In March, Developers Diversified Realty Corp. put a portfolio of 63 assets up for sale. In recent years, such a collection of assets would have been snatched up in no time at prevailing market rates as investors' insatiable demand for retail real estate seemed to know no limits.

But that's not what happened this time around.

In June, Developers Diversifed struck a deal with an unnamed private equity fund that put the portfolio under contract for about 50 basis points above where shopping centers are currently trading, working out to a 7.25 percent cap rate.

Why was the cap rate so high? Joe Padanilam, Developers Diversified's senior vice president of acquisitions believes it was because the assets are largely class-B and class-C assets. And the cap rate illustrates that interest in such properties has cooled. A year ago, he says, the same portfolio would have fetched a 7 percent cap rate or lower.

In fact, Padanilam says the cap rate could have been even higher had the properties been sold on a one-off basis. But because many funds want to deploy large amounts of capital, they are willing to pay a bit of a premium for portfolios.

That's not to say investors are backing off of retail. Far from it, in fact.

While Developers Diversified wrestled with divesting class-B and class-C assets, competition for higher quality properties remains cutthroat. Pricing for class-A assets — especially grocery-anchored strips and power centers in hot markets — is getting more aggressive and some predict that cap rates on these properties may hit new lows.

During the Kimco Realty Corp.'s presentation at NAREIT's REIT Week conference in New York in June, CEO Milt Cooper noted that he would not be surprised if cap rates in areas with high projected population growth, such as the Southwest, moved from the current 6 percent range down to 5 percent or even as low as 4 percent. “On an adjusted basis, cap rates are currently not too low. They have room to go lower,” he said.

When you look at the numbers for retail as a whole, cap rates are holding steady — and even sliding down in some markets and on certain property types. In the first quarter of 2007, retail properties traded at an average price per square foot of $172 and an average cap rate of 6.7 percent according to Real Capital Analytics, near all-time records.

Underneath that a more complex picture is developing. Brokers and investors say a pricing spread between asset classes is working itself back in the market, much as what existed before the run-up in asset values that began in earnest in 2002. For years, cap rates on retail assets moved in concert, dropping across the board with only a very slim spread in pricing between asset classes. As long as it was retail and producing income, investors were willing to fork over their money.

That's no longer the case.

Padanilam, and others, say today there are fewer buyers looking for non-institutional quality retail assets. “In addition to the fact that we've had a pullback on the pricing, we're also seeing pullback in the number of participants,” he says. He believes that Developers Diversified's portfolio, which received only a couple of offers, would have generated interest from 10 or more buyers just 12 months ago.

The main reason for that is debt. The crash in the sub-prime residential mortgage market has had a chilling effect on the CDO and CMBS markets. Investors who got burned by sub-prime backed bonds are not eager to get hurt elsewhere. They are demanding pools with less risk. So conduit lenders that supply the loans to the pools have tightened underwriting standards. Concretely, that has meant an end to 10-year interest-only loans and high loan-to-value deals. And pricing is also going up with some borrowers saying they are being quoted rates 150 to 400 basis points higher than what were available earlier this year.

At the same time, 10-year Treasuries are closing in on their 5-year high. After hovering between 4 percent and 5 percent for a long stretch, they cracked the 5 percent mark in mid-June and were trading comfortably above that level at press time.

“Interest rates are the catalyst,” Padanilam says. “I think the rate movement really woke people up and forced them to realize that there should be a spread between A-quality properties and those that are lower quality.”

Gerard Mason, executive managing director of Granite Partners LLC, agrees. Until recently, asset quality didn't factor as highly into investors' equations. “People justified low cap rates because they were juicing their returns with interest-only money and low interest rates,” he says. Investment decisions were interest rate plays.

And because these sorts of deals were most prevalent on class-B and class-C properties, the market has cooled. Meanwhile class-A, where more all-cash buyers operate, has been less affected. And, if anything, there has been a renewed “flight to quality,” which has kept pricing on A assets steady and even driven cap rates down in some markets.

Anecdotally, brokers say that lower quality assets are trading at cap rates 30 to 50 basis points higher than they were 12 months ago and some believe they have softened as much as 100 basis points in some areas.

“We're seeing much more discernment for the quality of the credit, asset and location,” says Bernard Haddigan, senior vice president and managing director of Marcus & Millichap. “Demand still exists for all properties, but the risk premium is being priced back in for lower quality properties.”

Pricing in upside

Richard Latella, senior managing director and managing director of Los Angeles-based Cushman & Wakefield Inc., says the cap rate spread for different levels of quality is most obvious in the regional mall sector. He estimates that fortress malls would trade at a 4.75 percent cap rate (but none have traded in a while). Cap rates for class-B malls range from 6.25 percent to 7.25 percent, while cap rates for class-C malls range from 8.5 percent to 11 percent.

Latella has also noticed that cap rates for mall properties have softened. “I'd say they're up 25 to 50 basis points compared to 12 months ago,” he says, adding that they could inch up another 25 to 50 basis points over the next six months.

Regional malls, particularly fortress malls, continue to be one of the most sought after property types within retail. However, the small number of assets and the limited pool of buyers means that transaction volume is hardly robust. In 2006, for example, only $5.4 billion worth of malls traded hands, down 37 percent from 2005, according to Real Capital Analytics. On average, malls sold for $135 per square foot with a cap rate of 7.08 percent.

Mall transaction volume will end up much higher this year given the number of lower class portfolios that have either traded or are on the market. In May, Simon Property Group and Farallon Capital Management LLC acquired Mills Corp. for $1.6 billion.

And, in May, Babcock & Brown, an Australia-based investment firm, agreed to acquire Gregory Greenfield & Associates Ltd., an Atlanta-based owner and operator of regional malls. The deal included the purchase of eight malls totaling about 6 million square feet and the management responsibilities for six other properties that Gregory Greenfield managed for third-party investors. The purchase price was undisclosed, but industry experts estimate the portfolio traded at a cap rate in the 6 percent range.

Many of the class-B and class-C deals with value-added components are trading at cap rates that already factor in any upside. “Sellers have become more sophisticated and have recognized that there are so many opportunistic buyers out there that they've started to incorporate the value-added component into the price,” notes Michael Dee, head of Grubb & Ellis Co.'s retail division.

Latella points to the Pyramid Cos.' mall portfolio, which he thinks might trade at a cap rate below 6 percent. Similarly, Reza Etedali, CEO of Reza Investment Group Inc., says he has received offers for value-added mall opportunities with cap rates ranging from 5 percent to 8 percent.

“It's really a case of beauty being in the eye of the beholder,” explains Larry Krasner, a managing director in Jones Lang LaSalle's Los Angeles office. “Some investors are pricing opportunistic deals based on a combination of sustainable going-in yield and the stabilized yield of the future.” Just recently, he sold a regional mall in a secondary market where offers varied by as much as 300 basis points.

Grocers regain confidence

Grocery-anchored properties are also hot. Recent news about Wal-Mart's lackluster sales growth and pullback in new construction has given investors renewed confidence in grocers. “Overall, most market dominant grocers have found a way to compete with Wal-Mart,” Latella says.

The value of a grocery-anchored center is increasingly dependent on the quality of the anchor, with centers anchored by the number one grocer in a given market trading at cap rates far below other centers.

“It really comes down to the strength of the anchor and having the right supermarket in the center,” notes Latella, who was involved in appraising New Plan Excel Realty Trust when Australia-based Centro was doing its pre-acquisition due diligence. He estimates that cap rates for class-A grocery-anchored centers are sub-6 percent.

“Core assets — the ones that have no hair — are selling for very aggressive cap rates,” says Joe French, managing director of Sperry Van Ness. “We see some deals in the New York area trading at cap rates as low as 5 percent.”

On average, grocery-anchored centers were trading at a 6.7 percent cap rate at the end the first quarter 2007, down from 6.99 percent at the end of 2006, according to Real Capital Analytics. The price per square foot increased to $162 per square foot from $156 per square foot over the same period. In 2005, the average cap rate was 7.4 percent and the price per square foot was also $156.

Even a center in a small market can generate a lot of institutional interest as long as it's anchored by a leading grocer, says Jon Wheeler, president of Wheeler Interests, a Norfolk, Va.-based owner and developer. The firm, which owns 26 shopping centers in nine states, has been a net seller over the past 18 months. Currently, it has two properties under contract — one in Houston and one in Richmond, Va.

The Richmond asset, Brook Run Shopping Center, is anchored by a Ukrops, an organic food store similar to Whole Foods Market and a market leader in the city. The center is under contract to a New York-based REIT, Wheeler says, and will trade at a 7.25 percent cap rate. “This anchor really commands a premium,” he explains, adding that it was initially listed at a 7.5 percent cap rate.

Power centers are also popular. Real Capital Analytics' most recent data shows that power centers were selling for $122 per square foot at the end of 2006, an increase of 4 percent over 2005. The centers traded at an average cap rate of 6.32 percent, 70 basis points lower than the average in 2005.

Cushman & Wakefield's Latella confirms that institutional quality power centers are trading at cap rates in the 6 percent range, about 50 to 75 basis points lower than the first half of 2006. However, lower class power centers have seen their value degrade slightly because they lack a concentration of credits and are vulnerable to overbuilding.

Krasner sold Chatham Plaza with top notch credit-tenants in Savannah, Ga. to Kimco. The center, which is located right across the street from a General Growth Properties mall, received 15 offers, he says, with cap rates ranging from 6.3 percent to 6.75 percent.

Like power centers, lifestyle centers are increasingly attractive to investors, although they don't trade as frequently as the other retail property types because of a lack of inventory, Latella notes. At first, investors were leery of lifestyle centers, and as a result, they had higher cap rates than power centers — about 50 basis points higher.

Now, lifestyle center values are consistent with power centers, with cap rates for the best lifestyle centers ranging from 5.75 percent to 6.25 percent, Mason says. He was recently involved in the sale of a lifestyle center in Birmingham, Ala. that had sales per square foot of $350. It sold to an offshore investor at a cap rate just below 7 percent, providing a decent yield since the buyer 5.5 percent note.

However, Mason speculates that had the interest rate been higher, the lifestyle center would not have achieved the pricing it did.

Looking forward, buyers and sellers will probably see even greater separation in pricing between asset classes, according to Padanilam. He predicts that cap rates for clower class properties will soften another 25 basis points by the end of the year.

It all depends on interest rates, French says. “I really believe that if interest rates hadn't moved, the cap rates wouldn't have budged because retail fundamentals are still good,” he notes.

But, all bets are off if 10-year Treasuries move above 6 percent. “If rates move up to that level, I would expect to see cap rates creep up to 9 percent or even 10 percent,” French forecasts. “Otherwise, deals just won't sell.”

French says the looming threat of higher interest rates has made him nervous about several deals he's working on right now. “I have two shadow-anchored properties available in Ohio right now, and the activity is slow because the increased interest rates have eliminated a lot of buyers,” he notes. “I am concerned that we won't be able to achieve the pricing the seller would like. We might even find ourselves in a buyer's market in a few months.”

REGIONAL MALL REVIEW

2002 2003 2004 2005 2006 2007*
Properties sold 127 117 110 108 76 28
Sales Volume $10.7 billion $8.4 billion $5.8 billion $8.5 billion $5.0 billion $2.0 billion
Square Feet Sold 99,862,404 75,699,777 60,240,204 65,156,241 44,281,018 11,319,539
Average $/sf $107 $111 $96 $131 $113 $176
Average Cap Rate 9.40% 8.60% 8.40% 7.90% 7.40% 7.20%
*Year To Date
Source: Real Capital Analytics

Who's Buying?

Institutions, Australians lead acquisition activity.

Institutional investors and Australian buyers represented nearly 60 percent of retail acquisition activity during the first four months of 2007, pushing investment volume to $27.7 billion, according Real Capital Analytics. That volume is more than double the investment activity reported during the same period in 2006.

So far this year, TIAA and Prudential Real Estate Investors are leading the pack on the institutional investor side. Centro Group and Macquarie Bank are the most active Australian buyers.

For their part, Australian buyers have been actively targeting the United States for several years, investing capital from superannuation funds — Australia's state-regulated pension system. With $950 billion under management, these funds are big investors in commercial real estate and have put a lot of that into retail. Overall, they allocate at least 9 percent to real estate.

REITs like Developers Diversified Realty Corp. and Kimco Realty Group accounted for 11 percent of the activity, largely through merger and acquisitions activity and joint venture partnerships. Private buyers represented 22 percent. Private equity funds, so active in other commercial real estate segments, accounted for only 4 percent of the investment activity in the retail sector, choosing instead to focus on acquiring retailers.

The buyer composition in 2007 is radically different from the buyer composition in previous years. In 2006, for example, institutional and foreign investment accounted for 30 percent of acquisitions. The most active investors were private buyers, representing nearly 50 percent of the investment activity.

From 2003 to 2005, REITs and private buyers were the most active investors, according to Real Capital Analytics. In 2003, for example, REITs accounted for 31 percent of the acquisition activity, while private buyers represented 33 percent of the activity. In both 2004 and 2005, REITs accounted for 20 percent or more of the investment volume, while private buyers represented more than 30 percent of the total.
JP