By Jennifer D. Duell

Little does the average consumer know that weekend errands of shopping for groceries, finding a new couch or purchasing a sweater have helped the retail sector become one of the strongest and most stable REIT sectors over the past 10 years. At the end of 2006, there were 30 retail REITs that had posted an average total one-year return of 29.01 percent. Industry analysts are forecasting returns in the mid-teens for 2007 and 2008, suggesting that the strong performance is expected to continue.

Not surprisingly, American consumers are supporting growth within the retail sector. Between 1999 and 2006, spending on furniture, household goods and clothing increased, driven by strong wage and salary growth, as well as cash from home mortgage refinancing, according to REIS Inc., a New York City-based real estate research firm. Strong retail sales have ensured tenant stability, which has allowed REITs to count on soaring occupancy rates and charge higher rents.

Retail
# of REITs	30
Industry Market Cap (in thousands)	$111,075,632
% of Industry	26.07%
Yield	3.39%
YTD Total Return	9.80%
One-Year Return	29.01%
Three-Year Return	40.23%
Five-Year Return	21.07%
Average Daily Trading Volume (Shares)	592,057.7
Source: NAREIT data as of Mar. 31, 2007

"The picture for retail REITs is absolutely exceptional," says Richard Moore, a research analyst with RBC Capital Markets Inc. "Retail tenants' demand is huge. All the landlords say it's as good as it's ever been."

Last year, retail sales increased by 6.3 percent, according to the National Retail Federation (NRF)—a rate much stronger than expected. This year, despite the housing slowdown, high energy costs and lackluster employment growth, retail sales growth is still expected to increase 4.8 percent. Forecasts for 2008 and beyond call for retail sales growth of 4 percent to 5 percent annually, which most experts consider fairly strong.

Solid Annual Returns

While some industry experts suggest that decreased consumer spending and weaker retail sales will moderate retailers' demand for new space, Jeffrey Donnelly, managing director at Wachovia Securities, suggests that retailers typically accelerate their store openings during an economic downturn to make up for such a shortfall in revenues and earnings. "Retailers continue to roll out new concepts, which creates ongoing demand," he says.

For example, during the most recent recession, the national va­cancy rate for the retail sector increased only modestly, from a low of 6.3 percent in 2000 to a peak of 7.3 percent in early 2002, according to REIS.

The retail sector stood head and shoulders above other sectors from 2002 to 2004, averaging a total return of 36.02 percent, compared to 25.25 percent for all REIT sectors, according to the FTSE NAREIT All REIT index. In fact, in 2003, the retail sector achieved its highest total return ever—46.77 percent, Donnelly says.

In 2005 and 2006, the retail sector underperformed the REIT market with total returns of 11.80 percent and 29.01 percent, respectively. However, Donnelly contends that "a perception of underperformance" doesn't mean that the sector is losing ground. "Retail is one of the few sectors that I can say with a high certainty will be better each year," he says.

Louis Taylor, senior real estate analyst at Deutsche Bank, expects the entire public retail sector to post steady earnings growth of 8 percent to 10 percent for the next three years.

Modest Development

Today, the retail sector has one of the highest occupancy rates, at 91.4 percent, according to a study conducted by the Urban Land Institute and International Council of Shopping Centers (ICSC). "Occupancy is very high on a national level, and I would not expect that to change in the next five years," Donnelly says. He says he believes that retailers are very strong and will continue to expand, which translates into high demand and increasing occupancy.

"In our view, retailers are expanding at a healthy rate," says Jeffrey Spector, an analyst with UBS Securities. "The balance sheets and credits of the retailers are the best they've been in years."

In addition to strong retailer performance, a modest construction pipeline allows vacancy rates to stay low and rents to move upward, Taylor says. "New supply is running at 1.4 percent of inventory, right in line with historical norms," he says, adding that development opportunities are abundant in the South and West, where populations are growing.

Across the sector, rental growth of 3 percent to 4 percent is expected to outpace inflation, according to REIS. However, some property types will experience far more robust rental growth, depending on nearby construction activity and demand from retailers, says Ross Smotrich, an analyst with Bear Stearns & Co. "Mall lease renewals have been robust, somewhere in the mid-teens," he says.

Bullish Outlook for Mall REITs

With a lack of new construction and strong growth from mall-based retailers, regional malls are achieving the highest rent growth within the retail sector, according to industry analysts. "On the mall side, we have negative supply growth, and that is why malls are getting the highest rental growth," Donnelly says.

Christy McElroy, an analyst with Banc of America Securities, is more bullish on supply/demand fundamentals for the regional mall sector and is forecasting internal same-store net operating income (NOI) growth of 3 percent to 4 percent for mall REITs. Moreover, she expects malls to see higher releasing spreads of 10 percent to 20 percent.

“Main Street” Competition There are now die-hard mall retailers willing to consider off-mall locations—those in lifestyle centers or “Main Street” type projects—because they’re having a hard time finding expansion opportunities within already crowded regional malls. “Without a doubt, the open-air phenomenon is driven by the retailer,” says Ross Smotrich, an analyst with Bear Stearns & Co. He adds that open-air centers boast rents that are typically lower than those in regional malls, with common area maintenance fees that are often 70 percent to 80 percent less and create a lower occupancy cost without an impact on sales volumes. Strong retailer demand has created a boom in open-air construction, which accounts for 10.9 percent of new construction activity, according to McGraw Hill Construction’s Pipeline database, a service that tracks real estate development. “The potential success is evident in many traditional mall owners’ efforts to add mixed-use components to existing regional malls, including residential, hotels, restaurants and services such as grocery stores and spas,” says Christy McElroy, an analyst with Banc of America Securities.

McElroy also says department store consolidation is the biggest reason mall performance is improving. "Department store closings have created opportunities for mall owners to regain control over a significant amount of space, fueling a surge in redevelopment activity that often includes finding a replacement anchor and/or adding restaurants," she says.

Spector is overweight in malls and expects a total return between 11 percent and 13 percent for mall REITs.

A More Conservative Outlook for Shopping Centers

The outlook for neighborhood and community shopping centers is a bit more conservative, primarily because of increased construction activity, according to industry analysts. These centers, which range from big-box anchored power centers to grocery-anchored neighborhood centers, represented the bulk of construction activity in 2006.

Specifically, big-box retail construction represented 34.2 percent of all new 2006 construction, while community centers represented 9 percent of total construction, according to McGraw Hill Construction's Pipeline database, a service that tracks real estate development.

The increased construction pushed vacancy rates for neighbor­hood and community shopping centers to 8.6 percent at the end of 2006, according to REIS. As a result, shopping center owners had to offer larger concessions to tenants, resulting in weaker rental rate growth. In 2006, effective rents increased 2.5 percent, and a similar rate is expected in 2007.

"Rents are not growing much in true power centers because big box retailers have all of the negotiating privilege and they tend to get very good terms," Donnelly says, adding that he expects rental rates to increase 3 percent to 4 percent this year.

Overall, most analysts expect 2007 to be another strong year for the retail sector, but that doesn't mean that they're not keeping an eye out for trouble. "The underlying fundamentals are good, however there are some yellow lights, and they have to do with what's happening to the consumer," Smotrich says. "We don't see any immediate near-term impact, but there could be some slowdown in 2008."