The retail vacancy rate for the first quarter of 2008 was 7.7 percent, with strip centers and regional malls at their highest vacancy levels since 1996 and 2002, respectively, according to Reis, Inc. data. By the second quarter, Marcus & Millichap, a national real estate firm based in Washington, D.C., posted predictions of a 10.2 percent vacancy rate for the year.

However, retail REIT analysts aren’t buying these gloomy predictions. “The vacancy forecast is irrelevant,” Moore says. “Retail is not a commodity. There are good assets and bad assets, and they are all figured into those averages. I pay little attention to them.”

The bottom line, Moore says, is that “business is very good for existing assets, and retailers will continue to take space at quality locations.”

Where retail malls are feeling a bit of a pinch is with lower quality, less productive space in less attractive markets. “That’s where we are starting to see a pullback in demand,” says Christy McElroy, senior analyst and head of REIT equity research with Bank of America Securities. “High productivity space—producing more than $600 a square foot in a desirable mall in a top city—there’s no problem in leasing it.”

Shopping centers anchored by grocery stores are holding their own. However, strip centers of smaller shops with local and regional owners are pulling back, pushing up the vacancy rate in some centers, McElroy says. She expects big box chains to close more stores this year but sees continuing good demand in urban and infill shopping centers with higher barriers-to-entry.

Retail Snapshot
*	Sector's total market capitalization is $76,645,168,000, the largest of any REIT sector.
*	REITs own ¼ of the retail industry, the highest penetration among all REIT sectors.
*	Kimco Realty Corporation (NYSE: KIM) is the largest retail REIT overall, owning 630 properties with a total market capitalization of $5.6 billion.
*	Developers Diversified Realty (NYSE: DDR) is the largest grocery-anchored shopping center owner with 205 centers and a total market cap of $2.4 billion.
Source: 123jump.com and NAREIT

Supply Slowdown

The combination of softening demand from retail tenants, stiff credit requirements and the resulting decline in development yields will keep new retail development constrained for the rest of the year.

As an alternative to growth by development or acquisition, retailers are pursuing better opportunities to grow internally through strategies such as increasing margins and closing unprofitable stores, Donnelly says. As a result, the demand for new space will continue to be modest at least through the rest of 2008. Retail REITs are responding by postponing opening dates for new shopping centers and scaling back the scope of their projects.

Stricter lending rules are the other force affecting development. Bank requirements for pre-sales and pre-leasing levels are so high that even the most experienced developers find them challenging, analysts report. “Instead of 10 percent or 20 percent, banks want 60 percent of a new project leased before a shovel goes into the ground,” McElroy says.

That’s not to say that retail REITs are pulling back completely. Retailers will still want to expand in high productivity areas, but at a lower velocity, she says. “We will continue to see a pullback on expansion plans, but not a complete stop. It’s still about asset quality and location.”

In the newly restrictive credit market, large loans—more than $150 million—for development have the strictest underwriting requirements. This is more of a restraint on regional mall REITs than shopping center REITs due to the nature of their projects. “However, the big players with lease commitments in major markets can still get financing,” Donnelly says.

Taylor agrees that the top retail REITs can readily obtain financing if they are willing to pay the higher cost of capital. “These are companies with strong balance sheets, high quality assets and solid management teams. They still have access to capital if they want it,” he says.

Even so, analysts expect that retail REIT construction starts will be down for the rest of 2008 as the sector reaches the peak of the construction cycle that started two years ago. This constrained supply growth, however, will not support strong occupancy and rental growth because of the underlying economic conditions, Moore notes. “This time, the advantage is tipped toward the retailer,” he says.

Meanwhile, REITs unwilling to risk development exposure at this time are embracing redevelopment as a growth strategy. “Shopping centers and malls are being redeveloped to add value, particularly as they get space back from department store consolidations,” McElroy says. Simon Property Group (NYSE: SPG), for example, will spend $450 million upgrading its 20 New England malls over the next two years.

Even more than renovation, converting shopping centers and older malls to lifestyle centers, such as mixed use, open air shopping centers with plenty of greenery and pedestrian areas, will continue to be a popular trend in retail. Retail REITs are transforming existing properties into lifestyle centers in every region of the country, as they continue to focus on strategies to enhance profitability of existing real estate.

At this halfway point in the year, Moore believes retail fundamentals will remain solid for the balance of 2008. “The sector is a little softer than in 2007, but the difference is in growth, not the heart of the fundamentals,” he says. “The general health of the sector is high, and retail REITs will continue to be a good defensive play for investors.”