The acute weakness of the retail industry and the real estate in which it resides is well documented. Last year retailers experienced low sales activity, and in the first four months of 1996, retail sales increases were significant only in March.

Meanwhile, vacant spaces cropped up in regional malls nationwide. Stores closed as retailers reorganized, consolidated, or liquidated. They are victims of dramatically changed consumer shopping patterns. Many shoppers are diverting the dollars they used to spend on apparel to more utilitarian items--products that are less likely to be purchased at a mall.

Big-box retailers, outlet malls, warehouse clubs, and catalogs continue to cut deeply into regional malls' market share, and other shopping alternatives are mushrooming. Electronic retailing is estimated at about 5.0% of total retail sales, and it is expected to increase to 15.0% soon after 2000. Technological advances to facilitate electronic shopping are being developed continuously.

Vacancies, lower rents, declining values all emphasize the fact that the retail property market is grossly overbuilt. Analysts estimate that 1 billion of the total 5 billion square feet of shopping center space is excess. And an additional 129 million square feet of retail space is projected annually through 2001.

Value Trends

The consequence of these conditions is erosion of regional mall values. This is evidenced by increasing yield rates (IRRs) and increasing equity capitalization rates (OARs).

To analyze the relationships between economic, retail, and property market conditions and regional mall values in an historical context, we plotted annual average IRRs and average OARs for a 16-year period, from 1980 through 1995. The annual averages were derived from 216 regional mall sales in our database. For comparison, we also plotted 10-year treasury yields and CPI change rates over the period. Rates are shown in Exhibit 1. Although the equity cap rate is not a yield rate like a treasury rate, it is an indicator of the anticipated level of return at the time of sale.

Rates and Economic Conditions

We examined rate patterns in relation to the last three recessions: January 1980 to July 1980, July 1981 to November 1982, and July 1990 to April/May 1991. Yield rates peaked during the 1981 to 1982 recession. The 10-year treasury rate peaked at 13.91% in 1981, and both regional mall yield rates and cap rates peaked in 1982. However, there was no significant increase in 10-year treasuries or regional mall yield and cap rates during the 1990 to 1991 recession. Therefore, we determined that treasury rates and mall IRRs and OARs do not always shadow recession-expansion cycles.

It is clearer that these rates track inflation cycles. Leading to 1980, the national economy experienced a lengthy period of extremely high inflation. In the early 1980s, the Federal Reserve Board began to get control of inflation, as shown by the declining CPI change rate. During the high-inflation period, investment returns on treasury bills and regional malls were at their highest. This was to be expected as investors required higher real rates of return to compensate for inflation.

What is more significant than the level of rates are the spreads between them. In 1981 the spread between the average regional mall IRR and 10-year treasuries was at the low for the analysis period, 122 basis points. The spread between the average IRR and the CPI change rate had hit its low, 150 basis points, the year before. As inflation was controlled, the spreads widened. By 1983 the spread between the average IRR and 10-year treasuries was nearly at its high for the analysis period. The spread between the average IRR and the CPI change rate peaked in 1983.

In the early 1980s, the CPI was a leading indicator. Although the Fed began to control inflation, the marketplace did not have confidence in its ability to hold inflation down. Therefore, for the first few years of declining inflation, yield rates did not decrease; in fact, they increased in 1982 and 1983 before they started to drop. As confidence in the economy grew and the marketplace began to believe that government could control inflation, yield rates started to descend.

Examination of rates during the 1990s reveals a substantially different picture. Yield rates on both 10-year treasuries and regional malls have been lower than in the 1980s. The spread between T-bill rates and mall IRRs has widened since 1989, except for 1994, which is a small aberration. The spread has stabilized somewhat at a relatively healthy level. However, the spread indicates the level of increased risk associated with property ownership compared with a safe investment such as treasuries.

Movement of rates of return in the 1990s has also been noticeably different from the 1980s experience. During the 1990s regional mall IRRs have not fluctuated substantially. The decrease from 1990 to 1995 was only 27 basis points. By comparison, the return on 10-year treasuries was 198 basis points lower in 1995 than in 1990. In addition, throughout the 1990s the year-to-year changes have been greater in the average treasury rates.

The regional mall IRR spread to 10-year treasuries increased from 1990 through 1993, when it reached its high point for the analysis period, 548 basis points. It decreased to 391 basis points in 1994 and increased to 480 basis points in 1995.

The IRR spread to the CPI change rate increased from 1990 through 1992, when it reached 858 basis points. It decreased to 836 basis points in 1993 and increased to 844 basis points and 854 basis points in 1994 and 1995, respectively. The IRR spread to the CPI has been fairly consistent in the 1990s because the economy is experiencing only moderate growth. Once this changes, the spread could shift.

Exhibit 1
Rates of Return

IRR to OAR Spread

Average cap rates increased steadily throughout the past six years. However, the spread between regional mall IRRs and OARs diminished dramatically. Using the average IRRs and OARs from the 216 regional mall sales, we graphed the spreads between the two rates over the analysis period. Results are shown in Exhibit 2.

The IRR to OAR spread was greatest in 1983, which is also the year in which the IRR to CPI spread was greatest. The IRR to OAR spread has been declining steadily ever since, except for two bumps, one in 1986 and one in 1990.

Analysis of the spread between regional mall IRRs and OARs reveals the current regional mall investment climate. The OAR indicates the current anticipated level of return, and the spread to the IRR shows anticipation of future increases in income and value. The wider the spread, the greater the expectation of growth in income and value over time. The narrower the spread, the smaller the anticipation of increased income and property appreciation.

In periods of high inflation, investors anticipate high appreciation and large increases in cash flow. In periods of low inflation, the spread declines because investors anticipate low appreciation and small increases in income. The narrowing of the spreads between IRRs and OARs says more about investors' attitudes toward regional mall investment than about inflation.

During the 1990s, regional mall yields have been relatively constant. But the spread between the going-in cap rate and the yield rate has continuously narrowed. The reason is that investors are more concerned about the future of shopping centers and the potential for increases in income and value. They anticipate less growth in income and value. Hence, the going-in cap rate and the yield rate come closer together.

The 1990s Experience

Our analyses of actual rates of return and investment criteria rates for regional malls reveal that the movement of yield rates and cap rates in the 1990s is more a function of what is happening in retailing than what is happening in the general economy. The national economy has been relatively stable, and investors are confident that this pattern will continue. They are not so confident in the retail pattern, and they are somewhat apprehensive about the risk involved in the regional mall investment. This is demonstrated by the widening spread between mall IRRs and 10-year treasuries.

In the early 1980s, regional mall investors expected tremendous upside in both cash flow and property appreciation. Then the spreads between IRRs and OARs were substantial. Now expectation of income growth and property appreciation has diminished to the point that in 1995 the spread was 263 basis points. This is down 508 basis points from the 1983 peak. Unlike the 1980s experience, investors cannot depend on the longevity and profitability of many retailers who tenant regional malls. They cannot anticipate retail sales as high as in the past.

Exhibit 2
OAR to IRR Spread

Rates from Sales vs. Survey Rates

We are often asked if the investor criteria in published surveys mirror actual market activity. The quantity of data we used in the above analyses is more than sufficient to be statistically significant. Therefore, it provided us the opportunity to compare our Survey rates with those in market transactions of regional malls. Average equity IRRs and average equity cap rates from the two sources are plotted in Exhibit 3.

The graph shows a close pattern between the sale rates and those from our Investor Survey. Over the years for which we have Survey data, there were some divergences, which could be caused by the different amounts and quality of data from the two sources. On balance, the Survey rates track transaction rates remarkably closely.

Exhibit 3
OARs and IRRs - Actual Sales vs. Korpacz Survey

Investment Market Trends

The number of regional malls on the open market is substantial, and more are being quietly offered. Many institutional owners believe that their portfolios are weighted too heavily with retail property, and they are trying to shed some malls and shift into other property types. In a contrarian approach, others are aggressively pursuing acquisitions, hoping to buy high-quality malls at relatively low prices.

The preponderance of available malls are in small to midsized markets, with in-line mall store GLA of 150,000 to 200,000 square feet and retail sales of $190 to $240 per square foot. These are the malls that are most affected by poor tenant quality. Consequently, their likely buyers are opportunity funds buying at cap rates above 10.00%, free and clear IRRs in the mid-teens and leveraged IRRs above 20.00%.

As the year progresses, more good product from institutional portfolios is expected to be offered. There will be plenty of buyers for Class-A and some B malls that are efficiently managed and produce good income. It is the income that distinguishes the best malls.

In discussions of mall classifications with select participants, it became evident that the decisive factor is retail sales per square foot of in-line mall GLA. Consequently, we define mall classes as follows:

The amount of available product and the range of buyers--from pension funds to opportunity funds--should result in an active transaction market. Even in the face of negative retail trends, potential investors have a degree of optimism about the future of the better regional malls. Class-C and D centers are the likely candidates for elimination from the total mall inventory. By contrast, malls in the top tiers are positioned to survive--and thrive. They have the prime locations in their market areas and strong national tenants. In addition, they can be reconfigured and repositioned if needed.

Outlook

Like all markets, the regional mall market is cyclical. No one knows if the present down market is permanent, but in past slumps investors have wondered the same thing. We do know that the present confluence of retail trends will transfigure many malls.

People will always want to get together in an interesting environment. But they may not want to do as much shopping there as they used to. Malls may become showrooms where shoppers examine merchandise--"kick the tires," so to speak. But purchases of many items may well be made via the Internet or TV or phone.

The future is not clear, but historically, malls have been a resilient property type. There is no reason to believe they cannot continue to adapt to change--present and yet to come.

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