Despite grim news in the US retail sector, all is not doom and gloom for investors. There are bargains to be had and innovative retailers are still identifying development potential. Stephanie Schwartz-Driver reports

The spreading economic recession has encouraged Americans to increase their savings and cut back on spending. While the personal savings rate rose to its highest point in six years, personal spending was also down. The ramifications for US retailers are clear, and their woes are spreading not only to their landlords but also to institutional investors with exposure to retail properties.

As Americans cut back on discretionary spending, retail sales declined in January for the fourth consecutive month, according to figures released by the International Council of Shopping Centers (ICSC) and Goldman Sachs. January's 1.6% fall was bolstered by positive results at Wal-Mart (which represents more than half the index). If Wal-mart figures are excluded, sales actually fell 4.8%. Upmarket retailers were hit the hardest: same-store sales declined nearly 24% at department store Sachs and close to 20% at youth-oriented fashion chain Abercrombie & Fitch. Even clothes giant Gap is feeling the pinch, with same-store sales also declining around 20%.

On the other hand, discount retailers, such as Target or Costco, fared better than most, with same-store sales down by 2.5%, again excluding Wal-Mart. (At Wal-Mart, sales were actually up in January 2.1% over the previous year.) And while sales of discretionary goods are down, other sectors, such as grocery stores and drug store chains, where sales actually climbed, are doing well.

When retail sales fall, lower rents and higher vacancy rates result. "At the property level, this deterioration in fundamentals has put pressure on cash flows this year," says Suzanne Mulvee, real estate strategist at Property Portfolio & Research (PPR) in Boston, Massachusetts. "While centres with institutional owners tend to have better credit tenants, even those chains are getting hit."

It is those chains that have the leverage to negotiate with their landlords for lower rents. PPR is projecting that US retail rates will decline around 6% in 2009, on a year-over-year basis, following on from a 4% decline in 2008.

At the same time, vacancy rates are expected to reach new highs: "rates we have not seen since the early 1990s", says Mulvey. This is due to a combination of factors, including chain bankruptcies and store closures - ICSC estimates there could be up to 73,000 store closures nationally during 2009 - as well as the record level of retail construction completed in 2008. In a record high for 25 years, 147m square feet of new retail space was built in 2008.

Mulvee points out that the news is not all gloomy, however. "The silver lining is at the actual property level itself," she says. "Class-A properties will hold up better, because of location."

But despite value, transaction volumes are way down, especially for big properties. "When you look at the transaction numbers, people are running away from retail," Mulvee says.

Only five malls valued at $5m (€3.86m) or more sold in the second half of 2008, compared with 68 malls during the same period the previous year. There are some signs that the market may improve somewhat in 2009, as the size of investment sales transactions has increased somewhat - January saw some deals creeping above the $20m range. However, most of the deals closed at significant discounts to the asking price. "There will be opportunities in the next year to pick up good quality properties at reasonable prices," Mulvee notes.

Grocery sales have also held up well, Mulvee points out, although they do not contribute as much to the revenue stream as inline tenants. However, they do represent one sector that is expanding, notes Gregory Gunter, co-founder of 3rd Works, a retail development services firm.

There is development potential on two fronts. Some regional grocers, such as Wegmans, are expanding, although they are not as valued from the credit side as other kinds of stores. At the same time, some national and international retailers, such as Tesco, Carrefour and even Wal-Mart are exploring the potential of smaller-format stores throughout the US.

Tesco's Fresh & Easy, based on a successful British model, has been a huge hit in the US, where consumers have been attracted to the 930 square metre (10,000 square feet) stores, despite their limited product range. Wal-Mart has also been experimenting with the format in its Marketside stores, which at around 1,400 square metres (15,000 square feet) are approximately 10% the size of the usual Wal-Mart superstore; four small-format stores have opened with initial plans for a total of 60.

One advantage of these smaller format stores is they can be built in infill locations, Gunter says. "Inland empire locations are suffering badly as residential areas are hit by repossessions, and grocers are closing down for the same reason. In infill locations, where the trade market remains stronger, retailers enjoy better odds for weathering economic downturns," he explains.

For the same reason, retail is a crucial component of mixed-use developments. "Retail is the primary driver of mixed use that makes it successful," Gunter says. "It's the glue that strengthens the desirability of other components of mixed-use." In fact, mixed-use represents the biggest growth area for retail, especially as the market for new standalone retail is slowing dramatically.

Historically, mixed-use developments in the US market have not been vertically integrated as they would be in Europe or South America. Often the lead developer in the US will keep the retail then spin off the residential or office component to another developer. This practice evolved in part to suit the commercial mortgage backed securities (CMBS) market, which preferred easy-to-rate tranches.

"We may see that change as the CMBS market will not be a viable component for some time," Gunter says.