Retail's robust returns will begin to shrink in 2005, but the sector will remain an attractive investment compared to other commercial property sectors and investments, according to a new forecast by Principal Real Estate Investors, Real Estate Research Corp. and Torto Wheaton Research.
It's no secret that retail has enjoyed a strong run in recent years. But few people may be aware of the scope of the appreciation. From 1978 to 2004 retail real estate experienced a cumulative net value appreciation of 53 percent, with almost half in just the last three years, according to the report. No wonder buyers have flooded the sector and sent cap rates to historic lows -- a trend that will slow.
"Going forward we don't see this as sustainable," says Brian Velky, a real estate analyst with Real Estate Research. But, he quickly adds, "we still feel quite bullish on retail, especially when you're talking about the right properties and the right markets." The firms conclude that rising interest rates, the slowing housing market and higher energy pricing should slow consumer spending. Also, they suggest U.S. economic growth will shift away from retail toward other sectors, strengthening other commercial real estate properties that will begin to catch up.
Cumulative 2004 deal volume in retail real estate increased 43 percent from 2003, according to Real Capital Analytics. Even with an expected slowdown in the sector in 2005, real estate -- and retail in particular -- will remain an attractive bet to beat the stock and bond markets. Overall growth will slow next year, but could still top 9 percent, exceeding the bond market's approximate 4.2 percent growth in 2004 and the 8.5 percent rise in the S&P 500.
The huge volume of activity in retail real estate, though, is sending up cautionary flares. Pricing for community and neighborhood centers, for example, is now well above replacement costs. Principal Real Estate Investors puts the average acquisition cost in the 110 percent to 125 percent range in relation to replacement cost. Another risky dynamic involves cap rates. While cap rates are at all time lows, the spread between average cap rates and the 10-year Treasury is near the historic average. But if interest rates shoot up -- as indicators are pointing to -- the lag effect in real estate, unless investors adjust their pricing, could lead to shrinking spreads.
"If interest rates are to move up quickly," that would set some pressure on cap rates to move up," says Velky. "We don't think that the sectors' net operating income would be enough to offset the rise in rates. That could put some pressure on price in the long run."
The findings are part of the three groups' joint forecast: Expectations & Market Realities in Real Estate: 2005.
A similar study put out by the National Association of Realtors is somewhat more optimistic, suggesting retail real estate fundamentals will stay strong next year. The NAR measured 27.5 million square feet of positive absorption in the retail sector in 2004, more than double the 2003 figure. Looking ahead, it forecasts positive absorption of 33.6 million square feet in 2005 and 27 million square feet in 2006.
The average vacancy rate for retail space should be 7.5 percent in 2004, down from 8.1 percent in 2003. Vacancies are projected at 6.8 percent for 2005 and 7.5 percent in 2006. Retail rent growth is seen at 3.3 percent in 2004, with a rise of 4.4 percent in 2005 and 3.6 percent in 2006.