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December 5, 2012

Retail REITs – Stabilizing Fundamentals Support Stable Credit Outlook for Sector

By Merrie S. Frankel, Moody’s Investors Service, Vice President & Senior Credit Officer

Real estate fundamentals for retail properties have stabilized further over the past several quarters. Occupancy, leasing spreads and renewals, have all improved, which also bodes well for the credit ratings of retail REITs. We do not expect the investment-grade retail REITs to see material changes to their current ratings or rating outlooks over the next year. Moody’s has a stable outlook on nine of its 17 rated retail REITs, a positive outlook on six, one negative outlook and one on review for upgrade.

Moody’s retail group maintains a stable outlook on the U.S. retailers. We expect growth in U.S. retail sales growth to soften in the first half of 2013 because of consumer uncertainty surrounding the U.S. fiscal cliff and potential tax increases, but sales will strengthen in second quarter of 2013 because of pent-up demand.  However, Moody’s expects 2012 holiday sales will overcome the fiscal cliff and rise about 4 percent (compared with 6.5 percent growth in November-December 2011). This compares favorably with ICSC’s forecast of a 4.2 percent increase for 2012 holiday sales. The success of Black Friday and Cyber Monday suggest the generally favorable holiday trend.[1]

Consumers will continue to focus on value, which should benefit discounters and dollar stores. There is a significant bifurcation in performance among retailers. Retailers operating at both ends of the value spectrum – luxury merchants on the one side and dollar stores, auto-part retailers, drugstores, discounters and warehouse clubs on the other side–are outperforming other segments such as apparel and supermarkets.

Retail REITs tend to have properties that are above average in quality. Many have long-term leases with solid occupancies that support relatively stable cash flows. “B” and “C” properties, in secondary and tertiary locations with weaker tenants, continue to feel the effects of the weakening economy more acutely than do their “A” counterparts. National retailers, however, are showing increased interest in leasing the “B” space and private investors have low-cost debt capital available to purchase these noncore properties.

Although recent re-leasing spreads have been trending positive, they may be poised to turn negative. Leases signed at the market peak in 2004-07 may incur roll-downs when retailers sign renewals. Some small businesses such as the mom-and-pop stores are still feeling pressures due to low sales, which impacts inline store leasing and the ability to increase rents. One positive for leasing is that fresh retail concepts continue to spur new store openings as national retailers exploit the opportunity to capture attractive stores in quality locations that failed retailers previously occupied. Also helpful is the dearth of new retail development, allowing landlords to lease presently vacant space and regain pricing power. In addition, malls are reinventing themselves by becoming multidimensional purveyors of not only apparel and cosmetics, but also services such as hair salons, crafts, and yoga.

E-commerce sales comprised 5.2 percent of total retail sales during third quarter and increased 17.3 percent from the third quarter of 2011, while total retail sales increased 4.6 percent during the same period. The prevailing notion is that bricks-and-mortar space and e-commerce are both fundamental elements of a successful retail strategy, which is spurring some retailers to downsize store sizes.[2]

Outlet centers performed well throughout the recession, prompting an increased number of REITs such as Taubman, Macerich, and CBL to explore this sub-sector. Both Simon (with Calloway REIT) and Tanger (with RioCan REIT) have entered joint ventures to build outlets in Canada. Although the US-style outlet center has not existed in Canada to date, Canadians frequently cross the border to shop in the US outlets.

Some overseas investment has occurred — such as Simon’s investment in Klépierre and continued expansion of its Asian outlets, as well as Kimco’s investment in Mexico and DDR’s in Brazil. Still, the vast majority of retail REITs’ portfolios remain in the US.

Most retail REITs are managing their balance sheets conservatively. Retail REITs rated by Moody’s have maintained stable leverage metrics due to robust equity issuances, cost containment and astute balance sheet management. For Moody’s rated retail REITs, average secured debt/gross assets (23.6% at 3Q12) and debt/EBITDA (7.1x at 3Q12) have declined for the past three years, and fixed charge coverage has increased to 2.5x at 3Q12 because of improved earnings and decreased interest expense. (See graph below).

[1] Moody’s Investors Service, Industry Outlook, US Retail: US Consumers Remain Cautious, Limiting Earnings Growth in 2013, Nov 2, 2012; www.icsc.org.

[1] U.S. Department of Commerce, U.S. Census Bureau, Quarterly Retail E-Commerce Sales, 3rd Quarter 2012, Nov. 16, 2012.

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