COVER STORY, JULY 2006

NEW ENGLAND RETAIL REPORT
Industry experts discuss factors affecting retail.
Interviews by Stephanie Mayhew

Northeast Real Estate Business recently spoke with several industry experts in the New England markets to find out the current trends and the status of the retail markets in their respective areas. The interviewees included Ernest DesRochers, senior vice president and managing director of NorthMarq Capital, in the Long Island, New York office; Tom Fini, owner of The Fini Real Estate Group in Bedford, New Hampshire; Jennifer Gray, an advisor for Grubb & Ellis|Coldstream Real Estate Advisors in Portsmouth, New Hampshire; Robert Shannon, senior advisor at Sperry Van Ness in Boston; and Steven Siegel, senior associate and director of Marcus & Millichap’s national retail group in Manhattan, New York City.

DesRochers specializes in financing major commercial property categories and covers Connecticut, and Westchester County and Long Island, New York. Fini specializes in commercial real estate and covers southern New Hampshire and northeastern Massachusetts. Gray specializes in retail, investment and office properties in northern Massachusetts, southern New Hampshire and southern Maine. Shannon is a retail specialist and covers the metro Boston area, with his primary market located within the Interstate 495 belt; he also handles single-tenant and net lease properties on a national basis. Siegel specializes in retail, multifamily and mixed-use.

NREB: How would you characterize retail development activity in New England this year?

DesRochers: Development has been very difficult due to tight land use constraints. New mixed-use retail/residential is being planned, especially in older urban locations, as communities emphasize smart growth. Infill type locations where property is recycled from industrial type uses to retail uses are popular as well.

Gray: Retail development in northern Massachusetts, southern New Hampshire and southern Maine remans active.

Fini: Retail activity is continuing with steady growth throughout the southern New Hampshire region, but northern Massachusetts has less opportunity for development.

Shannon: Development in the Boston area in general is difficult because of permitting requirements, environmental controls and the lack of land. Finding good, well-located vacant parcels of land that are close to an interchange with easy access is difficult. Thus, most of the development activity in the metro Boston market involves turning an old industrial facility into a retail property.

 Siegel: New development has slowed compared to previous years, but it’s still steady. In Boston, we have seen a slowdown. A number of redevelopment and infill projects are underway in several urban areas. Throughout New England, the development of new urban lifestyle centers has grown in popularity, a reflection of a broader trend sweeping the nation.

NREB: How would you characterize retail leasing activity in your area this year?

DesRochers: It has been very strong over the past 12 months as is evidenced by occupancy rates of the retail property loans that we have originated this year or service for third-party lenders.

Gray: Coinciding with the development activity, the retail leasing activity in my market has remined active.

Fini: Most major retail centers remain at nearly full occupancy. Secondary markets vary from 1.5 percent to 11 percent vacancy. The overall vacancy rate in the southern New Hampshire market is around 5 percent.

Shannon: The leasing activity in the metro Boston area is very strong. Vacancy rates are decreasing and rents are still increasing. Various reports in this area show vacancy rates in some markets at less than 5 percent. For instance, in the Metro West market, the Framingham and Natick area, reports show vacancy rates in the 2 percent range. The North Shore area in Boston  is showing vacancy in the 3 percent to 4 percent range. Most major markets are under 5.5 percent and 6 percent. In comparison to the office and industrial park markets, which are in the 15 percent to 30 percent range depending on the market, retail is doing very well. Generally, that activity has been very strong because of low vacancy rates.

Siegel: Retail leasing activity has been extremely strong in New England. This trend will continue without abating this year. In the Greater Hartford, Connecticut, area, for example, the vacancy rate dropped to 9.5 percent, reflecting a decrease of about 1 percent. In eastern Massachusetts, retail leasing activity also remains strong. The region’s vacancy dropped from 6 percent to 5.5 percent. In most regions throughout New England, we are seeing similar decreases in vacancy rates as new projects are continuously being added. These new developments are bringing the total number of retail square footage in the overall market areas to new heights, which is another positive reflection of the strong market.

NREB: How would you describe the investment sales activity in your area?

DesRochers: It has been very strong over the past 12 months with record prices and record low cap rates in many cases.

Gray: The investment sales activity in northern Massachusetts, southern New Hampshire and southern Maine is moderate to active.

Fini: Investment sales have remained very aggressive. Buyers are continuing to accept low cap rates for the limited availabilities. Credit tenants in the area command cap rates in the 6s.

Shannon: The investment sales activity in metro Boston is probably even stronger than the leasing activity because of the lack of good product available for sale. Generally, owners in this area have a tendency to hang on to properties for a longer period of time, so you won’t see an ample inventory of available property for sale. For example, I just sold a single-tenanted Circuit City property, and after 2 to 3 weeks of marketing it, I already had 22 offers. The competition pushed the price from about $5.3 million up to $5.6 million, and we could have gone higher than that.

Siegel: The investment sales arena continues to be complex. With interest rates steadily climbing, investors are not necessarily seeing cap rates move at the same pace. That being said, we are still seeing many properties trading aggressively, as the lack of product continues to drive demand. We are also seeing many owners of shopping centers and triple-net leased properties starting to sell and also becoming more open to negotiation. The consensus is that they have missed the height of the market and do not want to lose too much value if interest rates continue to rise.

NREB: What retail markets (or submarkets) have grown in the past year, and which markets are poised for growth in 2006? Why?

DesRochers: Urban locations have seen much growth over the past couple of years, as national retailers have recognized that these areas have been long underserved despite generally  strong demographics. Infrastructure such as availability of parking is the key to success in urban locations.

Gray: Portsmouth, New Hampshire,  is a growing retail market and will continue to grow in 2006. It is a destination location for tourists and a desirable place to live for both primary and secondary homes. Based on population demographic patterns, Route 125 from the Massachusetts border into Maine is poised for substantial retail growth, and so is Route 4 from Seacoast to Concord, New Hampshire. Epping, New Hampshire is also growing due to the new Wal-Mart and Lowe’s Home Improvement Warehouse that opened in 2005. The Lee traffic circle is the next natural development area.

Fini: The southern New Hampshire market has seen continuing growth in the retail sector. Large projects, which will exceed 1 million square feet of additional retail space, are planned in Nashua and Hudson. The entire New Hampshire border continues to benefit from Massachusetts shoppers due to the fact that New Hampshire does not have a sales tax. The completed east/ west highway corridor in southern New Hampshire is developing at each major exit. The Epping area, halfway between Manchester and Portsmouth, has a Wal-Mart Supercenter, Lowe’s, Walgreens and Applebee’s completed with several other retailers in the process of completion at the exit. The area is made up of low population towns that draw from a 10-mile ring attracting retailers looking to infill growth area.

Shannon: The largest amount of activity for new construction has been in the South Shore market, mainly in the Plymouth area because generally there are more large tracts of vacant land close to convenient interchanges off the highway. There are also other existing markets that are well established and are still seeing some large expansion. For example, the Natick Mall is expanding by approximately 500,000 to 600,000 square feet, and there is another large development just north of Boston that is about 800,000 square feet. In  Westwood and Dedham there are two major proposals that will be approximately 1 million square feet combined. I think we are seeing the growth so much in these particular areas because they possess usable land in good locations, especially the availability of older industrial areas in good locations that can be converted to retail.

Siegel: New England has been consistently seeing retail development over the past year with the Greater Boston area showing the largest growth. That region has seen an impressive amount of projects completed in the past year, including The Derby Street Shoppes, a 400,000-square-foot lifestyle center, as well as the Crossing at Walker Brook, a 230,000-square-foot power center and the IKEA center in Stoughton. Overall, growth totaled 4.5 million square feet, or 2.6 percent. There are a large number of projects currently in various stages of completion scheduled for the near future as well. Connecticut follows closely behind with the addition of two lifestyle centers: the Shoppes at Farmington Valley in Canton and the Evergreen Walk project in South Windsor. Southeastern Connecticut, in particular, continues to grow at a staggering rate with the addition of more than 750,000 square feet underway and an additional 1 million square feet in the planning stages. Eastern Connecticut, specifically the Interstate 95 and 395 corridors, has started to receive more attention from developers as that area has become very desirable.

Despite some of the significant barriers to entry that exist in some New England markets, we expect the trend of retail growth to continue as suitable development sites are identified and assembled. Developers are becoming more and more creative in planning these projects and will find ways to enter this very desirable region.

NREB: What retail markets (or submarkets) are struggling? Why?

DesRochers: Generally, I have not seen any struggling markets, per se. Some properties struggle because of location, bad management, etc., but most are very well occupied.

Gray: Most markets in New Hampshire are thriving. 

Fini: Most Class B locations are experiencing higher than average vacancy rates. The timeless adage ‘location, location, location’ applies specifically to retail properties. Every market, regardless of size, has its share of Class A and B properties. The greater Boston market has been showing increasing vacancy rates the last three quarters.

Shannon: I would not say any area is struggling because the vacancy rate is still below 10 percent, but the markets that are experiencing the highest vacancy rate are probably those in Massachusetts closest to the New Hampshire border — the Merrimack Valley — since New Hampshire does not have a sales tax. Thus, people close to the New Hampshire border will shop there rather than Massachusetts.

Siegel: The Boston retail property market will not perform as well as it did last year, as it is predicted to slip two places to number 15 on Marcus & Millichap’s National Retail Index. However, Boston still maintains its place among the top 20 retail markets in the United States. Perhaps the only thing the Boston retail property market needs most is newer properties. During the past 7 years, retail stock has been added at a slight 1.3 percent annual rate as expensive land and constraints on new development have discouraged retailers and developers.

NREB: What types of retail properties are hottest in your market? Why?

DesRochers: From an investment perspective, grocery-anchored and credit-tenant properties are the hottest because of demographics and inability to add to inventory.

Gray: Downtown storefronts and restaurants are hot due to community investment into downtown areas. Also, development sites with frontage on retail corridors and multi-tenanted investment retail products are all hot in the Northeast.

Fini: This depends on the requirement. Investors are seeking out net-leased drug stores, credit restaurant concepts, equipment suppliers and automotive parts distributors, which still command low cap rates and are in high demand. Neighborhood strip centers as Class A properties have increased in value as retailers have been anxious to infill smaller markets, and investors are looking for value added properties. A failed traditional shopping center in northern Massachusetts was redeveloped into a lifestyle center and now attracts shoppers from a wide area. Regional malls continue to attract a heavy volume of shoppers and diners.

Shannon: Anything that has a grocery or a drug store anchor as well as any single-tenanted net lease type properties.

Siegel: Urban lifestyle centers, strong grocery-anchored centers, drug stores, Starbucks, Wal-Mart and single-tenant properties. Properties like Starbucks, Walgreens and Wal-Mart are still trading at very aggressive numbers because of the security of having a strong credit tenant on the lease. Two types of investors are driving much of our retail activity right now. First, shopping center investors are looking for upside in existing properties and second, 1031 exchange investors are in the market, often looking for stability and cash flow. With retail leasing extremely strong right now, investors who either have existing relationships with tenants, or who are willing to roll up their sleeves, can make sense of low initial returns with future upside. The 1031 exchange buyer does not have the luxury of time when it comes to selecting investments. A lot of these investors are trading out of management-intensive properties into triple net-leased retail properties, which offer zero management responsibilities and the safety of a national tenant on a long-term lease.

NREB: What types of retail properties are struggling in your market? Why?

DesRochers: Unanchored retail centers where credit tends to be very local in nature and businesses may be poorly capitalized or do not have a long-term viable business model. However, we continue to see tenants almost immediately replaced with others with amazing regularity.

Gray: Being that we are a consumer society driven by the service industry versus an industrial industry, there are few retail properties that are struggling. However, non-modern structures are struggling until they are reconditioned or renovated.

Fini: Class B, unanchored locations that are tenanted by game stores, hobby shops, small book stores, jewelry stores and mom and pop retailers are struggling the most. Often these small centers are not tenanted with retailers that have a synergy that will attract large groups of customers, and vacancies can take a protracted period of time to fill.

Shannon: Non-anchored type properties, but even that really depends on the location. A property is really going to be struggling in this market if it is non-anchored and in a poor location with poor access.

Siegel: The current retail property type in a state of flux or in a transition phase is the typical regional mall. As new lifestyle center developments are getting started on large tracts of land, investors are shying away from suburban malls. Developers and investors alike are more attracted to newer lifestyle centers that bring shopping, dining and entertainment to one central location. On the single-tenant net- leased front, tenants that do not have investment-grade credit (i.e. franchisees with weak balance sheets) are having a more difficult time. Lenders are not taking risks like they used to, and some non-credit investments actually start with neutral or negative leverage. Investors are starting to shy away from those properties.

NREB: What retailers are most sought after? Why?

DesRochers: Credit tenants with solid business models because the financing tends to be very easy with minimal risk. Branch bank and drug store developments are good examples of retail properties that are in high demand by investors.

Gray: National tenants due to their credit rating and security.

Fini: Every community has different needs. Some New Hampshire towns have their first home improvement center and others their first supermarket. Everyone wants to have a convenient Starbucks or Panera Bread in their neighborhood along with retail services such as cleaners, beauty salons and banks.

Shannon: Generally, anything with an investment grade rating, which is a triple B rating. Any property with tenants such as Lowe’s, Home Depot, Staples or major supermarkets are  expanding in this market right now. They are really the most sought after niche because they are much easier for the owners to finance, and the value is more stabilized than local retailers that might not have the established credit that a national retailer does.

Siegel: Since mixed-use lifestyle centers are in vogue and popping up across New England, many are trying to develop these projects, despite the difficulty many face when it comes to receiving approvals and acquiring sites suitable and large enough. Retailers such as Chico’s, Talbots, Coldwater Creek, The Cheesecake Factory, J. Jill, P.F. Chang’s, California Pizza Kitchen and McCormick & Schmick’s are highly sought after. For example, New England Development’s new project, Westwood Station, currently underway about 10 miles west of Boston, is beginning its initial lease-up. At this point, a number of retailers have expressed interest in the property. The leasing consultant, Mitchell Friedel of Robert K. Futterman & Associates, says that the developer is trying to lease the property with a mix of upscale retailers and restaurants to match the surrounding affluent population base.

NREB: What do you think needs to happen in order for the market to improve in 2006 or 2007?

DesRochers: It is not a question of improvement, but whether or not the economy will soften and consumer spending will slow.

Gray: Pricing needs to adjust accordingly so that cap rates are more realistic. With more and more development, there is more competition for tenants; therefore, landlords should continue to be competitive in order to secure the best tenants (well-maintained properties, marketing initiatives, sign-on bonuses for example).

Fini: Traditional influences can help the market improve in 2006 and 2007. Interest rates and gas prices need to stabilize, job growth needs to continue and consumer confidence needs to increase.

Shannon: The market is quite good right now, but to improve it beyond its current level there would have to be more population and employment growth in the area. I think 2007 will be strong with vacancy rates still decreasing and rents increasing, but not at the pace we have seen in the last couple years.

Siegel: Consumer confidence must improve in some of the secondary and tertiary markets in the Northeast to stimulate the region’s economy. This would require more diligence and caution on the part of the Fed as it continues to raise interest rates. A slowdown in consumer spending as well as rising oil and energy prices will only lead to flat retail sales.

NREB: What retail trends do you think will emerge in 2006?

DesRochers: Continued growth by national retailers in urban areas and continued redevelopment of infill-type locations. The northeast is often the last to see new trends emerge because of the difficulty of finding new sites.

Gray: Drive-thrus are a hot commodity. Coffee wars are eating into the share of Dunkin Donuts (Tim Hortons and Starbucks for example). The Internet will continue to grow and retailers should continue to be wary of and take advantage of online sales. The footprint of the big boxes continues to get bigger. The development patterns continue to head out to the second, third and fourth tier markets. In the power corridors, like Route 28 in Salem, non-modern retail properties will continue to drive high demand for redevelopment.

Fini: I expect increases in home improvement centers, restaurants across all categories, drug stores and consumer services such as postal centers and stationery supplies. Some continued consolidation of banks, home furnishings, gifts, games and small decorating centers is expected.

Shannon: I think there will be a decrease in the prices of property because of the rise in interest rates; however, I don’t think there will be a decrease in rental rates. In the next 3 or 4 years, rents will go up, but not as fast as they have in the last couple of years.

Siegel: The development of urban lifestyle centers — particularly in inner-city areas with dependable mass-transit systems — will continue in most major metro markets in the northeast this year. In suburban areas, such as New Haven and Stamford, Connecticut, big-box development and investments will be sought-after.

NREB: What are your predictions for New England retail in 2006 and 2007?

DesRochers: More of the same, provided the economy does not soften substantially.

Gray: It will continue to grow at a healthy pace.

Fini: The retail market will remain robust for the foreseeable future. Many sub-markets still have significant growth capability, and the matured markets are performing satisfactorily. The only area that could weaken is the multi-tenant retail development segment, as rising interest rates may slow the growth of new projects because of the rental rate requirements needed to satisfy the increased debt service.

Shannon: Because of the lack of buildable land within the 128 belt area of Boston, the only development will be the redevelopment of industrial or office facilities. In the Interstate 495 market of Boston, there will still be new construction because the land is much more available.

Siegel: While investor demand for well-priced properties remains high, cap rates appear to be leveling. A moderate upward adjustment in some of the most heated markets is likely as interest rates rise further. Single-tenant cap rates, on average, are currently at 6.7 percent, with the average for multi-tenant properties approximately 20 basis points higher. Shifts in the investment market are becoming more apparent. Velocity has decelerated from last year’s record pace as the gap between buyer and seller expectations widened in response to higher interest rates. Overall, however, the adjustment period is expected to be relatively short-lived, as improving operations and the risk of additional rate increases provide motivation for both buyers and sellers to move forward with deals.

NREB: How would you describe the lending environment for retail properties in your market?

DesRochers: There has been a very strong demand on the part of lenders for retail properties. However, higher interest rates have not been reflected in capitalization rates yet; therefore, high leverage is getting more difficult to obtain.

Gray: Cautious, yet optimistic.

Fini: Lenders have remained very accommodating in providing satisfactory options for all viable real estate projects in the Northeast. There hasn’t been any shortage of resources or options for investors or developers.

Shannon: There is still a lot of money and chasing of deals in this market, but lenders are very selective as far as the quality of the deal. Deals in which there is a high vacancy or an anchor tenant that went dark are always difficult to finance. The best rates and deals in this market are for transactions that are well located and fully occupied facilities.

Siegel: Capital flows into retail will remain strong over the next year, but lenders are beginning to tighten underwriting standards for some property types. In the single-tenant sector, lenders are imposing stricter debt-service coverage ratios depending on credit quality of the tenant or franchisee. Marketwide, CMBS issuance is expected to remain strong, but higher-yields on other fixed-rate income securities may lead to some widening in spreads.

NREB: Interest rates are expected to rise in the coming year. How do you think this will affect real estate in your market?

DesRochers: That is the $64,000 question. The likelihood is that values will stay constant as rents have increased, which in turn supports higher capitalization rates. The question is: how far will they increase, if at all?

Gray: If there is significant escalation in rates, it will definitely affect the market.

Fini: Rising interest rates always affect real estate. Developers will have to increase lease rates to cover debt service, which usually reduces development because many tenants may opt for existing structures rather than pay increased rates. Sellers will have to lower prices in order to satisfy an investors required spread, which often reduces available inventory as sellers are reluctant or unable to sell below a certain strike price. Rising rates have the least affect on an owner/user of real estate because this group can factor the rising rates into their business budgets and offset the increase in rates on the operations side of the ledger.

Shannon: We will see a difference in the pricing of deals, so I think there will be hesitation from some sellers. They will be going and checking prices from the last 12 months to make sure they are getting a good deal.

Siegel: The Fed continued to raise rates through early 2006, and it appears likely that the tightening campaign will continue. One or two additional 25 basis point increases to the Fed Funds rate are expected before the end of 2006, which would bring the rate to the 5 percent to 5.25 percent range. After a long run in the low- to mid-4 percent range, the yield on the 10-year Treasury pushed beyond the 5 percent mark in mid-April for the first time since 2002. Based on expectations that inflation remains under control, we anticipate the yield on the 10-year to end 2006 in the low- to mid-5 percent range — still low by historical standards.

©2006 France Publications, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 554-6054.