Retail Roller Coaster

Investors hang on for what might be a wild ride this year.

Investors are maneuvering quickly to catch up with a retail property market that has done a 180-degree turn in the past year. This once-hot sector has cooled considerably in the wake of the capital markets crisis, the residential real estate slump, and a floundering economy. While investors and brokers are working harder to locate deals amid a more cautious environment, many are finding that ample opportunities still exist.

The fully leased, 80,247-sf Augusta Ranch Marketplace in Mesa, Ariz., sold for $18.7 million in February.

How Did We Get Here?

Turn back the calendar to the May 2007 International Council of Shopping Centers spring convention: “It looked like the retail boom was set to continue,” says Martin P. Forster, CCIM, director of retail investment sales with Pocklington, Pocklington & Forster Retail Investment at Cushman & Wakefield in Orlando, Fla. But by summer’s end, fallout from the subprime residential mortgage meltdown had contaminated the commercial real estate financing sector. The lending crunch was in full swing by fall. “It was looking to be a record year, but things just stopped,” Forster says.

Retail sales volume dropped about 45 percent during 2007’s latter half — from $46.2 billion in transactions during the first six months to $25.3 billion, according to Real Capital Analytics. “It was hard to lock in rates, and there were questions on whether you were even going to get financing. We saw a lot of busted deals,” Forster says. “So it has been a tough environment, and there has been a sense of wait-and-see among sellers.”

Both buyers and sellers are being affected by a tougher lending climate characterized by higher loan-to-value ratios, shifting spreads, and more-stringent underwriting. For example, the sale of the Village at Golden, a 67,000-square-foot retail strip center in Golden, Colo., closed in December 2007. Although the property sold for the original contract price of $6 million, the deal was shaky until the end. “Both the buyer and seller were very concerned about financing going right down to the wire,” says Tom R. Dermody, CCIM, a senior investment adviser with Sperry Van Ness in Monument, Colo.

The Village at Golden, a 67,000-sf retail strip center in Golden, Colo., closed in December 2007 for $6 million, but due to market conditions the deal was shaky until the end.

While the shifting market hasn’t scared buyers away, they are being more selective. “Investors still have an appetite for acquiring property, but buyers are demanding to see more money left on the table by the seller,” Dermody says.

The big question is what lies ahead for the remainder of the year. “At this point, it feels like 2008 is going to be a bumpy road, with slower velocity when it comes to sales activity,” says Bernie Haddigan, managing director of Marcus & Millichap’s national retail group in Irvine, Calif. Pricing probably will remain flat among quality properties in primary markets, while prices in secondary markets and on lesserquality assets are likely to slide an average of 25 to 50 basis points by year-end, he adds.

The Capital Question

A number of dynamics in the retail investment arena have contributed to slower transaction volume. During first quarter 2008, a paltry $3.6 billion in properties changed hands, according to Real Capital Analytics.

Availability and cost of capital are having a huge impact on investment activity. “There is still a ton of money out there looking to buy retail property,” says Joseph C. French Jr., CCIM, senior investment adviser for Sperry Van Ness in White Plains, N.Y. The difference is that buyers are not finding the leverage they had a year ago, which means they need to adjust the purchase price accordingly.

“Buyers are willing to buy, but they want a better return than sellers are willing to do yet,” Haddigan adds. In December 2006, Marcus & Millichap brokered the $105 million sale of a Super Wal-Mart to a buyer who was able to obtain an interest- only, 10-year loan on 90 percent of the value. If the same property was for sale today, it probably would sell for no more than $75 million because the debt coverage ratio available would be so much lower, Haddigan says. A year ago, 85 percent to 90 percent loan-to-value financing was typical compared to the 65 percent to 70 percent ratio that is the norm today.

The credit crunch has created a shift away from the sellers market of recent years. In many cases, buyers are waiting for sellers to adjust pricing to reflect the higher capital costs. Average capitalization rates have been ticking up since second-quarter 2007, climbing from 6.57 percent at midyear 2007 to 6.9 percent in January 2008, according to RCA.

Anecdotally, pricing has shifted more dramatically in recent months depending on the individual property and local market. High demand for class A properties is expected to hold pricing and cap rates steady, while cap rates on some B and C properties have risen as much as 60 to 70 basis points. In addition, many industry experts predict bigger price discounts on lesser-quality deals in the coming year.

Secondary and tertiary markets where prices climbed amid the frenzied sales market now are beginning to see the pendulum swing back toward lower pricing. For example, there was no price differential for buyers who were purchasing a retail power center in Atlanta or a similar property in Birmingham, Ala. “That is not the case now,” Haddigan notes. Buyers — and lenders for that matter — who are going into a secondary market or looking to buy a lower-quality property are going to be much more cautious about that risk and want pricing to reflect that risk, he adds.

Targeting Top Markets

In light of the forecast for slower economic and retail growth in the coming year, investors are working harder to identify markets that will buck that national trend. Cashon- cash returns and cap rates typically are higher in the Midwest than the coastal states and major cities including Los Angeles, New York, San Francisco, and Chicago.

“The upside and appeal in the coastal states and big cities is appreciation. Rents go up and in turn values go up,” says William Hugron, CCIM, SIOR, ALC, senior vice president of Ashwill Associates in Newport Beach, Calif. “The Midwest traditionally does not see the same appreciation as the coastal states and big cities.”

Land-constrained cities with barriers to entry for new retail development and cities that are exhibiting positive employment growth led Marcus & Millichap’s National Retail Index for 2008. The top five markets included San Francisco, San Diego, Seattle, New York, and San Jose, Calif. The index also pointed out cities such as Tampa, Fla., Phoenix, and Riverside- San Bernardino, Calif., that are likely to struggle in the coming year due to their exposure to the housing market and retail overbuilding.

The west Texas market of Lubbock is “white hot,” according to Randy Egenbacher, CCIM, owner of Egenbacher Real Estate in Lubbock. The city’s retail sector has been buoyed by a continued strong local economy and residential market. In fact, the area actually is benefiting from the economic turmoil found elsewhere as investors have turned to markets such as Lubbock in search of stable real estate investments.

“Investors are coming into this market because they are having the same problem everywhere,” Egenbacher says. “They are looking for good deals, and there are so many buyers in the primary markets that those deals are hard to find.” Egenbacher recently sold Mira Vista for $3.1 million. The 25,500-sf unanchored strip center sold in 4Q07 to a private investor at an 8 percent cap rate.

Mira Vista, a 25,500-sf unanchored strip center in Lubbock, Texas, sold in 4Q07 to a private investor at an 8 percent capitalization rate.

Retail Prices and Capitalization Rates

1Q07 2Q07 3Q07 4Q07 1Q08
Average sale price psf $158 $139 $165 $172 $257
Average cap rate 6.56% 6.57% 6.66% 6.73% 6.90%

Source: Real Capital Analytics

“We’re getting calls from a lot of firsttime investors,” Egenbacher says. Individuals who may be new to real estate investment are going to LoopNet or CoStar to check listings and then contacting sellers such as Egenbacher directly. “I think the volatility in the stock market has driven more people our way,” he says. That has been a growing trend over the past few years and is even more apparent now given the decline in the stock market during first quarter, he adds.

Flight to Quality

The capital crunch is creating a divide in the market in terms of quality, as buyers gravitate toward less risky investments. Well-located properties with good credit and national tenants remain popular with investors, while demand for B and C properties is beginning to diminish. “Since money has tightened up, certain property types are becoming very difficult to sell,” French says. C properties, for example, are difficult to sell at any price. Investors still are looking at C properties, but they want very aggressive prices. A year ago, C properties might have sold at an 8 percent cap rate. Now those properties are likely to sell only if the price is greatly discounted.

Many investors are gravitating toward “bread-and-butter” retail properties, such as grocery- or discount-store-anchored community and neighborhood centers that often are perceived as recession proof. “During bad times and good times, people need to eat, and they need necessities,” French says. That demand should benefit neighborhood and community centers that are home to grocery stores, drugstores, and fast-food restaurants.

Investors are eating up fast-food properties, which lead Marcus & Millichap’s 2008 lineup of top-performing single-tenant retail investments. Healthy sales and rising prices are expected this year as consumers seek affordable dining options in an unstable economy.

Wholesale clubs such as Costco posted the only significant sales growth during the month of January with an increase of 6.3 percent, according to ICSC. Department stores and luxury chains posted the biggest declines in sales growth at 5.7 percent and 2.2 percent respectively. U.S. chain stores sales were up slightly in February with same-store sales growing 1.9 percent compared to the previous year.

Demand also remains strong for triplenet- leased properties such as free-standing drugstores and fast-food restaurants. “In the right markets, they still are selling at 6 percent caps, which is amazing to me because the cost of capital is 6 percent,” French says. But those investors typically are cash buyers willing to pay a premium in order to defer capital gains as part of a Section 1031 tax-deferred exchange.

The tenancy-in-common industry also is expected to flourish. A pending exemption from the Securities and Exchange Commission would allow licensed commercial real estate brokers to participate in advising clients in the purchase of TICs packaged as securities. More importantly, real estate brokers would be eligible to collect a consulting fee on those deals. That could represent a lucrative niche for brokers, considering that TICs represent a $3 billion per year industry. Fractionalized ownership with exchange benefits and no management responsibility or negative cash flow appeals to many investors’ goals and objectives, Hugron notes. “It’s a huge opportunity that people don’t really realize,” he says.

Hugron recently represented a client who walked away with $1.7 million in proceeds from the sale of a horticultural nursery. Hugron helped his client roll that money into a 1031 exchange by investing in three separate TIC investments, including a stake in Cutler Bay Towne Center, a recently redeveloped retail center in Miami. The 103,566-sf center is 100 percent leased to tenants such as Office Depot and 24 Hour Fitness and benefits from traffic from the neighboring Publix grocery store. The purchase price was $30.5 million with a projected cash-on-cash return of 6.75 percent.

Other property types such as lifestyle centers may flounder in the more challenging economic environment. In recent years, the high cost of mall construction made lifestyle centers a natural fit for high-end mall tenants looking for new homes. Those also are the tenants that will be hardest hit in a slower economic cycle. “If we have a real recession, people won’t be buying Prada bags and shopping in those high-end stores, which were responsible for driving the expansion of these lifestyle centers,” French says.

In addition, while a groceryanchored center may be the gold standard in some parts of the country, it is not the rule everywhere. “In Southern California since we had a major grocery workers strike a few years ago, the grocery industry has not rebounded,” Hugron says. In addition, consolidation within the grocery industry has resulted in many dark stores in recent years.

National Single-Tenant Transaction Snapshot

Property Location Sales Price Cap Rate Price PSF
Walgreens Gardnerville, NV $6,050,000 6.0% $408
CVS Pharmacy Grand Prairie, TX $3,100,000 7.3% $277
Wendy’s Monrovia, CA $2,754,733 6.5% $1,052
Village Inn Restaurant Cedar Park, TX $2,350,000 7.8% $529
Denny’s Grand Forks, ND $2,025,000 8.0% $447
Applebee’s Louisville, KY $1,859,000 7.5% $425
Checker Auto Parts Phoenix, AZ $1,725,000 6.4% $216
7-Eleven Vienna, WV $1,717,791 8.2% $394
IHOP Jacksonville, FL $1,678,014 6.8% $298
Jack in the Box Santa Cruz, CA $1,666,177 5.2% $706

Source: Marcus & Millichap’s Single-Tenant Outlook

Digging for Values

The down market undoubtedly will focus attention on value-add opportunities — whether that involves squeezing more income from existing properties through renovation or re-tenanting or pursuing opportunities to purchase and reposition struggling properties. “We’re advising our clients to go back and look at each property and give it the attention they haven’t in the last five years because they’ve been too busy racing around doing deals,” Dermody says.

Owners need to look at shortcomings that may exist at a particular property, as well as identify specific opportunities for re-tenanting, boosting rents, and improving cash flow throughout their portfolios. “At least 50 percent of the time there is value in your portfolio that you may have overlooked,” Dermody says.

Some investors may find that now is an ideal time to snap up values in markets that are experiencing a dip. In Greenville, S.C., for example, vacancies dropped about 100 basis points in 2007 to 7.5 percent at yearend. “Expansion activity from a lot of the national retailers and some restaurants is slowing. There are very few announcements of new retailers coming to town,” says Ted Lyerly, CCIM, a retail broker with NAI Earle Furman LLC in Greenville.

That being said, Greenville has been a vibrant retail market over the past five years, and there still is strong investor interest among both local and national buyers. The current market actually represents a good opportunity for aggressive investors who can tolerate higher vacancies. “As with any downturn, there are folks that get pinched financially and it may be time to sell,” Lyerly says. “We are talking to our clients about how this possible downturn will affect them and how to turn the situation around.”

Many brokers are weathering the slower cycle of retail expansion by adapting to the unique dynamics within their own markets. In Dayton, Ohio, for example, retail leasing has cooled considerably, while restaurants continue to fuel deal flow. “The majority of the market activity right now is restaurant driven,” says Kelly E. Gray, CCIM, a vice president at Richard Flagel Realty in Dayton. That activity is spurred by newcomers entering the market as well as some shake-ups among some of the existing concepts.

For example, four restaurants closed during a one-week period in January alone, including a Don Pablo’s, Joe’s Crab Shack, Ruby Tuesday, and an independent operator. At the same time, concepts such as the Melting Pot, Buffalo Wings & Rings, and Sonic Drive-In are all opening new locations in the Dayton metropolitan area. In fact, Sonic has opened eight new locations in the area in recent months.

Restaurant operators are eyeing both lease and buy options, and there is a good bit of vacant second-generation space on the market that remains very desirable. “People are being very picky in terms of what they want, and what they want is an A location,” Gray says. “Rents for all of the available locations are quite expensive, so you need national or very strong regional players to come in and make a move.”

Investors Move Cautiously

The retail sector will undoubtedly take a hit from slower economic growth and fears of waning consumer spending. The most immediate impact of slower retail growth will be on the development side. Developers and retailers are expected to proceed with projects already in the pipeline, but many retailers are putting additional store expansions on hold — at least for the short term. The completion of new retail centers is expected to total 125 million sf in 2008, a 16 percent drop from the 145 million sf built in 2007, according to Marcus & Millichap.

That being said, retail still is performing fairly well and fundamentals remain strong. “Although we are forecasting increased vacancy, it is nothing alarming,” Haddigan says. “Vacancies are moving up slightly, but from a historical perspective, the retail market overall is generally healthy right now.” The average U.S. retail vacancy rate is expected to increase 50 basis points in 2008 to 10.2 percent, following a 90 basis point increase last year, according to Marcus & Millichap. Approximately two-thirds of the space scheduled for completion this year already is preleased.

The current economic climate is more of a caution flag for retail investors rather than anything dire, Haddigan notes. “The market is cyclical. We tend to forget that because we have had such a long run,” he says. “Long term, retail is still a good product type.”

For those investors that can access capital, 2008 may be a welcome year as the intense competition for retail properties loosens up and brings with it more attractive pricing. In addition, some industry experts anticipate that there might very well be an influx of for-sale properties landing on the market in 2008 if real estate investment trusts sell off properties as a means to raise capital and boost profits. If that happens, there could be some additional softening of sale prices.

Brokers also will continue to benefit from strong demand from foreign investors. Since 2002, the value of the dollar has declined more than 20 percent, making U.S. property an attractive buy for foreign investors. Retail properties accounted for more than one-third of major foreign commercial real estate purchases last year, according to Marcus & Millichap.

Cash buyers in particular may benefit from the greater number of distressed properties that are likely to hit the market this year. Some tenants will struggle in a more difficult economic environment. And, for some owners who purchased highly leveraged centers, if they lose a key tenant they may not have sufficient operating income to meet their mortgages. By making contacts with the bankers, accountants, and lawyers, brokers can find owners who may be motivated to dispose of properties quickly. “The message that we as brokers need to take to heart is that the ownership of many of these assets may change hands,” Forster says. “So there is potential for us to address a slightly different clientele.”

Although 2008 may have gotten off to a slow start, many industry observers expect that investment activity will pick up later in the year. The most difficult time for brokers is when there is a pause in the market and pricing is not moving up or down. That’s what happened in the last half of 2007. Now that prices are beginning to move, deal flow is likely to accelerate. “Anecdotally, we’re getting a lot more calls and seeing a lot of buyers emerge and sellers decide this is the moment to sell,” Forster says. “I think that some people will no longer be able to wait and will need to take action on their portfolios whether it’s acquisitions or dispositions.”

Beth Mattson-Teig

Beth Mattson-Teig is a business writer based in Minneapolis.


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