averting of major credit issues.
With continued economic growth, the demand for new space will exceed net new supply in some of the larger markets, including Boston, New York, Chicago, and Los Angeles. These MSAs, however, have highly volatile growth patterns. Even a mild national recession would hit these markets hard, spoiling the favorable supply/demand balance.
These observations are reached by utilizing the historical relationships between income growth, retail sales, and the demand for retail property space, and these conclusions are primarily the result of the advanced stage of the retail property building cycle and the fundamental characteristics of the respective regional economies. However, there are two other forces at play now that could upset these relationships.
The Economics of Retail Sales
Individuals have become such aggressive consumers during the last few years that as a group they have stopped saving any of their income. This is the first time that the personal savings rate has hovered around zero in the post-World War II era.
What is most amazing about this recent strength is that it does not follow a recession but rather comes after a long stretch of robust expansion in retail sales. Since the beginning of 1992 through the second quarter of 1999, the increase in price adjusted retail sales equals 29.5%. With the rise in unit volume, the need for additional retail space increases, and the trend of retail sales provides some indication of this incremental demand.
Since 1991 the amount of occupied retail space has increased by about 20%. After allowing for some under-utilization of retail property at the beginning of the 1990s, the increase in newly occupied space approximates the gain in the volume of retail sales activity. The conclusion, therefore, is that there does not now appear to be a significant unmet demand for retail space even though the growth in retail sales activity has been very strong.
If retail sales were to begin growing at the rate of personal income during the next year, the increase in total retail sales would be lowered by $35 billion, reducing the demand for new retail space by about 50 million square feet.
Jupiter Communications estimates that in 1997 $3 billion of products were purchased online. For 1999, this figure rises to $12 billion and is projected to increase to $41.0 billion by 2002. If one works on the simple assumption that sales on the web substitute for sales at retail real estate space, $12 billion of retail sales represents a reduced demand for about 40 million square feet of retail space. The projected increase in Internet sales from $12 to $41 billion implies a reduced demand over this three year period of about 100 million square feet of retail space.
For the nation as a whole, the total demand for retail space has been running in the range of 120 million to 140 million square feet a year over the past three years. This implies that the reduction in demand for new retail store space could be reduced by about a 25% over the next three years.
Risks in the Retail Property Sector
While at the national level there appears to be a rough balance between the demand for retail property space and the prospective supply of that space, the supply/demand balances in the regional markets are spread over a wide range. One conclusion, then, emphasizes just how important is the analysis of local property conditions in the process of assessing the credit quality of a mortgage and the real estate that supports that debt.