Investors are still throwing money at all types of retail. But when will the joy ride end? In one sign of a slowdown, pension and institutional funds are beginning to steer their money away from core retail properties. According to the Winter 2006 Real Estate Report, a survey of institutional investors conducted by Real Estate Research Corp., retail properties are perceived as one of the least attractive investments right now.

They're not shunning retail entirely. Survey respondents thought regional malls and neighborhood/community centers see average performance, while power centers will underperform in 2006. But rather than buying in proven insulated markets, or not at all, these funds are putting capital in secondary, tertiary and international directions.

The problem is pricing.

“We are not doing much in the way of regional malls,” says Steve Vittorio, a principal with Prudential Real Estate Investors and its national retail specialist.

He explains, “There is a lot of capital chasing retail these days. It has driven down cap rates to a point where it makes it very difficult to complete a transaction. If it is the right product line in the right market and we think there are inherent opportunities, we will stretch and bid in the auction process, but that is pretty rare.”

TIAA-CREF, based in New York, ranks as one of the world's largest retirement systems with more than $360 billion in combined assets under management. Of that, almost $16 billion is invested in real estate, but it is currently underweighted in the retail space.

“We would love to get that underweighting up, but we will remain disciplined,” says Tom Garbutt, TIAA-CREF's managing director and head of real estate. “If things get too pricey, we shy away or trade it off.”

Heitman, a private fund manager based in Chicago, is looking for retail opportunities, but is looking for properties with problems or in secondary or tertiary markets. “Our focus is going to be more toward value-added opportunities versus core and that is being driven by what is happening in terms of pricing,”says Blaise Keane, an executive vice president with Heitman. “Core is effectively priced and a number of our clients are saying, ‘Take me to a place where I can get some higher yield.’”

Heitman has been able to get that enhanced yield for investors by looking for opportunities in secondary markets. “We found we can still get access to the same tenant credits, meaning you are still doing business with a Barnes & Noble, Borders, TJ Maxx or whatever,” Keane says. “However, since there is a secondary market nature to where we are investing, we can get 25 to 50 basis points premium.”

TIAA-CREF has traveled even farther afield in its hunt for yield, looking overseas. “We are finding very good retail opportunities in Europe and have been able to capitalize on those opportunities,” says Garbutt. In Europe, TIAA-CREF has gone after hypermarkets, and has even gotten involved in development joint ventures; it is planning to hit Asia next.

PREI has been chasing after value-added acquisition opportunities, but it has chosen to do so through new development rather than acquisitions. “We have been moving most of our investment capital on the retail front to development,” says Vittorio. “We are more interested in providing capital to developers. This way we are getting in at cost and not just buying retail on the open market.”

Interestingly, smaller players, who take part in big investments through publicly traded companies such as REITs, are not moving their capital away from retail quite like the private investment sector.

Damon Andres, a senior portfolio manager with Philadelphia-based Delaware Investment Advisors, oversees its $475 million REIT fund, and he has taken a market weight position on retail in general. “There is more growth expectation for regional malls than what the market is assuming,” he says. He does warn of lower growth expectations for shopping centers, however, citing the omnipresent Wal-Mart impact, which continues to eat away at the grocery business.

Meanwhile, take a brief look at the $9.9 billion in assets managed by ING Clarion Real Estate Securities LP, and you'll see that it's about half a point overweight in the mall sector, according to managing director Kenneth Campbell. It's had success with malls in the past, holding stakes in the two largest mall REITs, Simon Property Group and General Growth Properties, since their IPOs in the early 1990s. However, Campbell is also bullish on non-REITs, such as Forest City Enterprises Inc.

And Principal Financial Group Inc. of Des Moines, Iowa, which has $1.4 billion under management through its funds, also overweighted retail companies in 2005 — also emphasizing the regional mall sector.

But even these players' loyalties are shifting, and they're playing their cards delicately. “Retail has been a bit of a laggard this year,” says Kelly Rush, managing director at Principal and portfolio manager for Principal Investors Real Estate Securities funds. “While retail sector fundamentals remain sound, some of the other property types are improving. The trajectory of the improving conditions at office, apartments and hotels is steeper than at retail.”

Hints of diminishing consumer spending (think rising gas prices, for example), as well as the consumer-spending impact of mortgage equity withdrawals, also have Rush concerned. “There are some clouds on the horizon which we are watching closely.”

Across the board, investment and portfolio managers have ridden retail real estate's rise in recent years. But the signals today are clear: the experienced investors are not paying full price for retail. When buying at all, value-add opportunities, secondary and tertiary markets at home or developing markets abroad define the investment opportunities of choice.

Perhaps that's a sign of what less sophisticated investors should be doing, too. It all depends on the price you want to pay and the returns you think you can get.

CURRENT QUARTER INVESTMENT CONDITIONS AND CAPITALIZATION TECHNIQUES - 4Q 2005

Investment Conditions Direct Cap Cap Rate
4Q 2005 3Q 2005 4Q 2004 4Q 2003 NOI First Year NOI Stabilized Before Reserves After Reserves
Office - CBD 6.3 5.6 5.5 5.1 44% 56% 82% 18%
Office - Suburban 5.6 5.4 4.7 4 41 59 81 19
Industrial - Warehouse 6.5 6.3 6.1 5.5 39 61 76 24
Industrial - R&D 5.2 5.6 5 4.3 44 56 75 25
Retail - Regional Mall 5.8 6.5 6.2 5.6 58 42 83 17
Retail - Power Center 5.6 6.5 6.6 5.8 40 60 80 20
Retail - Neighborhood 6.2 6.7 6.9 5.9 39 61 82 18
Apartment 5.7 5.9 6 5 37 63 39 61
Hotel 5.9 6.1 5.9 4.8 60 40 80 20
Investment conditions rated on a scale of 1 = poor to 10 = excellent.
Source: RERC Investment Survey.

RERC REQUIRED RETURN EXPECTATIONS BY PROPERTY TYPE - 4Q 2005

Office Industrial Retail Apartment Hotel Average All Types RERC Portfolio Index
CBD Suburban Warehouse R&D Regional Mall Power Center Neighbor/Comm.
Pre-tax Yield (IRR) (%) Range 7.3 - 10.0 7.5 - 10.5 7.0 - 10.0 7.5 - 10.5 7.5 - 10.0 7.0 - 10.0 7.0 - 10.5 7.5 - 10.0 9.5 - 12.0 7.0 - 12.0 7.0 - 12.0
Average 8.6 9.1 8.6 9.2 8.9 8.5 8.5 8.4 11 9 8.7
Going-In Cap Rate (%) Range 6.0 - 7.8 6.5 - 8.8 6.0 - 7.5 7.0 - 8.8 5.5 - 7.8 6.3 - 7.8 6.0 - 8.0 5.5 - 7.3 6.0 - 9.5 5.5 - 9.5 5.5 - 9.5
Average 6.8 7.4 6.9 7.7 7.2 6.9 6.8 6.3 8.4 7.2 6.9
Terminal Cap Rate (%) Range 6.5 - 8.3 7.3 - 9.3 6.5 - 8.0 7.3 - 9.3 6.5 - 8.3 6.5 - 8.3 6.5 - 8.5 6.0 - 8.0 7.0 - 10.5 6.0 - 10.5 6.0 - 10.5
Average 7.5 8 7.4 8.3 7.8 7.5 7.4 7.2 9.3 7.8 7.6
Rental Growth (%) Range 0.7 - 4.0 1.0 - 4.0 1.2 - 3.5 -4.5 1.0 - 4.0 0.0 - 3.0 1.2 - 3.0 0.0 - 4.0 3.0 - 6.0 -6.5 -6.5
Average 3.1 3 2.7 2.8 2.8 2.4 2.6 2.8 3.8 2.8 2.9
Expense Growth (%) Range 2.5 - 3.5 2.0 - 3.5 2.0 - 3.5 2.0 - 3.5 2.0 - 3.5 2.0 - 3.5 2.0 - 3.5 2.9 - 4.0 3.0 - 3.5 2.0 - 4.0 2.0 - 4.0
Average 3.1 3 2.9 3 2.9 2.9 3 3.1 3.1 3 3
Figures above reflect percent return expectations.
Source: RERC Investment Survey