Have retail real estate investors come back around to accounting for risk?

Judging from the latest investment statistics, one might be tempted to say, “No.” According to data from Real Capital Analytics, cap rates on many types of retail are still at or near record lows. The average cap rate on all retail deals in the first quarter of 2007 was 6.86 percent — the lowest figure since Real Capital began compiling data in the fourth quarter of 2001.

Overall, nearly $58.9 billion in retail property changed hands over the 12-month span ending March 31, 2007 — a 17 percent increase over the same span a year prior. And the extremes are even more amazing. The lowest cap rate Real Capital recorded on an unanchored strip center was 3.3 percent (in the West). For grocery-anchored strips it was 4.1 percent (in the Northeast). For single-tenant retail it was 2.7 percent (also in the Northeast).

So it might seem absurd to suggest that investors have discovered a newfound discipline when it comes to buying retail properties. Yet that is exactly what experts suggest is happening. Brokers and investors we interviewed across the country for this month's cover story swear that a spread in pricing is working its way back in the market (see p. 18).

On one end of the spectrum, the investors chasing class-A assets — most of whom are not as reliant on debt and are sitting on piles of cash — are getting even more aggressive. At the other end, buyers of class-B and class-C assets are getting less aggressive.

Well capitalized investors chasing class-A properties have not been affected and continue to acquire with abandon. That has led to speculation that top-quality properties cap rates may continue to fall. So we can expect to see more deals done with 3 percent and 4 percent cap rates.

But at the other end of the spectrum things have suddenly gotten very dicey. Tremors in the debt markets have led some lenders to shut off the spigot of cheap and easy money. It was this debt that enabled some investors to rationalize paying very low cap rates for properties with quite a bit of hair. As long as they could juice their returns with this low debt, they didn't mind taking on some risk. For the most part it paid off. In reality, this meant that many deals were not real estate deals; they were interest rate arbitrage plays.

With the debt picture changing dramatically — by all accounts 10-year interest only loans are disappearing and pricing on CMBS loans have shot up by between 150 and 300 basis points — the types of investors that were absorbing class-B and class-C assets are suddenly thinking twice. The net affect is that the pool of buyers for these kinds of properties is shrinking and the bidding is getting less aggressive.

So the picture is a bit complicated.

What will this mean for the numbers? In aggregate, will compression in cap rates on top-quality properties balance out the effect of increasing cap rates at the lower end?

It's hard to say for sure.

But, regardless of what the numbers say, brokers and investors assure us that the retail investment climate has changed dramatically in just the past few months. Some experts have even speculated that it is turning from a seller's market to a buyer's market and that a lot of owners are already not getting the pricing they wanted or expected with assets put up for sale in recent months.

So if you haven't changed your strategy yet, you better do it soon or else risk getting burned.