2013: The year retail rebounds?
By Gary Glick, partner, Cox, Castle & Nicholson LLP
Absent a major upheaval caused by the inability of our politicians in Washington to reach reasonable compromises on debt reduction and the debt ceiling, 2013 could finally be the year when the economy starts to pick up a more significant amount of momentum. It will not be substantial, but with housing and job growth continuing to rise, we may finally start to see the “seeds” of new retail development and the return of may retailers to the marketplace. This could eventually lead to the return of capital to secondary and tertiary markets.
2012 turned out to be a year of slow but incremental growth for the economy; albeit one that was dominated by the presidential political campaign. Employment gains continued at a reasonable if not robust pace, picking up towards the last few months of 2012. The stock market surged, and Europe seemed to have the wherewithal to avert any major sovereign debt crisis. Retail sales for November and December increased about 3% over the same months for the prior year despite hurricane Sandy. Consumer confidence showed signs of growth. According to the ChainLinks Retail Advisors U.S. National Report (the “Report”), the “Conference Board’s Consumer Confidence Index (CCI) reached 73.7 in November 2012. While this remains well below the historical average of 95.0, it is the highest level of consumer confidence recorded since February 2008 when it measured 76.4.” The other major development of 2012 was the “uptick” in the residential housing market. Among numerous commentators, Wall Street seems convinced that the housing depression is over for good: An index of 11 major builder stocks rocketed 80% in 2012 to the highest level since mid-2007. It is ironic to note that the real estate sector that plunged the U.S. into recession may be the sector that is most influential in leading to a recovery in the retail industry.
The biggest obstacle in the way of economic recovery may be our representatives in Washington. Although they were able to avert the first potential “fiscal cliff” crisis by reaching a “last minute” agreement on preventing tax increases most Americans in 2013, it is still incumbent upon them to reach an agreement which would begin to bring down the ever ballooning national debt. To do so, they must avoid the potential devastating impacts of sequestration and a government shutdown or credit rating downgrade in connection with a stalemate over increasing the debt ceiling to pay for already accrued governmental expenditures. Though it has been endlessly politicized, the impact of a government shutdown or credit rating downgrade could be a significant enough shock to the economy that could slide the United States economy back into a recession. However, since the remaining “fiscal cliff” issues are “man-made,” we will assume for the purposes of this Article that the politicians in Washington will show some level of responsibility and fashion a compromise with respect to these issues that will not lead to economic calamity.
As stated in the report, “Retailer expansion in 2013 is still about ‘the sure thing;’ urban over suburban, Class A and B over Class C, and locations with greater population densities and higher income demographics still winning out most of the time.” The same can be said for capital. For the most part, capital in 2013 will chase Class A properties, developers with proven track records and housing and population densities. As was the case in 2012, significant capital was available in the market for the purchase of income producing retail properties meeting these criteria. With interest rates at historical lows and the stock market continuing to show volatility, “cap” rates for these properties remained at historical lows. Also driving investment sales in fourth quarter 2012, was the fear of property owners that capital gains rates would rise in 2013 (which, in fact, they did). Title companies reported more volume in the fourth quarter of 2012 than at any time since 2007. We expect interest rates to continue to remain extremely low for at least the next two to five years, leading to more of the same with investment sales. The only significant change may be the return of capital for less than Class A properties as the economy continues to improve. However, as of this date, although assets in secondary cities and tertiary markets offer greater yields, they continue to be outside the risk/reward threshold of a majority of the investment community.
With respect to the debt markets, lending will have many of the same characteristics we are seeing with investment sales. According to 2013 Emerging Trends in Real Estate (published by the Urban Land Institute and pwc) (“Emerging Trends”), “good assets with solid income streams and good credit borrowers will have no trouble attracting financing from life insurance companies and banks eager to choose from the pick of the litter. As markets improve, more properties will enter this worry-free zone, and rich-can-get-richer mortgagors [will] lock in ‘exceptionally cheap money.’ But players with bad credit and/or marginal assets, who need capital infusions to keep afloat, [will] continue to find themselves cast aside or placed in extend-and-pretend limbo. ‘It is still the best – and all the rest.” In this environment, lenders will continue to hold onto a significant number of underperforming loans. However, as housing continues to strengthen and a market begins to become available for more than Class A properties, some of this product may start to reach the marketplace.
In 2012, portfolio banks continued to lend but remained cautious about underwriting standards and sponsors. Most new loans continue to chase “core” properties in top tier geographic regions. With no secondary market, these banks continue to “lay off” some of the risk of larger loans by bringing in participating banks or co-lenders. Banks are still in no rush to sell distressed assets and take losses.They will continue their preferred strategy of extending many loans with modifications rather than refinancing or disposing of them. As in 2012, they would rather wait for more promising opportunities and avoid balance-sheet issues until markets improve. It is interesting to note that many of the underwater assets of these banks may be among their highest yielding assets as long as these loans remain current. Much like in 2012, typical loan to value ratios for bank permanent loans will range from 50% to 70%. Terms will be short – typically in the 5 to 10 year range with amortization over 30 years, and interest rates will be in the vicinity of 1.5 to 2 basis points over the 10 year treasury yield. Interest rate swaps will continue to be required of many borrowers as a hedge against significant interest rate fluctuations. Banks will also make construction loans to preferred sponsors with development deals in densely populated “top-tier” markets. However, significant pre-leasing will be required. These loans will be short term (i.e., 3 to 5 years), will require significant equity (20% to 40%), will be recourse, and will typically have interest rates in the vicinity of LIBOR plus 3%, with a “floor” in the neighborhood of 5%.
Life insurance companies remained extremely active in 2012, and will continue to be active in 2013, especially without any significant increase in the CMBS market. As with banks, the underwriting of life insurance companies will remain very strict since they have plenty of options available to them. They will continue to originate record volumes, usually with high-credit clients, and with loan-to-value ratios of around 65%. The life insurance companies are not as concerned about values as they are cash flows. Life company loans will continue to be predominantly permanent loans with terms between 5 and 10 years. They will be non-recourse loans with fixed interest rates between 3% and 5%, and with amortizations between 25 to 30 years. It should be noted that some of the life companies are beginning to require floating-rate debt to hedge against the current low-interest rate environment. The life companies will continue to confine their lending to Class A assets in “top-tier” geographic regions. Unfortunately, they will not fill the lending void in helping troubled borrowers owning Class B or C properties.
CMBS originations continued to remain tepid in 2012, especially compared to the ten year period before 2008. With more stringent regulations and not much capital chasing Class B and C assets, commentators do not see any major strengthening of the CMBS market in 2013. As stated in Emerging Trends, “the CMBS market may need to confront bigger obstacles in order to rebound. Although most interviewees contend that a properly functioning mortgage securities engine is necessary for liquidity in the real estate capital markets, they also express serious concerns about the failures to address evident problems in CMBS underwriting, regulation, ratings and servicing since the marked collapse at the depths of the credit crisis. The problem for bond buyers remains: the people running CMBS shops have ‘shuffled around,’ underwriting is only marginally better, originators and issuers ‘don’t have enough skin in the game’ for an alignment of interests, the rating agencies still get paid by the issuers, and ‘attitudes haven’t changed.’ In short, ‘nothing meaningful has happened’ to correct the problems, which sent bond buyers running to the exits.”
As in 2012, mezzanine debt and preferred equity will remain plentiful for Class A assets since the returns achieved by these investors far exceed anything that can be obtained on the traditional debt side, although the risks to these investors are considerably greater. This money is necessary for borrowers to meet the stricter equity requirements of lenders and for refinancing or restructuring existing debt. However, this capital will continue to come at a high cost – projected “equity-like returns” in the 9% to 12% range.
Gary Glick is a partner in the Los Angeles office of Cox, Castle & Nicholson LLP. He specializes in shopping center development and retail and office leasing, generally representing shopping center, office and commercial landlords, as well as major tenants.
CVS Caremark bullish on international opportunities
WOONSOCKET, R.I. — CVS Caremark executives expressed optimism Wednesday morning as the company posted record fourth-quarter results, raised its 2013 guidance and continues to work to leverage its distinctive business model to help people on their path to better health amid a rapidly changing healthcare environment.
“We are very pleased with the strong results we posted in the fourth quarter and full year 2012 with solid performance throughout the enterprise,” CVS Caremark president and CEO Larry Merlo told analysts during Wednesday morning’s conference call. … Our fourth-quarter results reflect strong performances at the high end of our expectations in both the [pharmacy benefit management] and retail segments.”
The quarter exceeded the high end of the company’s guidance by 3 cents per share.
Net revenues for the fourth quarter ended Dec. 31 increased 10.9%, to $31.4 billion, up from $28.3 billion in the three months ended in the year-ago period.
Income from continuing operations attributable to CVS Caremark for the quarter increased 2.7% to $1.13 billion, compared with $1.10 billion during the year-ago period.
During the call, CVS Caremark told analysts that late last week it closed on the acquisition of privately held Brazilian drug store chain Onofre. Merlo said the acquisition of the 44 stores is not financially material to CVS Caremark; however, it does mark CVS Caremark’s foray into the international drug store space.
“As you know, we have been exploring opportunities for possible international expansion, and we have said many times that our approach would be measured and we would exercise financial discipline,” Merlo said. “We believe this acquisition is a great example of that strategy and action.”
According to Merlo, Onofre has a strong reputation in the marketplace and is successful in tailoring its stores to market to different customer segments.
“We view Brazil as an attractive market given that health care and pharmacy are expected to grow double digits for the next decade, and while chains are prevalent, it is still a highly fragmented market. So, we see nice opportunities to grow the business over time,” Merlo said.
It has been reported in published reports that Onofre is the eighth-largest drug store chain in Brazil in terms of revenues, posting gross revenue of BR1.2 billion in 2011.
As for the retail business, Merlo said the company had “a very strong quarter” with same-store sales increasing 4%. Pharmacy same-store sales also increased 4% as front-end same-store sales increased 3.9%. Revenues in the retail pharmacy segment increased 5.1% to $16.3 billion during the fourth quarter.
Merlo noted that quarter benefited slightly from flu-related scripts, and flu shots increasing during December, as well as the retention of scripts gained during the Walgreens and Express Scripts impasse. As expected, CVS Caremark retained at least 60% of the scripts gained during the impasse, and it expects to continue to retain at least 60% of the scripts in 2013.
Eager to touch upon the company’s ExtraCare loyalty program, Merlo told analysts that the program continues to be a “key differentiator” with the scale of the program increasing dramatically in 2012 despite increased competitive activity in the loyalty program space.
“Increased engagement of our ExtraCare members is driving meaningful results. As an example, we have doubled our email program to more than 15 million active participants. Many have received over 60 million personalized email offers; that’s up 69% versus the prior year,” Merlo said. And its ExtraCare Beauty Club program now stands at about 11 million members.
Meanwhile, the chain announced Monday the launch of the ExtraCare Pharmacy & Health Rewards program, which allows members to earn larger and more frequent rewards when filling prescriptions or making healthy decisions, as well as providing another choice for members and giving them the ability to opt-in to parts of the program most relevant to their needs and preferences.
“While ExtraCare has been in the marketplace for 15 years, I think these [enhanced programs] are examples of how we are not sitting still,” Merlo said.
Given its solid results throughout the enterprise, the company raised its earnings guidance for the full year 2013 to reflect the anticipated 2 cents per share of EPS accretion related to the debt tender and refinancing that was executed during the fourth quarter of last year. The company currently expects to deliver adjusted EPS of $3.86 to $4 and GAAP diluted earnings per share from continuing operations of $3.61 to $3.75 per share in 2013. The company confirmed its 2013 free cash flow guidance of $4.8 billion to $5.1 billion, and its 2013 cash flow from operations guidance of $6.4 billion to $6.6 billion. These 2013 guidance estimates assume the completion of $4.0 billion in share repurchases.
Kmart, Essence help empower African Americans
HOFFMAN ESTATES, Ill. — Kmart has partnered with Essence Magazine‘s finance expert, Tanisha Sykes, for the sixth-annual Share the Word campaign to provide financial empowerment to African-Americans.
"Financial empowerment is extremely important within the African-American community," Sykes said. "This year’s Share the Word campaign will provide the tools, information and resources to help pave the road to financial success."
Kmart will use social networking platforms such as Twitter, Facebook and its own shopyourway.com website, where Shop Your Way loyalty card members can enter a sweepstakes to win tax preparation services from Jackson Hewitt. The campaign will close on Feb. 23 with an in-store event in Hyattsville, Md., including interactive financial discussions, special discounts for attendees, prizes and giveaways.
"Kmart embraces diversity and inclusion throughout the year," Kmart interim chief marketing officer Andrew Stein said. "We are always looking for ways to reach our audiences with programs that resonate and provide value."