FEATURE ARTICLE, MAY 2006

RETAIL FINANCING REMAINS STRONG
Consumer spending slowdown affects the market, but the finance environment for Northeast retailers remains positive.
Jeffrey Gould

The economic good times keep rolling along in the United States. All real estate market segments — office, residential, retail — have been experiencing growth and increases in capital from boom-like conditions that seem to defy rising interest rates. As far as the environment for retail finance goes, the question is “can it continue like this through 2006 and into 2007?”

Listening to economic predictions for the U.S. real estate market can parallel listening to the weather report. Often, the economists are right. Sometimes they’re not. The reason is simple. For all the complicated, in-depth analysis of economic conditions, both globally and nationally, the one thing numbers cannot take into account is the unpredictable nature of human behavior.

Take the scenario of how the residential housing market has remained vibrant and active despite market conditions and unemployment uncertainties. Flying in the face of predictions, American consumers kept buying homes, lavishing money on them and trading up to bigger ones.

Also contrary to predictions, retailer balance sheets have continued to profit from American consumers’ ongoing spending spree, much of that spending fueled by enormous increases in home equity that have been cashed out to the tune of more than $700 billion in the last 5 years.

Now we are looking at a convergence of economic conditions — rising interest rates reflected in the higher cost of mortgages, higher energy costs and a noticeable (though not abrupt) softening of the residential market — that will all influence the health of the retail sector, slowing its growth and influencing the finance environment for new construction, renovation and acquisition.

Though it is not yet noticeable, as 2006 evolves, banks and other traditional lending institutions may well start tightening loan criteria and credit lines, becoming more risk-averse based on anticipation of a slowdown in consumer spending, rising costs, higher inflation and increases in interest rates.

One timeline that may loom large for Northeast corridor retail property owners is the large number of loans coming due or being extended (on new terms with higher interest rates) from 5 and 10 years ago, as well as the increased stress on the cash flow of owners locked into leases as the cost of money rises.

If consumer spending momentum decelerates, concern about where those dwindling dollars are spent may drive more owners of older retail developments to refinance to fund improvements and, subsequently, reposition and upgrade properties. Though not huge, there already is an uptick in owners of older retail properties seeking financing for a myriad of cosmetic improvements including parking lots, signage, lighting, canopies and store fronts, as the strategy of improving a property to stay current and competitive leads to the ability to increase rents and upgrade tenants.

Expect to see a significant increase in activity in this arena; within a year, there should be many less tired retail centers through refinance by current owners or via acquisition of mismanaged properties in tandem with improvements and market repositioning.

The ability to finance a retail property can be based not only on current cash flow, but also on cash flow when leases come due. When current cash flow isn’t adequate due to vacancies or undermarket leases, a retail property owner can leverage the most financing with non-institutional lenders if other collateral is available with built-in equity. The gap between the financing desired or a higher loan to value can be bridged by collateralizing with other equity value in owned property via a junior mortgage.

Though underwriting by traditional lending institutions may tighten, property owners can seek a loan-to-value ratio of up to 90 or 95 percent from an unconventional lender, dependent upon other collateral. Though lenders will allow equity cash-out, the preference is to have the borrower retain an equity position in the property to avoid overleveraging and sustain their financial interest.

There is potential that the Northeast will see more foreclosure activity on retail centers, especially with owners who leveraged early. Property owners who financed cheaply at a 5-year or 10-year fixed rate and have their loans coming due may also find themselves pushed to sell a property when faced with higher interest rates.

There is an expression that “all generalizations are false including this one.” This is relevant to any broad summary of or predictions about real estate because real estate is, and always will be, a local market. Every aspect of retail, including financing, must be tempered by that age-old mantra of location, location, location.

In New York City, upscale international retailers will continue to seek a significant presence, reinforcing their upscale brand images by a location in a world-class city. In all urban centers, retailers — from big box to small boutique — are, regardless of high rents, seeking to profit from population density. Though suburban and rural retail properties may have less feet walking in front of their doors, from the financing point of view, they have the upside of additional parcels to build out their land, new traffic trends and highways and increases in development of nearby commercial office parks or residential communities that favorably effect their financing viability.

The environment for retail financing will remain strong and positive because, on the bottom line, all real estate remains an attractive investment, a tangible asset with cash flow and a continued outlook for appreciation.

Jeffrey Gould is president and CEO of BRT Realty Trust, a Great Neck, New York-based public mortgage REIT traded on the New York Stock Exchange.

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