As the industry makes its way through the second quarter of 2008, the outlook for the U.S. retail property market remains muddled, according to the first quarter report from Reis, Inc., a New York City-based provider of commercial real estate information. Transaction volume during the first quarter continued its downward slide, but pricing for the assets that did trade hands remained relatively stable. Where the market will go from here will depend largely on the performance of the credit markets in the next few quarters, said Sam Chandan, chief economist of Reis, during the company’s first quarter presentation on May 28.
After months of little activity in the investment sales sector, the volume of retail transactions in the first quarter amounted to only $7 billion, an 81 percent decline from $37 billion during the same period in 2007. Portfolio sales, which made up the bulk of activity in 2006 and 2007, have been virtually non-existent this year, coming off a high of $208 billion for the entire commercial sector in 2007. The change has been due to the decreased appeal of properties in secondary markets, which makes it harder to get rid of sub-par portfolio assets, and the difficulty of getting enough credit to finance such transactions, according to Chandan.
With credit markets still in a funk, the easiest loans to obtain are those under $25 million, since they can be financed by regional banks, instead of Wall Street players, according to Gary E. Mozer, managing director and principal with George Smith Partners, a Los Angeles-based real estate investment banking firm.
At the same time, the price depreciation in the retail sector for the properties trading hands has been relatively modest. The price per square foot during the first quarter was down just 2.8 percent from the high of more than $180 in the second quarter of 2007. In contrast, apartment prices were down more than 13 percent. However, part of the reason that prices have remained stable is because only the best assets in large markets are trading hands. Had lower quality properties been trading, it's likely the price drop would have been more severe, according to Chandan.
Currently, cap rates for retail properties range from just under 6.4 percent to approximately 9.5 percent on lesser quality centers, with Las Vegas, San Diego, Orange County, Los Angeles and Chicago registering the lowest cap rates in the country. In the past 12 months, cap rates for retail properties averaged about 7.2 percent.
However, Chandan cautioned the industry against taking the current transaction statistics out of context. While transaction volume may be down and cap rates up compared to the fever pitch of the past three years, they are roughly in line with the levels experienced in 2004. “Last year’s transaction levels are far above the normal rate for the market,” he noted.
At the same time, Chandan remains worried about the availability of debt for commercial properties in the coming months. In recent weeks, the freeze in the credit markets has eased—LIBOR spreads over Treasury have narrowed to 75 basis points from 198 basis points on March 20 and spreads over swaps on AAA-rated notes have come down as well, to 142 basis points from 325 basis points. But similar drops have occurred twice already since the onset of the credit crunch last summer, in November 2007 and in February 2008, only to blow back open again after further credit problems arose.
If the spreads widen once again, the difficulty of re-financing existing properties will likely lead to distressed property sales in the commercial sector, Chandan notes. Reis estimates that CMBS issuance will range from $32 billion to $35 billion this year, compared to $230 billion in 2007, taking away a significant source of financing for real estate owners. Traditional lenders have not been able to pick up the slack. Currently, many of the country’s leading financial institutions are over-leveraged and don’t have the capacity to extend credit to commercial owners, Chandan says.
In the first quarter of 2008, the delinquency rate on loans in the commercial property sector stood at 3.7 percent, according to Reis, the highest level since 1994. But if the owners who bought their properties in 2005, 2006 and early 2007 counting on easy availability of credit and rapidly rising cash flows won’t be able to refinance, that number will rise, leading to a negative price bubble, Chandan cautions.
“There is material downward risk for the market later this year,” he says, predicting further cap rate increases in the weaker markets.