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Experts: Retail property won’t hear housing bubble pop

By Curt Hazlett

If the U.S. housing market goes into a deep freeze, will retail real estate feel the chill?

This is a question on the minds of plenty of developers these days. After years of record gains in home prices and housing starts, a residential pullback seems to be under way, though most economists expect the reduction to be modest and not the oft-predicted bursting of a real estate bubble.

The robust health of the housing market has been mirrored on the commercial real estate side, which is not surprising given that both have been fueled by years of rock-bottom interest rates and a generally solid economy. The retail component has enjoyed an added boost as consumers have continued to spend, the result of rising home-equity values and a wave of refinancings that put more cash into household budgets.

So the direction of the housing market is of more than passing interest to retail developers. Any slowdown in housing growth, or an outright decline in house values, could lead to a slump in consumer spending and hurt shopping center tenants. A severe slump could trigger mortgage delinquencies among heavily indebted homeowners and also tighten lending for commercial properties. And no one wants the spike in development costs, for residential and commercial projects alike, that rising interest rates would surely bring.

But if the fear of such dire outcomes exists among retail developers out there, it is hard to find. “I don’t want to speak for others, but it’s not something we’re very concerned about,” said Stephen D. Lebovitz, president of Chattanooga, Tenn.-based CBL & Associates Properties, which manages or owns interests in 132 shopping centers. “We’ve felt there would be a correction for a long time, because prices have gone up so much, but I don’t think we’ve felt that would have a significant impact on us or our performance.” The reason is that retail property supply and demand has stayed in balance, he says.

“Our occupancy levels ended last year at 95 percent, and across the board retail occupancy levels have stayed strong even when other areas of real estate have been weak over the past three or four years,” said Lebovitz. “I don’t see that overbuilding has occurred, and I don’t think there will all of a sudden be a lot of vacancies. Strong retailers that are looking to grow will help us weather any negative impacts that the housing market might have.”

Predictions of a housing downturn began sounding as long ago as 2001, but housing starts and prices defiantly climbed ever higher. Now, however, there seems to be agreement that a correction has in fact begun, though opinions vary on its depth.

Among the most optimistic observers is David Seiders, chief economist of the National Association of Home Builders, who says housing will experience a “simmering down” this year that will pull price increases back into the single digits and housing starts down to 1.94 million from last year’s 2.07 million. Though Seiders stops short of saying homes are in oversupply, he concedes that “last year’s record level of housing starts and double-digit price appreciation were unsustainable.”

Of course, what happens to housing will depend on where it is. In areas where prices and supply have grown fastest, significant decreases are likely over the next couple of years, says Brian Carey, an economist at Moody’s Economy.com, an independent research firm and one of three entities that constitute Moody’s Corp. “We’ve already seen it starting to slow,” Carey said. “The third quarter of 2005 was the peak for housing, both for volume of sales and price growth.”

What that means for commercial properties is open to debate. “Residential and commercial are cousins,” said Dennis Yeskey, a principal at Deloitte Financial Advisory Services who heads its real estate capital markets practice. “Residential operates on some drivers and commercial on other ones, so they are not directly linked, but they are related for sure.”

Of all the commercial sectors, retail is likely to feel the biggest impact from any pronounced decline, Yeskey says. “We’re in a negative savings environment where people have been using the equity in their houses to buy stuff, so I would think there would be a negative impact on retail,” he said. “Retail is pretty hot — it’s been one of the hottest categories in commercial real estate the last three or four years. So it’s probably due for a little bit of a slowdown.”

But when, and how big? Michael P. Niemira, ICSC’s chief economist and director of research, says commercial real estate typically lags the housing sector by about 14 months, “partly because the residential side consists of much smaller projects and they tend to react to higher interest rates much faster than the nonresidential side.”

Niemira addresses the issue of commercial real estate’s vulnerability in a research paper posted on the ICSC Web site in April. In the paper, he notes that nonresidential construction has grown less speculative over the past 20 years, thanks in part to consolidation in the banking industry and an increase in nonbank financing, which “resulted in less speculative commercial building and provided more discipline to the market.” The result, Niemira says, is a commercial market with fewer upside surges and less downside risk.

Based on his analysis, Niemira expects only a small decrease in nonresidential construction this year. Despite the strong pace of construction in recent years, “there may not be a bubble that bursts,” he said in an interview. “There may not even have been a bubble, just a catching up on the commercial side. Consequently, you don’t have a big downside.”

Yeskey takes a similarly positive overall view. In Deloitte’s real estate capital markets outlook for 2006, Yeskey writes that commercial real estate, unlike residential, has avoided overheating during the prolonged rally of the past 12 years. “The good news is that as of today, there are no clear signs that the commercial real estate market is ready to take a drastic turn downward,” he wrote.

Yeskey says he believes it would take a substantial rise in interest rates — perhaps 100 or 200 basis points — before commercial construction would feel much of an effect, especially so given that a wide array of U.S. and foreign institutional investors continue to pour money into it. But a continued rise in rates could have other consequences. In a report last year, credit analysis firm Fitch Ratings warned that mall REITs are “particularly vulnerable” to higher rates because they are highly leveraged and have exposure to variable-rate debt.

Lebovitz says he finds it hard to generalize about the link between residential and commercial because of regional differences. “In markets where there is a lot of speculation in housing, there would be more of an impact,” he said. But housing in most of CBL’s markets has been driven by owner demand, not speculation. “And when the housing market slows, people just won’t sell their houses,” he said. “They’ll wait for the market to come back. We don’t expect that will have the same impact as the job market getting weak and unemployment going up.”

Even if commercial real estate catches residential’s cold, Yeskey says he believes retail will come through nicely. “Retailers have a wonderful way of reinventing how they sell things all the time, unlike other commercial real estate,” Yeskey said. “An office is always an office, but retailers are always able to figure out ways to put new buildings in place. And the consumers always figure out a new way to keep spending.”