COVER STORY, MAY 2006

TOP RATE RETAIL: MIDWEST RETAIL FINANCING REVIEW
Heartland Real Estate Business discusses the state of the Midwest retail finance market with an industry expert.
Interview by Kevin Jeselnik

Heartland Real Estate Business recently spoke with Dave Patchin, a senior vice president with Chicago-based LaSalle Bank, about the current state of the Midwest retail finance market.

HREB: What are you seeing in the retail sector in the Midwest market at this time?

Patchin: From what I see, retail is still doing well. Although, I would tell you that things are moving much more slowly than they had in the past, meaning retailers are taking a lot longer to negotiate and sign leases. They’re still interested; they’re still signing leases, but the whole process itself is taking much longer than it used to. The pipeline has just lengthened greatly, even more so than it did 5 years ago.

HREB: To what can you attribute this slower-moving development pipeline?

Patchin: I think everybody is just more focused on being in the right place and making the right deal. There are still probably a lot of retailers out there that just try to bang out as many stores as they can, but others, I think, are being a lot more cautious. Obviously, the department stores are being very cautious. There is a lot of consolidation, with Federated and that kind of thing. They still want to open stores, but they are very focused on where they are and what format they are in.

HREB: Is this a national trend or isolated in the Midwest?

Patchin: I think that’s pretty much everywhere; I don’t see a lot of difference in other areas of the country. I do see more product going up in, say, Southern California, in the Inland Empire in that area, and in Florida, but I think the delay of the whole process is pervasive no matter where you are.

HREB: Is there still a lot of capital flooding the market and competing for deals?

Patchin: There is a ton of money out there, and it is very competitive and it is compressing pricing a lot and structure as well.

HREB: How is the lending market right now compared to a year ago?

Patchin: In the lending market, as I just mentioned, there is a lot of money out there. So, there are lot of banks chasing relatively few deals, and what it’s doing is, you’ve got a lot of people lowering pricing by 50, 60 or 75 basis points [compared to] a year ago. So, I would say all pricing right now is going out under 200 basis points on a spread, whereas, even a year ago, you were getting 200-plus on everything.

HREB: How far down can this competition push the pricing before it stops?

Patchin: When you start to see other investments, when people start moving their money elsewhere, then it might come back to a little more normalcy. Or, if there is a problem in the market and you start to see some defaults, then the lenders will react with more stiff structure and pricing.

Retail in specific, but real estate in general, has been something everybody wants to invest in because the stock market is not there and other investments aren’t there; retail is still giving you higher returns than those other vehicles. So, that’s where a lot of focus is, not only from the developer/owner side, but also from the venture capital and/or lending side. There is not a lot going on in other areas, so, where are you going to put your money? You’re going to put your money where you are going to get a good deal and get some returns. So, as long as that continues, you are going to see the compressed pricing and probably more aggressive structure, because everybody wants to put their money there, in real estate in general.

HREB: How are interest rates affecting the market right now?

Patchin: Rates have gone up, but they haven’t really impacted anything. With retail projects, as I mentioned, the pipeline is fairly long. So, most of the developers will hopefully plan ahead and factor interest-carry and increased cost into their projects. Because, if it’s going to take you a year to get into the ground, you better be somewhat conservative and build [increased costs] in. And I think that most developers have. So, the rising interest rate, currently, has not impacted what’s going on. Will it affect projects that are just starting now? That’s a possibility, but we’ve been favored with such low rates for such a long time that now we’re getting back to an all-in rate that is still below 8 percent, which should work in a lot of people’s numbers all day.

HREB: Will the interest rates begin to affect the market to a greater extent in the near future? The long-term future?

Patchin: I think that’s still a little further off. With respect to development projects, you are going to hopefully have built that in, through the lease rates and everything else, so that increased rates will not hinder the project.

Where you’re going to see higher interest rates be somewhat of a problem is the acquisition market of stabilized properties out there, because they are dealing with existing lease rates and existing expenses, and you can’t change that. So, when cap rates start going back up versus down, where they are now, you’ll see some of those numbers not work as well as they used to.

HREB: In the acquisition and investment market, are you still seeing historically low cap rates?

Patchin: Yes, [the cap rates] in retail right now are all pretty much below 8 percent. We are even seeing some deals go off at a 6 percent cap rate, depending on the quality of the asset.

HREB: And these low cap rates are still not deterring buyers?

Patchin: No, but there are a lot of buyers out there that are starting to sit on the sidelines a little bit because the cap rates are so low. They are looking at the long-term horizon and asking, ‘What if the rates do continue to go up? I am not going to be able to make these numbers change because I am locked into a 5- or 10-year lease.’ So, if the rates do go up, margins will be compressed and it’s not quite as good a deal as it was.

HREB: In recent years, because of the attractive interest rates, many borrowers locked up a low, variable short-term rate as opposed to a longer, fixed-rate. How are they faring now?

Patchin: More people are fixing their interest rates right now, whether it be through a life company loan or a conduit loan. Because of the low-interest rate environment over the last 5 years or so, what a lot of owners were doing was just riding the wave. They were going at a floating rate of interest, because they could borrow at, for the most part, below 5 percent. You just can’t beat that, whereas long-term interest rates were a little higher. So, they were taking a chance and, to a certain extent, some were hedging with derivative products to hedge their interest rate risks, but a lot of them weren’t — they were just enjoying the excess cash flow that they were getting off the difference between a low variable rate and a long-term fixed rate. But, now with rates rising — and this started about a year ago — they are not taking that chance anymore. So, they are going out, with respect to stabilized properties, and trying to lock up a longer term, fixed rate now.

I think [the Midwest retail market] is still going strong. There are a lot of projects still going on. It’s a good market; it’s just taking a little longer for things to get done.

©2006 France Publications, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 554-6054.