The retail real estate industry feared this moment for the past three years, but everyone knew it would come. The first hints arrived early this summer, when class B and C retail assets started trading at cap rates higher than 7 percent, above last year's sector-wide average of 6.9 percent. The reported increases ranged from 30 to 100 basis points, depending on the region.

At the time, brokers talked of a bifurcated market. Because of the assets' higher quality and because buyers of class A real estate don't rely on debt as much as buyers of B and C assets, pricing would hold up, the reasoning went. But today, as the subprime mortgage meltdown continues to rankle debt markets, some brokers are saying that offers for A assets are declining and cap rates may rise. Even the most hopeful are coming to the conclusion that the long boom in commercial real estate is ending.

In July, investors closed the smallest number of commercial real estate deals since August 2006, at 930 transactions valued at more than $5 million, Real Capital Analytics researchers told Bloomberg.com.

Stephannie Mower, executive vice president with PM Realty Group, a Houston-based real estate services firm, reports that this July the firm experienced a 14 percent drop in sales activity across all asset classes, the worst performance in five years.

She says many of her institutional clients are purposefully staying away from acquisitions right now, not because they don't have the cash, but because they figure that prices will soon begin to drop on even the best quality assets. Across the board, they expect to see a discount of 15 percent before year's end.

Troubles in the debt markets are crippling leveraged buyers. Conduit lenders especially have stumbled, unable to sell loans they originated at terms they used six months ago into a secondary market suddenly squeamish about risk. From 2006 to August 2007, spreads to 10-year Treasuries on AA-rated fixed-rate CMBS loans, for example, more than doubled, jumping 122 basis points in all to 211 basis points from 89 basis points in 2006, according to RBS Greenwich Capital. Meanwhile, spreads on A-rated loans rose 162 basis points, to 261 basis points, and spreads on BBB-rated loans rose 262 basis points, to 396 basis points.

Bernard J. Haddigan, senior vice president and managing director of the national retail group with brokerage firm Marcus & Millichap Real Estate Investment Services says CMBS lenders also no longer play fast and loose with their underwriting. They won't grant investors interest only mortgages, nor are they willing to hike up the loan amount to cover for small property defects, such as a vacant space, in a core asset. In the past year, the acceptable loan to value ratio dropped to 60 percent, whereas in 2006, investors still closed deals at 95 percent loan to value.

"Now the lenders are really looking at their coverage," Haddigan says.

Forced to turn to life insurance companies for loans, investors are dealing with higher spreads, according to Philip D. Voorhees, senior vice president of retail investments with global brokerage firm CB Richard Ellis, at 160 basis points above the Treasury rate, whereas last year, they completed deals at 140 basis points above the Treasury. The tighter lending standards in turn have sapped the pool of potential buyers, with cash-rich institutional funds still going strong, while the more debt-reliant individual investors struggle to find deals that work.

As a result, brokers get less offers on class A assets than they did a year ago. The same property that received 10 to 15 bids last year now gets 5 to 10 bids, according to Voorhees. Mower says that in secondary markets, including St. Louis and Minneapolis, A class assets already trade at cap rates close to 7 percent, but the sellers have a hard time getting used to the new reality.

"People have been asking when the cap rates are going to go up and the answer is about eight weeks ago," Voorhees says, though he notes that because the summer tends to be a historically slow period for real estate it will take another 60 to 90 days to determine how much the debt markets really affected pricing.

Still, Voorhees says that so far, prices on class A assets remain largely unchanged. Quality shopping centers in urban locations are so hard to come by investors will go out of their way to pay a premium on those, according to Joseph French, senior vice president with real estate investment brokerage firm Sperry Van Ness. Cap rates on class A assets in certain markets even dropped a bit this year, by 10 to 15 basis points, Haddigan argues. Moreover, the buyers for those assets--institutional investors like pension funds and REITs--are less reliant on debt than buyers of lower-grade assets. So they are not as affected by the problems in the debt markets as are the typical buyers of class B and class C properties.

But some observers believe that class A assets will not emerge unscathed. In deals he's seen, prices for class A shopping centers dropped by up to 5 percent in the past quarter, according to P. Evan Farahnik, principal of Starpoint Commercial Properties, LLC, a Beverly Hills, Calif.-based real estate investment firm. Meanwhile, prices for B class assets climbed down as much as 7 percent.

"We do see a reduction hitting class A assets," Farahnik says, though he adds that his firm will continue to aggressively target retail properties. Over the next 12 months, Starpoint will invest approximately $150 million in retail real estate.

To be sure, retail real estate remains a sound investment. This year, average rents for retail properties will rise 2.9 percent, according to the recently released Commercial Real Estate Outlook report from the National Association of Realtors, while vacancies will increase slightly, to 9.3 percent from 8.1 percent in the last quarter of 2006. In 2008, rents will rise a further 1 percent, while vacancies will climb down to 8.9 percent. The rent growth will be below last year's 3.9 percent, but still a respectable result.

With all the troubles in the debt market, however, investors are demanding higher returns, Farahnik says. So if last year an acceptable ROI for a given deal was in the mid-teens, this year, that number moved to the high teens.

That kind of attitude drives the market right now, according to French. Though buyers are putting out lower bids on class A assets--this summer, some offered bids of 8 percent and higher--and though the period between the listing and the closing nearly doubled to 150 days compared to 2006, people still think that retail properties are a good investment.

Going forward, however, that equilibrium might not last. In the past few years, the private investors and 1031 exchange buyers drove cap rates down by taking on a lot of leverage, according to Mower. Now that the credit crunch has limited their ability to borrow, institutional funds will once again rule the day.

"The private investors and 1031s won't be able to be as aggressive on their pricing," Mower says. "Meanwhile, the institutional players have so much money, they will end up driving the market."

--Elaine Misonzhnik