21 January 2009

Ghost Malls Will Be Appearing

Commercial real estate, next shoe to drop....

James Quinn
January 19th 2009

America’s economy supports more than 1.1 million retail stores. There are approximately 1,100 Malls in the United States, not counting the thousands of strip mall centers. That will soon change as once thriving malls become ghost malls. By 2011, America’s malls within two years will have an entirely different set of numbers.

International Council of Shopping Centers (ICSC) chief economist Michael Niemira tries to put a good face on the gloom. He says, “In the midst of all this doom and gloom, it’s hard to imagine it getting better… But keep in mind, what happens in strong downturns is there’s a hefty pent-up demand. It’s wrong to extrapolate these conditions for the next year or two.”

But Mr. Niemira is probably wrong. There is no pent-up demand. Americans have bought everything they’ve desired for the last twenty years. The over-spending and over-leverage will take a decade to unwind.

According to the ICSC, about 150,000 stores are anticipated to shut down in 2009, in addition to the 150,000 that closed in 2008 and 135,000 in 2007. Normally, 110,000 to 125,000 new stores open per year. At least 700,000 of retail jobs will be lost. The opening of new stores will grind to a halt in 2009.

Some major retailers that have closed or will close include: Circuit City -728 stores; Linens N Things - 500 stores; Bombay Company- 384 stores; Sharper Image-184 stores; Foot Locker -140; Pacific Sunwear - 153. Other large retailers are closing underperforming stores and scaling back expansions plans. By 2011, at least 15% of the existing retail base will have gone to retail heaven. With the amount of vacant stores likely to be in excess of 200,000, there will be no need for the construction of new locations for many years.

Most of the retailers that are closing lease their locations from mall developers such as General Growth Properties, Simon Properties, Mills Corp., Pennsylvania REIT, and Vornado Realty Trust. These developers have a quadruple whammy hitting them in 2009. Many borrowed heavily to finance massive mall expansion. These loans were generally for five to seven year terms. The Wall Street wiz kids and their Collaterized Debt Obligation (CDO) machine generated the vast majority of financing in the last half decade.

According to commercial real estate expert Andy Miller, the collapse will come more rapidly than the residential collapse. “By contrast,” he says, “in the commercial world, the properties are fewer and much bigger. For example, you may have ten properties in a commercial pool that ultimately works its way into CDOs. Those loans are huge. You may have a shopping center loan in there for $25 million and an office building loan for $30 million dollars. As a result, if you have a default on just one of those loans, you can effectually wipe out all of the subordinate tranches.

Miller adds, “And that is why when you see the problems begin to appear on the commercial front. It’s going to be a much quicker sort of devolution than we saw on the residential side. In the commercial world, most of the financing that happened outside of the apartment business was done by conduits, and there are no more conduits left, and conduits were doing the stupidest loans you could find. They were doing an advertised 80 percent loan-to-value, which was usually more closely aligned to a 100 percent loan-to-value. They were dealing with no coverage. They were all non-recourse loans. Many of them were interest-only loans. Those loans are now gone. You can’t refinance them, and if you could, the terms would be onerous.”

The meltdown of materialism has hit the malls. For the last twenty years the American consumer has carried the weight of the world on its shoulders. This has been a heavy burden, but with consumers on steroids, it didn’t seem so heavy. The steroid of choice for the American consumer has been debt. They have utilized home equity loans, cash out refinancing, credit card debt, and auto loans to live far above their means. It has been a wild ride, but the ride is over. They can’t get steroids from their dealers (banks) anymore. The pseudo-wealth that has been created in the last twenty years has begun to unwind, but the deceleration will increase in 2009.

Average Americans, who saw their paper wealth growing rapidly as their home values increased, took advantage of this by refinancing their mortgages and extracting the equity from their homes and spending it. They sucked $3 trillion of equity out of their houses. Major Banks offered credit cards using your home equity as a way to pay everyday expenses like groceries, gas and clothes. Eating your house was never so easy. The massive number of excess home sales and equity withdrawal led to huge demand for home furnishings, remodeling services, appliances, electronic gadgets, BMWs, and exotic vacations. This led to massive expansion by retail and restaurant chains based on extrapolation of this demand. Enter mall mania.

But a psychological change has occurred in American consumers. They have lost $30 trillion in value from their homes and investments in the last two years. No amount of fiscal stimulation will reverse this psychological trauma. The savings rate will go from 0 percent to 8 percent. Mike Shedlock of Sitka Pacific Capital Management recently described the situation. “Peak credit has been reached. That final wave of consumer recklessness created the exact conditions required for its own destruction. The housing bubble orgy was the last hurrah. It is not coming back and there will be no bigger bubble to replace it. Consumers and banks have both been burnt, and attitudes have changed.” Now the impact of a retrenching consumer will be felt far and wide. Consumer spending has accounted for 70 percent of GDP. It will revert to at least.the long term mean of 65 percent.

David Rosenberg, the brilliant economist from Merrill Lynch, describes what will happen next: “This is an epic event; we’re talking about the end of a 20-year secular credit expansion that went absolutely parabolic from 2001-2007.Before the US economy can truly begin to expand again, the savings rate must rise to pre-bubble levels of 8 percent, US housing stocks must fall to below eight months’ supply, and the household interest coverage ratio must fall from 14 percent to 10.5 percent. It’s important to note what sort of surgery this is going to require. We will probably have to eliminate $2 trillion of household debt to get there. This will happen either through debt being written off, as major financial institutions continue to do, or for consumers themselves to shrink their own balance sheets.”

Billions of debt needs to be refinanced, and there is no one willing to make those loans. The major mall developers are so worried they have made an all out press to get a piece of the TARP. As retailers go bankrupt, vacancy rates have reached 9.4 percent for shopping centers, according to CoStar Group. With virtually no demand, rental income is plunging. With cap rates eroding and operating expenses going up, a perfect storm will hit mall developers in 2009.

The negative feedback loop will accelerate as the year progresses and will likely spiral out of control by late 2009 and early 2010. The negative feedback loop will lead to developer bankruptcies and ultimately to Ghost Malls, particularly in the outer suburbs. The collapse of developers will result in more major write-offs by banks. This time, many smaller regional banks will feel the major pain. The U.S. taxpayer will need to step up to the plate and assume responsibility for their lack of spending.

Mall owners and commercial developers are on the brink of bankruptcy. Commercial developer CB Richard Ellis didn’t sound too optimistic in a recent 10Q filing. He stated, “We are highly leveraged and have significant debt service obligations. Although our management believes that the incurrence of long-term indebtedness has been important in the development of our business, including facilitating our acquisitions of Insignia and Trammell Crow Company, the cash flow necessary to service this debt is not available for other general corporate purposes, which may limit our flexibility in planning for, or reacting to, changes in our business and in the commercial real estate services industry. Notwithstanding the actions described above, however, our level of indebtedness and the operating and financial restrictions in our debt agreements both place constraints on the operation of our business.”

As Americans realize that they don’t “need” a $5 Starbucks latte, IKEA knickknacks, Jimmy Choo shoes, Rolex watches, granite counters, and stainless steel appliances, our mall-centric world will end. As low prices become the only factor that drives retail sales, retailers will have lower profits in the future, further restricting expansion and renovations.

General Growth Properties, a mall developer which owns or operates 200 malls, added $4 billion of debt in the last three years and is teetering on the brink of bankruptcy. Simon Properties, which owns or operates 320 malls, added $3 billion of debt in the last three years and will be greatly affected by the coming downturn. Many smaller developers will be in even dire straits. With shrinking cash flow, looming debt refinancing, and dim prospects for a resumption of conspicuous consumption, Mall developers are destined for a bleak future.

Every major retailer in the United States has built their expansion plans on an assumption that American consumers would continue to spend at an unsustainable rate. That crucial assumption error will lead to the bankruptcy of any retailer that financed their expansion with debt. Warren Buffet’s wisdom will be borne out, “Only when the tide goes out do you discover who’s been swimming naked.”


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