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A Word With ...

Merrie Frankel

Executive Editor Russ Colchamiro talked with Merrie Frankel, a vice president & senior credit officer for Moody's Investors Service, about the current status of the retail REIT industry.





CPN: What trends have you seen in the retail market over the past year, and what trends do you see emerging over the next year?



Frankel: I would say there are four major trends. First, consolidation among REITs. ... Examples include General Growth/Rouse, Simon/Chelsea and Kramont's recent impending purchase by Centro, an Australian REIT. Consolidation can be positive for ratings if it creates a more geographically and tenant-diverse company, better credit metrics and a larger platform from which to negotiate with tenants and build a franchise. It can be a credit negative if it increases the resulting company's leverage. The issue is the amount of debt in the deal, potentially exacerbated by joint-venture structures, with consolidation being a positive factor in general.

Second is consolidation among retailers. Mergers such as Federated/May fuel discussion about the future of department stores, their value as mall anchors, their influence over mall owners and store closings. Retailer consolidation can be a REIT credit negative by decreasing the supply of tenants, creating empty spaces, concentrating tenant credit exposures and adversely shifting negotiating power. This is a moderate, but growing, risk. Typically, REITs with tenant diversification can work through the consolidations and bankruptcies by swiftly shifting current tenants or adding new tenants to open spaces.

Third is consumer sales. Sales have continued to be robust and increased 8.9 percent in 2004 over 2003—the best year since 1999. Whether consumers will continue to spend in the face of increased interest rates and energy prices, static salaries and reduced mortgage refinancing benefits is questionable. Although the REITs lease space on relatively long-term leases to the retailers, which stabilizes the REITs' cash flows, a prolonged decrease in consumer sales would impact the ability of the retailer tenants to pay rent.

Fourth are the new formats. The relentless growth of supercenters and big-box formats continues to pressure (B-grade) regional malls and community centers that do not enjoy true infill locations, market-leading anchors—usually grocers—and appropriate size, such as grocers in the 50,000-plus square foot range. More pressure may be coming. Entertainment centers are also taking some of the wind out of premium regional mall sales, and we see entertainment-center formats continuing to grow. These have already fundamentally changed how malls are designed, with Main Street outdoor features with higher-end destination restaurants now common. Well-positioned REITs are cognizant of these new formats and either have leading tenants who are competitive with the new formats or incorporate alternate formats into their structures. Our ratings reflect the extent to which a REIT anticipates and incorporates such changes.



CPN: How extensively is Sarbanes-Oxley impacting the retail sector?



Frankel: As with all REIT sectors, Sarbanes-Oxley has impacted the audit fees for the retail REITs. I hear that SOX/404 compliance can cost approximately 100 to 300 percent of a company's total audit bill. For many companies, this can mean $1 million to $1.5 million on top of their usual audit fees. Such expenditures are easier to bear for larger companies than most REITs, which are smaller-cap stocks.



CPN: Are there particular retail property types that currently seem like better investments than others, both in the short and long term?



Frankel: Grade-A malls seem to be doing very well, particularly those with high-end tenants. The retail shops in between seem to be a little more problematic, depending upon the product they sell. ... We're also seeing some cross-selling, where people buy a suit at Bloomingdale's and then purchase the t-shirt at Gap or Target. It makes you feel like you're saving something. Why spend $100 on the t-shirt when you can spend $12 (elsewhere) on a similar item?



CPN: What is more active right now, leasing or sales?



Frankel: Both are doing OK. It just depends on the subsector. Retail REITs have reported increases to space leased as well as rents per square foot. Like all REITs, they have sold some non-core properties.

CPN: Las Vegas and Phoenix are among the fastest-growing areas in the country. What effect has this had on the retail market and what can we expect during the next few years?



Frankel: More retail outlets are now supplying product. In Las Vegas, a recent survey surprised me: It indicated that more locals are buying higher-end goods, and that you have more tourists visit Las Vegas who come specifically for the shopping rather than gambling.



CPN: Are there other areas in the United States showing significant growth in the retail market? If so, what are they?



Frankel: Looking at sales per square foot, the (International Council of Shopping Centers) statistics clearly indicate that for non-anchor mall tenants, the Southern and Western parts of the country are performing considerably better than the Northeast and Midwest. Overall, the sales per square foot for non-anchor tenants are up 3.7 percent, as of February 2005.



CPN: What retail opportunities do you see for U.S. companies overseas? And do you see international investors increasing their interest in U.S. retail properties?



Frankel: Numerous retail REITs have ventured overseas. Kimco has investments in Canada and Mexico. Simon Property Group has joint ventures in France, Italy, Poland, Portugal and Canada. Chelsea Property Group, a unit of Simon, has outlets in Mexico and Japan and recently formed a joint venture to develop Premium Outlet centers in South Korea. Retailers that need distribution space spur industrial REITs such as AMB and ProLogis to develop in certain locales so that they can distribute goods to their stores.

More Australian companies are looking to the United States for opportunities. About 45 percent of real estate in Australia is publicly listed, versus about 12 percent of U.S. real property, so they're used to that format. An example is that Kramont Realty Trust was just merged into an affiliate of Centro Properties Group.



CPN: Have there been any retail transactions that have surprised you?



Frankel: No transactions have surprised me, but with Brookstone being purchased by a Singapore company, it just goes to show that, globally, it's becoming a smaller world.