What would it take to slow investor interest in retail properties in 2006? Rising long-term interest rates? A couple of major natural disasters? High energy costs that threaten to take consumer dollars away from stores?

Those events have all occurred this year, yet investors seem undaunted. Some $32.2 billion worth of retail properties traded hands in the first three quarters of 2005, according to Real Capital Analytics, 14% more than the same period in 2004.

“There's a sense of urgency on both sides of retail deals, stronger than I've ever seen, that's driving things,” says Dan Fasulo, director of the market analysis group at Real Capital Analytics.

“On the seller's side, higher interest rates in the future will affect property values, and higher expenses will affect retailers,” according to Fasulo. “Buyers, on the other hand, either have capital that needs a home right now, or want to borrow money on good terms while they can.”

Indeed, the 10-year Treasury yield, the benchmark for permanent, long-term financing in commercial real estate, was hovering near a relatively low 4.5% as of mid-November.

Encouraging vital signs

Fasulo is optimistic that the volume of investment sales still has several quarters to go before slowing down. “There's still that much money out there,” he says. “I'm also bullish because retail fundamentals are still strong. For instance, rents are still going up, especially for CBD retail. Demand from retailers is there.”

In Chicago's central business district, which includes State Street, asking rents in the third quarter averaged $50.30 per sq. ft., the highest since 2001 when they registered $56.34. In the past year alone, asking rents have climbed 30%.

According to Reis, retail completions are expected to reach 31.5 million sq. ft. and increase to 37.1 million sq. ft. in 2006, some 21.5 million sq. ft. of which will be community centers (grocery-anchored and the like), with 15.4 million sq. ft. in smaller neighborhood strip centers. “This volume of new space exceeds that of recent years by 5 million to 12 million sq. ft., and exceeds the expected absorption — most notably in 2006, when the difference will be 6 million sq. ft.,” wrote Lloyd Lynford, CEO of Reis, in an October national retail market report.

As a result, the national retail vacancy rate will finish 2005 slightly higher, at 6.9%, rising to 7.1% in 2006. But this small change in vacancy won't be enough to contain upward pressure on rents. Effective rents are forecast to rise 3.2% this year, followed by a 3% increase in 2006, according to Reis.

Redevelopment wave under way

Property owners are still pouring money into upgrading or reconfiguring their space to remain competitive. Changes in ownership, such as the purchase of May Department Stores Co. by Federated Department Stores, will also spur retail reconfigurations.

“With the May-Federated merger, a lot of department stores are going to close in the not-so-distant future, and there has to be radical redevelopment of that space,” says Scott Wolstein, CEO of Beachwood, Ohio-based Developers Diversified Realty. The REIT specializes in community and neighborhood centers. That reconfiguration will lead to even further blurring of retail niches. “Malls will be converted to power centers, and power centers will add lifestyle elements,” says Wolstein.

Stocking up on grocery anchors

Whatever the outlook for malls, which represent a fully mature retail segment, investors are still keen on grocery- and drug store-anchored properties, despite the persistent threat of the likes of Wal-Mart and Costco to eat away at the market share held by traditional grocers.

“Neighborhood shopping centers are still the property of choice, grocery- and drug store-anchored, but the demand is so great that not everyone can buy into that segment,” says Patrick Dempsey, a principal and real investment specialist with Lee & Associates in Phoenix. Investors don't seem to be differentiating among segments the way they used to, says Dempsey.

“We've seen, in previous cycles, 100 to 150 basis points difference between quality, credit grocery-anchored shopping centers and strip centers,” Dempsey says. Now that gap has virtually disappeared in some markets, with investors willing to acquire either a solid grocery-anchored shopping center or an unanchored strip center at a 6.5% cap rate.

This non-differentiation is likely a function of capital looking to buy anything at any price, say industry experts. Another possibility, Dempsey suggests, is that investors are now rethinking which class of retail offers the lowest risk — that is, which niche is the most resistant to Wal-Mart and its ilk.

Properties previously thought to be riskier than grocery-anchored centers, such as strip centers and other convenience-oriented retail, might emerge as comparable investment choices.

RETAIL PROPERTY SALES VOLUME RISES
Sales Volume YTD thru 9/05 % increase year-over-year
Retail (all classes) $32.1 billion 14%
Malls $5.5 billion 11%
Strip centers $20.9 billion 7%
Other* $5.7 billion 57%
“Other” category includes freestanding stores, outlets as well as urban retail
Source: Real Capital Analytics