Retail Real Estate 2011

After two consecutive years of poor performance, the retail commercial real estate market in Southern Maine may be poised for rebound. Two critical factors foreshadow this recovery. 

First and foremost are retail sales. As the economy appears to be gaining positive momentum late in the fourth quarter of 2010, retail spending has increased significantly during the holding season. Despite a lag in hiring, consumers appear to be abandoning austerity and are ready to begin resuming the types of consumer spending that fuel the American lifestyle. 

They say to get a handle on trends in the economy, visit stores and observe consumer behavior. At a recent visit to Walmart in Falmouth on December 18, I noticed the garden center was closed. The reason? All the Christmas trees and wreaths were sold out two weeks before Christmas. Neighboring Skillins in Falmouth was also very low on Christmas tree inventory. Inventory for popular items at major retailers is also low, resulting in less of the discounting offered during the Christmas season in 2008 and 2009. 

Should holiday sales in 2010 end strongly this year, and the economy continues to gain momentum (avoiding a double dip recession), retailers will begin committing to expansion, which will also help with overall employment. 

The second critical factor is current retail leasing activity. Strong national retailers (especially discounters) are taking advantage of soft conditions by committing to new stores in good locations. Companies like T.J. Maxx, Marshalls, Staples, Big Lots and Goodwill are active. They are on the front end of this trend and should be followed by a more broad based expansion. 

However, don’t expect this recovery to happen dramatically. The retail market is still feeling the effects of a decade long expansion and many markets are simply “over retailed.” 

The best retail markets will recover first. This includes markets that appeal to national and local tenants. Exchange Street in Portland’s Old Port is a good example. Exchange Street is Maine’s premier market for local boutique stores and restaurants. After a decade long run up in rents, Exchange Street experienced significant vacancy in 2009. By mid 2010, vacancies had been filled by a new generation of restaurants and boutiques. 

The Maine Mall area is attracting new national retailers and restaurants. A new retail strip center is actually under construction at the intersection of Western Avenue and Gorham Road in South Portland. The pace of leasing at this new center should be a real test of the strength of the recovery.

Community shopping centers with strong anchors should benefit as well. Centers anchored by successful national grocery stores or Walmart/Target stores will be likely to attract new tenants early in the cycle. A good example of this is the Maine Coast Mall in Ellsworth. The center has an excellent location at the intersection of Routes One and Three, and is anchored by a strong Hannaford store. Marden’s recently vacated a 65,000 square foot box in the center to relocate at a former Walmart. Several national tenants are currently in negotiations for the box as well as in-line space that is becoming available.  

On the downside, retail centers in secondary locations in both suburban and downtown areas may not feel the effects of a recovery for several years. Retail construction, particularly for big boxes, will remain very slow, a predictable outcome of a decade of expansion combined with a recession.

In summary, look for a modest retail leasing recovery in Southern Maine’s strongest markets, with a lagging recovery in secondary markets and new construction over time. 

-Charlie Craig

In a typical commercial real estate downturn, there is often a lag between softening demand for space and reduced lease rates. In early stages of downturn, landlords often resist reducing lease rates based on an expectation that the downturn will be short lived and landlords will “ride it out” until demand for space recovers. After months of minimal leasing activity and increasing supply of vacant space, reality sets in. In many cases, landlords have acknowledged the market has softened and are offering low rates and incentives, such as free rent and higher tenant improvement allowances to prospective tenants.

 To take advantage of today’s market, you need to consider several factors: 

Limited Quality Space. In a soft market, the good spaces tend to lease first, such as downtown Portland Class A office space with ocean views, high end suburban buildings in parks and medical buildings with good access and parking. People who wait thinking the market will get worse, often are left with attractive rates for sub par space. If you find a space you like with good incentives, don’t second guess yourself and wait for a better deal. Odds are you will be looking at inferior space the next go around.

Know the Market. To get the best deals, you need to create competition for your lease and you need to know how to counter proposals based on the market. The best way to do this is to hire a good commercial real estate broker who will act as your tenant representative. The broker will be paid a commission by your new landlord. The broker should have recent experience in your market and not be a generalist that dabbles in all kinds of different real estate. Ask the prospective broker to demonstrate recent experience in your marketplace.

Know  Your Needs. Put a detailed description of your needs in a Request for Proposal (RFP). Your broker can help you with this. You want to receive “turn-key” proposals from potential landlords to truly quantify your future rent costs, which means construction of your layout has been priced into your lease rate. Vague build-out allowances often result in increases in your rent because the build-out allowance was not sufficient to construct your needs.

 Allow Reasonable Time.  Touring spaces, sending out RFP’s, evaluating proposals and negotiating a letter of intent can take two months or more. Negotiating a lease can easily take a month. Construction of your layout can require two months. Relocating your telecommunications services requires lead time as well. Six months before your move date is an appropriate amount of time to start evaluating spaces.

 Hire a Real Estate Attorney. When negotiating a lease, utilize an attorney that specializes in commercial real estate. Attorneys that don’t have this experience tend to go through a learning curve that results in extra time and money due to a lack of comfort and unrealistic demands.

 Commit to a Longer Term if Possible. Landlords are more apt to provide you with lower rent, better build-out allowances and free rent if you commit to five years or more. The concept is “deal with the pain now and keep the space full for an extended period of time.”

The market for purchasing a building is currently not as attractive as leasing. Many investors anticipated a strong buyer’s market by now, similar to the market in the late eighties and early nineties. This has not materialized. The big difference is the lenders. In the early 90’s, due to differing banking regulations, lenders were quick to default borrowers and flooded the market with discounted commercial buildings. This has not been the case in 2009 and 2010. Lenders have provided borrowers with a lot more flexibility including interest only loans and other vehicles to provide borrowers time to ride out the market, which should help the borrower and the lender in the long run. 

This may change over time. Look for office buildings that have been vacant for an extended period of time, i.e. one to two years. Even if the owners have the staying power to cover loan payments, real estate taxes and other operating expenses, they may reach a point where they decide that holding the asset and waiting for a lease simply doesn’t make sense any more. If they decide to sell, they will need to price their property within today’s market, which could result in attractive buying opportunities. Owner/occupants can particularly benefit from this because interest rates are at historic lows and owner/occupants can potentially qualify for down payments as low as 10% of the purchase price.

 - Charlie Craig, Partner

From the Desk of Charlie Craig:

 

I was recently working with a client that had purchased a small shopping center listing of mine nine years ago.  My client financed the acquisition through a conduit and the 10-year term of the loan was expiring in a year.  I ran financing projections for the client prior to closing and these projections included loan payments as well as loan amortization.

 

My client requested that the lender provide a projected loan balance at the expiration of the ten-year note.  The loan amortization period was 25 years. The lender projected a loan balance that was approximately $33,000 higher than my projection based on initial loan of $1,461,000.  My client asked me to help him account for this discrepancy. 

 

I recalculated the mortgage balance with several different mortgage balance software programs available on line and the result was the same.  My projected mortgage balance calculation continued to be approximately $33,000 lower than the lender.

 

The lender eventually provided a breakdown of the monthly loan payments including interest, principal reduction and daily interest charges.  The interest charges seemed high and offsetting principal reduction low, given a fixed 10 year rate of 9.19%.  It turns out that my client was being charged daily interest based on a 360 day year; however, the 360 day daily interest charge was being applied to the actual number of days in the calendar year, typically 365.  This methodology resulted in an effective interest rate of 9.32% and a reduction of principal amortization, given the monthly fixed loan payments.

 

When this methodology was relayed to the lender, her response was “this is consistent with your loan document and a standard practice in the commercial real estate mortgage industry.” I reviewed the loan document, and the note clearly stated an initial loan balance of $1,461,000 and annual interest rate of 9.19% fixed for 10 years, a 10 year term and a 25 year amortization.  The annual monthly loan payments of $12,451.31 stated in the note matched the calculation based on the standard 360 day monthly payment schedule.

 

However, buried in the agreement was the following language “Interest on the principal sum shall be calculated on a 360 day year, and shall be charged on the actual number of days in the month”

 

The issue is the months typically total 365 days a year. Over a compounding period of ten years, this overcharged interest resulted in an additional $33,000 to the mortgage balance.

 

The lender balked at any insinuation that this practice, which resulted in an effective rate of 9.32%, was misleading or unethical. 

 

No one, including the borrower’s lawyer, mortgage broker and me understood or challenged this language.

 

And, apparently, the lender was right about this practice being a wide spread industry standard.  Based on my conversations with commercial banks, a large majority of banks follow this practice, which results in commercial borrowers being overcharged relative to the interest rates they were quoted.  It is very rare that any borrowers challenge this practice.  Residential borrowers, in contrast, are protected from the activity via Truth in Lending Laws.

 

To be fair to the commercial banks I spoke with, they initially did not understand the ramification of a 360 day year per diem interest charge applied to a 365 day calendar year.

 

My advice?  Make sure you are quoted an interest rate based on a 360 day year applied to 360 actual days or 365 day simple interest before committing to any lender.  And review your loan document to make sure your interest calculation is correct before signing. Otherwise, you may be in for a very unpleasant surprise when your loan is due.

Charlie Craig (Charlescraig@dunham-group.com) is a Partner at NAI The Dunham Group. 

http://www.dunham-group.com/office_retail.asp