Houston Market Profile: Red Light, Green Light

Houston - This spring's opening of the 700,000-square-foot expansion of The Galleria, which includes Houston's first Nordstrom department store, signaled the city was ready for two things: a wider variety of stores and more investment in the retail sector.

The Galleria, which was acquired by Simon Property Group Inc. last year for more than $200 million, is just one of several retail assets in the area to change hands recently. Another is the Woodlands Mall, which was acquired by General Growth Properties Inc. and is undergoing a multimillion-dollar expansion, as is MetroNational's Memorial City Mall.

While the giant mall owners were busy penning sizable deals, grocery-anchored REITs were collecting their share of assets. New Plan Excel Realty Trust Inc. acquired 92 community and neighborhood shopping centers (most were located in Houston) from CenterAmerica Property Trust L.P. Similarly, Regency Centers Corp. spent more than $100 million for four grocery-anchored centers in The Woodlands.

According to Real Capital Analytics Inc., more than $600 million worth of retail assets traded hands in Houston last year, with a price per square foot ranging from $80 to $200.

"Houston has attracted institutional investor interest. ? Their interest says a lot about Houston?that it's a marketable, valuable city," said Joe Dubuc, director of business development for Insignia/ESG Inc. He estimated that REITs accounted for at least 60 percent of all retail investment in Houston in the past year.

"There's a lot of money in the Houston market to be invested, but just not (enough) deals," said Dan Smith, managing director of Transwestern Commercial Services Inc.

According to Scott Shilling, vice president of retail services for The Staubach Co., investment-grade buyers are fighting for the limited number of good-quality retail assets, while small investors are buying the Class B and C product. "As long as the stock market and interest rates are down, it will remain a seller's market," he said.

Power centers and grocery-anchored centers are so attractive that cap rates now range from 8.5 to 9.5 percent, a decrease from more than 10 percent last year, said Smith. Transwestern benefited from the favorable climate when it sold its grocery-anchored center, The Market at Lake Houston, to a pension fund after receiving 15 bids.

But Bill Forrest, a Sperry Van Ness senior advisor who has been tracking the retail market for two decades, is concerned enough about softening retail fundamentals that he has suggested to owners that they sell now.

"A lot of buyers out there are starting to think that they'll be able to get a better deal later this year as fundamentals soften," Forrest said. "It's a seller's market right now, but I think we're going to see a shift toward a buyer's market."



Flashing Yellow:

Proceed with Caution

Despite the weak national economy and a slowdown in consumer spending, the Houston retail market has performed well. But retailers and owners need to be cautious, explained Matt Keener, director of retail brokerage services for Trammell Crow Co. "Retail is doing a lot better than office or industrial, but I think there are areas of concern," he said.

One troubling spot is the city's falloff in absorption. According to a report from Sperry Van Ness, the exit of several large retailers in 2002 caused a negative net absorption of almost 3 million square feet?the highest level experienced in several years. Kmart Corp. alone added almost 5 million square feet of space onto the market.

Forrest pointed out that Houston historically absorbs about 4 million square feet of retail space each year. "This negative net absorption is a red flag that new development needs to slow down," he said. "Even if you excluded the big-boxes, there's too much development."

Although new development has slowed somewhat?3.4 million square feet of retail space was added to the Houston metropolitan area in 2002, compared to 8.6 million square feet delivered in 2001?13 centers totaling 2 million square feet were under development at the end of the year. Construction on another 5 million square feet of retail space is planned for later this year.

"We're overbuilding in a lot of areas," Forrest said, well aware that Houston is often unfairly accused of excessive development because of the well-publicized real estate bust in the 1980s and the city's lack of zoning. Still, he maintains that retailers and retail owners have a bumpy road ahead of them.

"A lot of these projects are starting off 50 percent leased, and because retail sales are down and retailers are more cautious, it's going to take more than 12 months to get these projects stabilized," Forrest said.

Mirroring nationwide trends, Houston has experienced a lot of new-home sales, primarily in the suburbs. Consequently, these new communities saw a flurry of grocery-anchored developments and power centers come out of the ground. However, many grocery-anchored projects were scratched as Kroger, Randalls and H-E-B backfilled much of the space left vacant when Idaho-based Albertson's exited the market.

Even power center players?such as WalMart, Target, Home Depot, Lowe's and Kohl's?are applying the brakes to their growth plans, not to mention the smaller retailers that have to fight for market share and lack a solid consumer base in Houston. "Second-tier retailers are really moving cautiously," Keener said. "They're (showing) even more trepidation."

"Retailers are still expanding, but if they are doing fewer stores nationwide then it stands to reason that they're doing fewer stores in Houston," said Tom Estus, president of Shelby/Estus Realty Group Inc.

However, not all retail experts believe the development picture is darkening. "I don't see a lot of dumb development being done," Estus said. "Houston has been more prudent than a lot of other cities just because we have been burned in the past."

Varying industry reports indicate that Houston's retail vacancy rates ranged from 11.5 percent to as much as 15 percent at the end of 2002. At the beginning of 2002, many market reports indicated a vacancy rate of less than 10 percent. And over the next 12 to 18 months, vacancies are expected to increase another 2 to 3 percent.

But mall owners like Simon and General Growth are expanding nonetheless. And Patrick Egan, vice president of investments for Regency Centers, believes the leasing environment at his centers is holding strong. "In all honesty, I expected there to be a slowdown in leasing momentum," he said. Egan also noted that his REIT has been able to maintain its standard rental rates. "I am surprised it hasn't been tougher."

And Regency is not alone. According to The Weitzman Group, rental rates have remained stable marketwide, with Class A retail property commanding $18 to $20 per square foot, while Class B and Class C assets were in the mid-teens.

But rents could slide if the economy fails to find its footing. "If the economy picks up, retail picks up," Shilling said.

He also pointed out that Houston retail owners and retailers are facing another challenge: Houstonians are demanding more options. "The consumer is getting bored with the category killers, so new concepts will have to evolve to attract capital for expansion."

To answer that call, both Simon and General Growth are adding new retailers. In addition to Nordstrom, Simon is introducing Aldo Shoes, BebeSport, Pottery Barn Kids and Steve Madden to The Galleria.

"Shoppers are used to having very good retail at their disposal, which means that retailers and owners have to be constantly reinvesting time and money," said Tim Haislet, senior vice president of General Growth.



Macro Market Trends



Employment Overview: Texas' unemployment rate rose to 6.6 percent in February, from 6.4 percent in January, according to the Texas Workforce Commission. The Houston metropolitan area's unemployment rate was 6.4 percent in February.

Transportation Report: Houstonians spend 72 hours per year sitting in traffic, the fourth longest in the nation, according to the 2002 Urban Mobility Study conducted by the Texas Transportation Institute at Texas A&M University. The city also ranks seventh in the nation with an annual congestion cost of more than $2.3 billion per year.

Taxes & Incentives: One way Houston encourages smart growth is through its Tax Increment Reinvestment Zones, which help finance the cost of redeveloping or encourage development in the inner city, on raw land in the suburban fringes and in major activity centers. Developers still have to pay taxes to the school districts, but city and county taxes are deferred for several years.

Infrastructure Improvements: The Federal Highway Administration, the Texas Department of Transportation and the Harris County Toll Road Authority agreed to a $1 billion expansion of the Katy Freeway by using a combination of toll lanes and non-toll lanes.