Investors went on a buying spree in the retail sector during the first years of this decade and made a pile of money in the process. As consumers gorged on electronics, luxury apparel and home décor, owners of retail real estate saw their incomes rise and the sale prices of their properties soar — drawing even more investment dollars to the category.

Retail reigned as the top performing property type in commercial real estate from 2002 through 2004, racking up total annual returns of 17.9 percent versus 10.1 percent annually for all commercial real estate, according to the National Council of Real Estate Investment Fiduciaries (NCREIF). In 2004, retail achieved its highest return ever, 22.95 percent, according to NCREIF data.

But retail is no longer the darling of real estate investors. While retail properties posted a return of 16.19 percent in the 12 months ended Oct. 31, it had the lowest return of all five core sectors, according to NCREIF. The hotel sector was the strongest with a return of 22.63 percent (see chart, p. 30). The office sector, the largest class of commercial property, followed with a return of 17.27 percent.

Recent surveys by the Real Estate Research Corp. and CCIM confirm that retail has lost its allure. On a scale of 1 to 10 (with 1 being the lowest), industrial warehouse and apartment sectors received the best ranking, at an average of 6.3. Of all the core sectors, retail earned the lowest ratings — neighborhood/community centers: 5.6; power centers ranking: 5; and regional malls: 4.6 (the lowest of all property types).

In fact, when questioned as to which was the worst-performing commercial real estate sector, one of the institutional survey respondents stated, “None are terrible, but there is not much upside left for retail.” No respondents saw retail as a strong investment, and nearly all of them indicated that the problems with the sector stemmed from decreased consumer spending, overbuilding and overpricing.

“The retail property market has peaked in terms of both NOI growth and value,” says Allan Billingsley, director of research at RREEF, Deutsche Bank's U.S.-based real estate investment advisor. “Apartments, industrial and office, still in the growth phases of their market cycles have more room to grow and are outpacing retail properties.” In comparison, retail properties are “aggressively priced,” according to Billingsley.

Even though cap rates have begun to budge from the historic lows set in 2005, Billingsley and other market watchers predict there will be little action in the sector until investors see more upside potential. Rising interest and inflation rates, along with the softening housing market, decreased refinancing activity, and volatile energy prices, have reduced consumer spending and have eroded demand for new retail space.

Yet, there is a wild card for retail investing in 2007: The massive pile of private equity stalking real estate. So far, private-equity giants have focused on retailers, rather than retail real estate (see Barbarians at the Mall in our Septmember issue). But the appetite for prime real estate holdings among private investors seems boundless: In late November the Blackstone Group announced plans to acquire the nation's largest office landlord Equity Office Properties, for $36 billion, including the assumption of $17 billion in debt (see sidebar, p. 33). Indeed, news of the Equity Office buyout sent shares of other public REITs — including retail giants Simon Property Group and Kimco Realty Corp. — soaring nearly 3 percent, while the S&P dipped .05 percent.

Retail not invited

While the private equity binge is helping drive the biggest deal year ever in commercial real estate, this is a party to which retail has not been invited. The volume of retail property transactions has dropped for four straight quarters. As of the end of October, the year-to-date tab was $29.6 billion, 20 percent lower than at the same point last year, according to data from Real Capital Analytics.

Now, instead of hearing tales of how overeager investors are bidding up prices and driving down cap rates, brokers are talking about a rising inventory of product for sale. Roughly $9 billion worth of retail properties were available during the third quarter 2006, compared to the $6 billion available at the same time last year.

In the third quarter of 2006, cap rates across the nation remained flat from last year — making this the first year in a while in which cap rates didn't drop. Cap rates range from 6 percent to 6.25 percent in California to 6.5 percent to 6.75 percent in the coastal markets of Seattle and Boston and the high growth markets like Phoenix and Las Vegas. In less supply-constrained markets such as Houston, Chicago and Atlanta it was 7.25 percent to 7.75 percent.

Moreover, cap rates for new retail offerings are higher than those on closed deals, which will likely cause cap rates to increase 25 to 50 basis points in 2007. That may be good news for buy-and-hold investors. But rising cap rates could spell trouble for more speculative buyers, who levered up on pricey mezzanine debt to complete deals. “We're alarmed about them because we think that people may have bought properties assuming that cap rates would drop much lower,” notes Dennis Yeskey, national director of Deloitte & Touche LLP's Real Estate Capital Markets practice. Now, he says, investors can't live off of cap-rate compression. “Investors are going to have to have some real operating experience.”

Indeed, making money the old-fashioned way — off of retail operations — may become more challenging in 2007 as well. RREEF's Billingsley expects retail sales growth to average between four percent and five percent annually over the next several years, while rent growth will be in line with inflation — about 3 percent to 4 percent annually.

And, with a significant increase in new product coming to market, retailers may have more negotiating power, keeping a lid on rent increases, speculates Sam Chandan, chief economist at REIS Inc.. Retail construction starts reached 300 million square feet this year, just a slight dip from 306 million square feet in 2005. (See our development supplement beginning on p. 34)

Roughly 6.6 million square feet of retail space was added to the market during the third quarter of 2006 alone, a big jump from the previous quarter's 5.4 million square feet, according to REIS. Also, during the third quarter, absorption declined to 4.1 million square feet from 5.5 million square feet during the second quarter of 2006. That's the lowest level since the first quarter of 2004.

“Operators have had to offer slightly greater concessions in two of the last three quarters, and effective rents have been growing at a fractionally slower rate than asking rents,” according to Chandan. During the first nine months of 2006, asking rents climbed by 2.8 percent, while effective rents rose 2.5 percent.

In this environment, says Susan Stupin, CEO of the Prescott Group, a New York-investment bank, “to achieve any upside, investors are going to have to work very hard and roll up their sleeves on the leasing and management.”

No more portfolio plays?

A big factor in the drop of 2006 sales volume stemmed from the lack of big portfolio deals in the first nine months of the year. Through September, $5.4 billion of retail portfolio sales had closed — a 50 percent drop from a year ago.

Single, one-off, transactions will continue to dominate the retail investment market in 2007, according to analysts. Yeskey expects that nearly 80 percent of 2006's investment activity will be single deals.

Cedars Shopping Centers, for example, is growing its portfolio through single transactions. The Port Washington, N.Y. — based REIT has closed on nine grocery-anchored properties totaling 1.9 million square feet so far this year — and none of them have been portfolio transactions, according to CEO Leo Ullman.

Ullman says that the strongest competition for retail assets came from non-REIT investors in 2006, and he expects that trend to continue into 2007. “As long as rates stay below 6 percent, other investors have the advantage over REITs because they can put on greater debt,” he explains.

Many players expect pension funds, advisors and life insurance companies will pursue retail properties more aggressively in 2007. And, toward the end of 2006 that began to come to fruition. Several big deals were announced including Developers Diversified Realty Corp.'s agreement to acquire Oak Brook, Ill. — based Inland Real Estate Investment Trust for $6.2 billion. That followed Kimco Realty Corp.'s acquisition of Pan Pacific Retail and Centro Watt purchase of Heritage Properties. All the deals included some private money.

But theses big, non-REIT investors are cycling capital toward retail not because they see an upside, but because they need to balance their holdings. “These investors are generally under-allocated to retail and they have significant money to invest,” says Scott Wolstein, CEO of Developers Diversified Realty Corp.

Developers Diversified itself teamed with TIAA-CREF Global Real Estate in early November to purchase $3 billion worth of retail assets acquired as part of Developers Diversified's $6.2 billion buyout of Inland. TIAA-CREF also teamed with Weingarten Realty Investors to take an 80 percent stake in a $325 million, 1.3-million-square-foot portfolio of seven strip center properties in Florida (see Traffic Report, p. 12).

“We've talked to a lot of institutional investors, and they've realized that they're over-weighted in office and industrial, so now is the time to start balancing their portfolios by adding some retail,” agrees Greg Maloney, president & CEO of Jones Lang LaSalle Retail.

Activity has also been inconsistent across property types.

There were far more deals involving urban retail properties and net leased properties in 2006, and investors will be most interested in acquiring those types of assets in 2007, Stupin says.

Lifestyle centers will also be attractive, says Maloney. “Very few lifestyle centers have been brought to market, which makes them even more appealing,” he explains. “But, in 2007, some lifestyle center developers are going to want to take some profit off the table, and they're going to sell their centers.”

In contrast, investors in 2006 have largely backed off regional malls. Volume on those properties has dropped 53 percent. Volume on strip centers, meanwhile, is down 20 percent, according to Real Capital.

Maloney notes that few class A and B regional malls traded in 2006, but it's hard to say whether investors viewed mall properties as less attractive assets. Most REIT, non-REIT institutional owners and private owners chose to hold on to their malls rather than put them on the market, he contends. As a result, the supply of regional malls was far smaller than it has been over the past couple of years.

At the same time, demand for malls softened because the regional mall REITs that have been the acquirers — General Growth Properties, Macerich and Simon — are still working through the acquisitions they made in 2004 and 2005. GGP, for example, is showing signs of heartburn as it continues to digest the Rouse Co., posting lackluster results during each of the past three quarters. In fact, the REIT's performance, along with a debt load much greater than its peers, compelled Wachovia Securities' analysts to downgrade it.

For the third quarter 2006, GGP posted a loss of three cents for earnings per share — the same as in 2005 — while funds from operations per share was 65 cents compared to 71 cents for the same period in 2005. The REIT blamed its performance on the inability to sell Rouse's extensive land holdings as quickly as it had anticipated. Meanwhile, Macerich's financial performance has been weak for several quarters, coinciding with its acquisition of Westcor.

This is exactly where private equity could enter the fray. Their modus operandi has been to buy what they regard as undervalued companies. Some suddenly struggling mall REITs could fit the bill, especially those with high-quality assets but mid-priced stock.

Short of a private-equity raid, Maloney expects investment activity for class A and B malls to be minimal. However, he figures that a number of Class C regional mall properties will trade in 2007, as REITs divest underperforming assets and other institutional investors reach the end of their holding periods.

Class C malls in secondary or tertiary locations will be attractive as redevelopment opportunities, but not necessarily to REITs. For example, Steiner + Associates is redeveloping the Coliseum Mall in Hampton, Va., a 1960s-era enclosed mall into Peninsula Town Center, an open-air, mixed-use center.

Pulling the threads together makes for a complicated picture in 2007. On the whole, retail investment should slow as prices stabilize or drop, fundamentals slow, questions about the consumer swirl and other property sectors race past retail in investors' eyes. Is that for sure? No. But that's what makes this industry fun, right?

Private Equity Buyouts Nearing?

Private equity took another big bite out of the retail business when an investment group comprised of Bain Capital Partners, LLC and Catterton Partners offered $3.2 billion to buyout OSI Restaurant Partners Inc., the company that owns and operates the Outback Steakhouse and Carrabba's Italian Grill.

Is retail real estate the next item on the private equity plate? Industry experts say it's more than likely — just look at the splash they've already made on the rest of the real estate industry as office, apartment, industrial and hospitality REITs have all been taken private. Most recently, Blackstone Group reached a deal to acquire giant office REIT Equity Office Properties for $36 billion in cash and debt in the biggest real estate deal ever. The message is crystal clear: if Equity Office, the second largest REIT in the U.S., can be bought, than any REIT is fair game.

“In the U.S., we'll see a continuation of the privatization of REITs, and there's certainly interest in retail REITs,” says Dennis Yeskey, national director of Deloitte & Touche LLP's Real Estate Capital Markets practice. He says that private capital is searching for retail REITs that are undervalued based on the quality of their real estate.

Private equity has already stepped into the retail REIT sector through niche plays, points out Chris Volk, CEO of Phoenix-based REIT Spirit Finance. GE Capital Solutions, for example, is acquiring Trustreet Properties Inc., a REIT that focuses on net-leased restaurant property, while DRA Advisors took Capital Automotive Realty Trust private last December.

“It's very difficult for a sector-centric REIT to grow,” Volk says. “They tend to be candidates that are ripe for mergers and acquisitions.”

But, Greg Maloney, president & CEO of Jones Lang LaSalle Retail, isn't so sure that “pure” retail REITs like Simon Property Trust and Developers Diversified Realty Corp. are candidates for privatization. “In the other deals, the REITs have been broken up and sold off because the real estate was worth more separately,” he explains. “I think the market has placed a pretty good value on retail assets, so I am not sure what kind of opportunities exist. It may be a matter of just finding the right deal.”
JP