MAY 2007 VOL. 2

U.S. Retail Real Estate in Transition

Investors position portfolios for the next cycle

Last year brought the end of the boom cycle in retail real estate. After an amazing five-year run up in values and deal volume, investors turned their attention to other product types. Total deal volume in the U.S. remained flat at around $50.5 billion dollars in 2006, according to Real Capital Analytics Inc.

But in commercial real estate, the cycle is always advancing and 2007 is shaping up to be a key transition year as investors position themselves for the next phase. It is taking some creativity to navigate the market: cap rates have not budged from their lows and there is little differentiation in initial cap rates between top properties and those that need retenanting and renovation.

Indeed, even if total sales volume is relatively tame, there is still fierce competition for the properties that come to market, especially grocery-anchored centers. Why? Partly because the pundits were wrong—they predicted a major retreat among consumers as the home buying and refinancing craze petered out.

But retail sales haven’t fallen and landlords are still able to raise rents, especially if they concentrate on quality properties. "Buyers of every shape and size are coming to us as service providers to buy up property in prime markets,” says Michael Dee, senior vice president & national director of retail for Grubb & Ellis Co.

Grocery-anchored still hot

Among retail center types, investors still like grocery-anchored projects, says Stephen Bittel, chairman & founder of Terranova Corp., a Miami Beach, Fla.-based commercial real estate advisory firm. “They are still very attractive for institutional investors putting out large dollars in a single property,” he explains. “There is nothing better than generating twice-a-week customer visits.”

Cap rates for all types of desirable properties remain within 50 basis points on either side of 6 percent, says Tom Caputo, executive vice president with Kimco Realty Corp. in New Hyde Park, N.Y. Just a few years ago, supermarket-anchored centers carried a 9 percent to 10 percent cap rate, he says, while power centers had 8 percent to 9.5 percent caps.

When it comes to other types of retail properties, Bittel predicts that fewer lifestyle centers will be built because these properties are usually driven by significant residential development. The slowdown in homebuilding could also affect mixed-use development, he adds.

In the hot Washington, D.C. metropolitan area, there are 30 qualified buyers for every grocery-anchored center that hits the market, says Henry Fonvielle, executive vice president at the Rappaport Group, a McLean, Va.-based development and management firm. Further east in Chicago, a broker said that the number of letters of intent for a Jewel-anchored center that needed some fixing up broke all local records.

Prime properties justify prime prices, Bittel says. "There continues to be enormous interest for projects of very high quality and great income-growth possibilities as well as for properties in South Florida, metro D.C., Southern California and New York City,” he notes.

Acadia Realty Trust, for example, is focused on crowded markets with higher barriers to entry such as New York’s five boroughs, according to President and CEO Ken Bernstein. The REIT is pruning its low-density, non-core properties such as those in northeast Pennsylvania to invest in larger markets. “We like the risk-adjusted return profile in New York, but also are looking at additional high-density markets,” he says. 

Similarly, Weingarten Realty Advisors is paring non-core assets and exiting unprofitable locations. Last year, the company disposed of $316 million of smaller properties in markets where it was unable to achieve economies of scale, generating gains of $150 million.

“Our philosophy is to increase our property base in existing markets so we can intensively lease and manage them,” says Gary Greenberg, senior vice president of capital markets for Weingarten, adding that the company is looking for both development and acquisition opportunities. Last year was one of the company's biggest years for acquisitions with $1 billion worth of deals. Today, the Houston-based company has $1 billion in its construction pipeline, with projects scattered across the southern U.S. and in the Pacific Northwest, an area that the company began to target last year.

Beyond coastal markets

In 2006, the top 10 retail markets were all “coastal” with Los Angeles boasting the lowest vacancy rate at 2.4 percent, according to REIS Inc. The markets with the highest rental rate growth were also “coastal” with San Francisco, Los Angeles and San Diego generating rental rate growth of more than 2 percent.

In addition to coastal markets, developers, brokers and investors also cited the Las Vegas and Phoenix metropolitan areas, and the major markets in Texas, as promising because of their strong population and household growth.

And, some developers are having luck in secondary markets, says Herbert Weitzman, chairman & CEO of Dallas-based Weitzman Group and Cencor Realty Services. "As the competition for product in the major markets like Austin, Dallas, Houston and San Antonio continues at historically high levels, we are seeing investors move into second-tier markets where there is a little less competition,” he says.

Looking forward, vacancy in the retail sector is expected to rise slightly as completions outpace net absorption by 38.7 mil­lion square feet to 31.8 mil­lion square feet, according to REIS. But, that doesn’t mean that rental rates won’t grow – they’re forecast to increase 3.5 percent in 2007.

“Right now, we're in a truly unique period where we have a combination of extremely strong tenant demand driven by solid consumer spending and a significant amount of capital in the financial markets,” Bernstein says.