While other sectors in commercial real estate saw transaction volume sink last year, anybody in the retail end of the business will tell you that 2002 was a banner year. Sales of multi-tenant shopping centers jumped 21.8% to 2,500 deals and the volume in single-tenant transactions climbed 9.5% to 2,340 sales, according to a national retail investment market analysis conducted by Encino, Calif.-based Marcus & Millichap. Total dollar volume for shopping center transactions reached $10.6 billion — a 38.8% increase over 2001.

That's an amazing record, especially considering the soft economy. And, according to some investors, the phenomenon that drove those numbers in 2002 — lots of dollars chasing too few deals — is a warning sign for 2003. Some players are moving to the sidelines, while others are looking to sell properties at what they figure may be the top of the market.

It's easy to see why so many investors have flocked to retail, however. “The reason retail has become the flavor of the month is the defensive characteristics of the product itself,” says Stuart Tanz, CEO and president of Pan Pacific Retail Properties in Vista, Calif. A large component of retail's income stream comes from long-term stabilized leases, Tanz points out, and leases can span 20 to 40 years compared with the typical three- to five-year life span of office leases.

That steady return is very reassuring for investors who see what is happening in other parts of commercial real estate. In the office sector, massive job cuts have produced a 16% national vacancy rate. And apartment owners, facing vacancies of 6.5%, are cutting rents and offering big concessions to keep renters from using low interest rates to become homeowners.

In retail, vacancies have barely budged — moving from 9.9% to 10.5% at year-end 2002. And there has been little new construction to create oversupply. Even better, despite rising unemployment and uncertainty in the economy, consumer spending has held up surprisingly well. Indeed, disposable personal income grew by 4.5% in 2002 and a booming mortgage refinance market pumped an estimated $20 billion of additional spending into the economy, according to Marcus & Millichap.

Sizable Deal Flow

Developers were doing their own shopping in 2002. “Last year was a year of terrific, unbelievable volume in the shopping center business due in part to consolidation and in part because pricing was more favorable on some larger public deals,” says Glenn Rufrano, CEO of New Plan Excel Realty Trust Inc. in New York.

Rufrano should know. New Plan alone closed on $1.2 billion in acquisitions in 2002. The bulk of that $1.2 billion was spent on two very large transactions, including the purchase of a 92-property portfolio from Houston-based CenterAmerica Property Trust L.P. for $650 million and a $440 million, 58-center purchase from Fort Wayne, Ind.-based Equity Investment Group.

This year, because of rising prices, New Plan says it will focus on smaller deals — single assets or two to three-property packages. “Pricing will become more of a factor,” Rufrano concedes. However, he says that New Plan is still willing to pay higher rates for quality properties with a durable income stream.

Buying Frenzy

Even now, retail buyers face stiff competition. In some cases, 20 or more bidders are chasing high-quality properties, notes William Maher, director of North American strategy and research at LaSalle Investment Management in Baltimore. The median price per square foot among multi-tenant properties rose 8.5% to $115 in 2002, according to Marcus & Millichap. The demand for high-quality anchored centers has depressed cap rates by 150 basis points or more in the last two years. Single-tenant properties are trading as low as 6.75%, while best-of-class, multi-tenant properties are trading at about 7.5%.

The buying is being fueled in part by the flood of private money into the sector and also by the ability of these investors to take advantage of low interest rates. “A lot of the frenzy is due to private buyers using as much leverage as possible,” Maher says. “However, that will diminish a lot when interest rates rise.” Currently, the 10-year Treasury yield stands at about 4%.

Historically, private and institutional buyers represented two different worlds. Institutions tended to buy larger, more expensive assets. Now they are scooping up all sorts of retail projects. “What's really changed is that these private buyers are not little guys any longer,” says Alan Billingsley, vice president in the San Francisco office of RREEF, a division of DB Real Estate, the real estate investment management group of Deutsche Asset Management.

Private buyers, who can use more leverage and are sometimes less demanding about rates of return, remain the biggest buyers of smaller properties. But that's a huge part of the market. Deals valued under $5 million accounted for 82.2% of sales in 2002, according to Marcus & Millichap. That's a 21% hike in the total number of transactions and a 22.6% increase in value — to $3.2 billion.

Single-Tenant Deals

In the single-tenant retail sector, 1031 exchange buyers are fueling sales. A growing desire among older investors to exchange management-intensive properties for more passive forms of real estate investment has led to huge amounts of capital chasing single-tenant, net-lease deals.

However, after climbing nearly 9% over the last two years, the median price per sq. ft. for single-tenant properties sold in 2002 actually dropped 1.9% to $161. Does that mean the market has cooled off? No, the average was skewed by a wave of lower-quality assets flooding the market, says Bernard Haddigan, director of Marcus & Millichap's National Retail Group based in Atlanta. “More owners are selling some of their marginal assets because they see the market trading at such ridiculous prices,” he says.

Atlanta-based JETS Associates Ltd., a private investment group, for example, is moving forward with its strategy to focus less on small retail strip centers and more on low-maintenance single- tenant, triple-net retail properties. JETS Associates was scheduled to close two sales in mid-April that would leave the family partnership with about $3 million to reinvest in a 1031 Exchange. The group is selling a 6,000 sq. ft., four-tenant building and a 15,000 sq. ft. two-building retail center in north Atlanta.

“We feel that we have gotten very good prices on the properties we're selling. The flip side is that everything we're looking to buy is more money,” says John Tegtmeyer, a principal at JETS Associates, which owns a $12 million retail portfolio. “The demand for properties is very strong. People are buying properties, to my way of thinking, that don't make sense,” he says. Tegtmeyer is optimistic that his partnership will find suitable deals, although he admits that they will have to dig deeper to find them.

Signs of a Top?

How long can the market continue at this pace — with double-digit increases in deal volume, big jumps in valuation and increasing signs of a sluggish economy? Even now, institutions are leery of rising prices.

“A year ago, retail was an excellent buy because it was relatively stable and reasonably priced,” says Billingsley of RREEF. “Now it's getting more expensive, so we are a bit more cautious.”

This year, RREEF is looking at more properties to find suitable buys. Two years ago, RREEF closed on approximately one out of every three properties on which it made an offer. These days that ratio is closer to one out of every 10 or 15 deals. Nevertheless, RREEF has three retail properties under contract totaling about $173 million. For all of last year, the company spent $60.1 million on acquisitions.

Pan Pacific continues to search for acquisition opportunities in the marketplace, but the company has set clear parameters: Properties on the selling block must be available at about a 9% cap rate and provide strong internal growth, Tanz says. “We're out there looking, but whether we execute is a whole different perspective.”

Although 9% deals are few and far between in today's environment, they do still exist. In January, Pan Pacific closed on the purchase of Pavilions Place — a 335,173 sq. ft. grocery-anchored center in Huntington Beach, Calif. — for $40.2 million at a 9.2% cap rate.

Too Much Money, Too Little Sense

Still, such caution is not universal. Given the alternatives — even within commercial real estate — investors keep coming back to retail properties. Buyers who feel that they have to make a deal keep driving up prices. “Do buyers discriminate between good properties and not-so-good properties? Not right now,” says Maher of LaSalle Investment Management. Weaker properties are selling for almost the same cap rates as some of the higher-quality properties, he says.

That's a sell signal for LaSalle, which has opted to liquidate some of its non-core retail assets. “We think we're getting a bigger premium today than we would in normal times,” Maher says. LaSalle sold the 100,000 sq. ft. Plaza Square in Wayne, N.J., in early April.

“It's a good property, but we didn't see any growth in that income stream,” Maher says. Although the northern New Jersey area where the center is located typically sees cap rates above 9%, LaSalle sold Plaza Square for just shy of 8%.

Tanz also is pruning. “We're taking advantage of the arbitrage in the market,” he says. Pan Pacific has sold $200 million already in 2003 in non-core retail assets. During the fourth quarter of 2002, Pan Pacific sold four retail properties in California and Oregon totaling 272,624 sq. ft. for $29.9 million.

Motivated sellers such as Pan Pacific are feeding investors' voracious appetite for retail properties. Ultimately, 2003 may very well be a continuation of 2002. Barring any unforeseen changes such as a rise in interest rates, the outlook for retail buyers over the next six months remains relatively the same — difficult and expensive.

As long as interest rates remain favorable, private buyers will continue to chase retail properties. “Once interest rates start creeping up a bit,” says Billingsley, “the leveraged buyer will fade and the pricing will get easier.”

Beth Mattson-Teig is a Minneapolis-based writer.