By Hugh F. Kelly, PhD, CRE
Rudy Clark penned the song “I Got My Mind Set on You” in 1962, a half-century ago, in an era when America’s current economic problems were probably beyond imagining. But as the long, slow recovery drags on into 2012, the lyrics resonate:
It’s gonna take money/
A whole lotta spending money…
It’s gonna take time/
A whole lotta precious time…
To do it right.
Much has been made of the role of the consumer in the U.S. economy. Personal consumption expenditures (PCE) account for about 71 percent of the $15 trillion U.S. economy. That in itself is a major change from the structure of the U.S. GDP in 1962, when consumption represented just 61 percent of total output. More significant, though, is the change in the distribution of consumer spending. In 1962, 13.4 percent of PCE was allocated to durable goods, 38.8 percent to non-durable goods and 47.8 percent to services. Currently, durable goods have an 11 percent share of all expenditures (a slight drop in share), but non-durable goods have seen a steep decline to a 23.1 percent share, while services have soared to 65.8 percent of consumer outlays.
The implications of this structural economic shift for retail property are, of course, immense. But they are, I believe, poorly understood by policymakers, by the general public and even by commercial real estate investors. Allare addicted in a very unhealthy way to the headline news that sways sentiment in the polls and moves the financial markets on a daily basis. Services spending—which includes housing and utilities, healthcare, financial services and insurance as its largest components—has been steadily crowding out the funds that households have available for purchases in shopping venues of all kinds.
Thus, reports like one that noted PCE contributed 1.24 percentage points of the third quarter gain of 1.8 percent in real GDP completely disguise the implications for demand in the stores sector of the real estate market. Services consumption accounted for 0.9 percentage points of the overall gain, and relatively good performance in the durables sector added 0.42 percentage points. This was offset by a negative contribution of 0.09 percentage points from non-durables—the heart of most retail center tenant rosters—with clothing and footwear most seriously challenged.
Remembering that consumer price inflation was 3 percent in 2011, it is hardly surprising to find that while real retail sales were up 3.5 percent last year, the gains were led by the automobile dealers and gasoline stations. General merchandise, sporting goods, book, music, electronics and appliance stores all posted negative sales, when adjusted for inflation. Encouragingly, though, stores related to the housing sector showed some signs of reviving, with a real gain of 2.6 percent for furniture and home furnishings outlets and 2.8 percent for building materials and supplies stores. Restaurants and bars, as well as apparel, also closed the year in the plus column.
Mixed patterns of demand need to be unpacked to sort out the conditions and prospects for retail real estate. These also vary considerably by geography and by income cohort. In this context, broad measures such as the Consumer Confidence Index have very little utility for commercial real estate executives. Further complicating matters, the retailing sector is still suffering from the self-inflicted wounds of undisciplined expansion in the chain stores that are the supposed “credit tenancy” anchoring shopping center cash flow.
The story of the boom years was unbridled additions to the physical footprints of virtually every retailer. As a result, merchandisers now acknowledge that they are over-stored in just about every U.S. market, diluting profitability and shifting attention (rightfully) to improving operations at the best-performing locations while shedding excess capacity. That means more dark stores for owners of retail property in 2012.
Pricing for retail assets is reflecting this risk, at least compared to the low capitalization rates that characterized the boom years. Average retail cap rates are higher than for multi-family and office properties, and within the retail sector smaller centers and secondary markets have higher required risk premiums than the norm for all retail centers. This bespeaks a flight to quality as wellas an understanding that much of the overbuilding occurred in the so-called growth markets that have been hammered in the housing collapse.
So to return to the insights of Rudy Clark, it’s gonna take patience and time. Retailing, both from the demand perspective of the economically stretched consumer budget and from the supply perspective of too many stores chasing too few customer dollars, is far from equilibrium. At this point, the sector is volatile and rents are fairly inelastic with respect to overall economic trends. That won’t last forever, of course, but it does describe the landscape in 2012.
To get through this period, it’s gonna take money—patient capital; capital invested for the long haul—to do it right in the cut-throat competition of U.S. retailing and the stores sector of the property market.
—Hugh F. Kelly, PhD, CRE, is a clinicalassociate professor at the NYU Schack Real Estate Institute.