Real estate brokers had hoped the steep decline in investment sales of retail properties in the last quarter of 2007 was a temporary setback. Now it's well into the second quarter of 2008 and little has changed.

In February, the volume of investment sales in the retail sector was a paltry $1.1 billion, an 88 percent crash from a year ago, according to data from New York City-based Real Capital Analytics. The figure was down compared to January 2008 as well, by 55 percent. At the same time, the ratio of new listings to closings rose, to 4 to 1 in February, from 2 to 1 the previous month. And as there were few deals under contract in March, the figures aren't likely to improve.

The credit crunch caused the initial dropoff. Highly leveraged buyers that previously dominated the market can no longer get financing and have exited the scene.

But there's more at work. A rift has emerged between buyers and sellers. Sellers have moderated their expectations to some degree, as evidenced by rising cap rates, especially on class-B and class-C assets. The problem, industry observers note, is that not enough of them have done so. Special services firms and institutional sellers understand that they might have to accept discounts. But almost every private investor with a property on offer has to be counseled about the changes that have taken place in the market since last summer, says Stephannie Mower, executive vice president and managing director of investment services with PM Realty Group, a Houston-based real estate services firm.

A lack of clarity on appropriate pricing levels might be partly to blame. Real Capital Analytics reports that from June 2007 to March 2008, average cap rates on retail properties moved by 30 basis points, to 6.9 percent. But the firm's managing director Dan Fasulo has told our sister publication National Real Estate Investor the numbers are skewed because they are limited to price increases on the best assets, the only kind that have been trading hands in the past few months.

Sellers still expect to see cap rates in the 5 percent and low 6 percent range on freestanding single-tenant properties, says Jim Koury, managing director of retail investment sales with Jones Lang LaSalle, a Chicago-based commercial real estate services firm. With multitenant shopping centers, sellers tend to be as much as between 25 and 50 basis points off the previous average cap rates.

That has affected transaction volume. When private investors find out they'll have to accept a discount, in about 20 percent of the cases, they decide not to go through with the sale, according to Mower. “Many of them bought these assets in the past five years and still expect to get an unbelievable return on their investment,” she says.

Stonemar Properties, a New York City-based real estate investment firm that plans to buy centers worth up to $150 million this year, is under contract for only one acquisition so far, a 180,000-square-foot property in the northeastern United States that features a $29.5 million price tag and a cap rate in the mid-7 percent. The slow start to the year has been due both to the difficulty of finding appropriately priced assets and the reluctance on the part of many sellers to bring their properties to market during a down period, says Jonathan Gould, CEO of Stonemar.

“I think sellers' expectations have lowered, but they have not lowered enough,” Gould notes. “But there is a lot less wheeling and dealing going on in general. The number of properties available for sale is down substantially compared to last year.”

Meanwhile, with so few deals in progress, even experienced brokers can find themselves at a loss in how to value new offerings. In more than 20 percent of transactions, the listing price is lowered by an average of 5 percent, says Mower.

In one listing handled by brokerage firm Sperry Van Ness, a Wal-Mart-anchored shopping center in a tertiary market in the Midwest remained on offer for almost 60 days without getting much interest, recalls Joseph French, national director of retail properties with the firm. With cap rates for similar properties averaging 7 percent in the past six months, the firm's brokers figured a 9 percent rate would guarantee a flood of bidders. Sperry Van Ness ended up having to raise the rate to 10 percent to generate offers.

“In a different market, we would have sold that very quickly and probably at a different cap rate,” French says. “But what's happened is buyers have more options and they are more cautious. If they don't get one property, they just go to the next.”

Sellers should expect cap rates to climb another 25 basis points to 50 basis points before the market hits bottom, according to Koury. Mower predicts that prices will drop another 5 percent to 10 percent.

Money woes

The buyers are not just being capricious, however. With a lack of available financing, they can no longer make the lower cap rates work, says Stephen Ifshin, chairman of DLC Management Corp., a Tarrytown, N.Y.-based shopping center owner and operator. In 2007, DLC would often complete acquisitions using leverage of 80 percent, which was then sold through the commercial mortgage-backed securities (CMBS) market. That allowed the company to pay cap rates in the 6 percent and 7 percent range. But this year, acceptable leverage levels have fallen to 50 percent or 60 percent and the CMBS market has shut down. As of Apr. 15, U.S. CMBS issuance for the month equaled $0.0, according to the Commercial Mortgage Alert, an industry newsletter.

That left many buyers reliant on life insurance companies and pension funds as primary sources of lending. Such institutions, however, tend to be risk averse.

Meanwhile, rising vacancies at retail centers throughout the country have made buyers more careful about how much they pay for an under-occupied asset. Whereas investors are currently willing to accept a cap rate of 7.13 percent for a fully occupied power center, they would insist on a cap rate of 7.27 percent for an asset that was only 85 percent leased and a cap rate of 7.38 percent for an asset that was 75 percent leased, reveals the first quarter 2008 Korpacz Real Estate Investor Survey from PricewaterhouseCoopers.

“We are sitting on the sidelines until the market corrects itself,” Ifshin says. “Cap rates have moved, there is no question they have — by about 70 to 80 basis points on class-A deals and 100 to 125 basis points on class-B deals. But the B deals would have to move 300 basis points to make a difference to us.”

That's why DLC, like Stonemar, has managed only one deal in the first two quarters of 2008 — the purchase of a 130,000-square-foot, class-A grocery- anchored shopping center outside of Cincinnati — compared to nine in the first two quarters of 2007. Because the property comes with an attractive debt in place (the loan features an interest rate below 5 percent and a seven-year term) DLC agreed to buy it at a cap rate of 7.5 percent. Last year, however, it would have sold in the 6 percent range, Ifshin notes.

Meanwhile, many deals have been falling through because buyers can't get sufficient financing, even when both parties at the negotiating table are in perfect agreement about the price, says David M. Jacobstein, chief advisor to the real estate group at New York City-based Deloitte and former president and COO of shopping center REIT Developers Diversified Realty Corp.

At the moment, only 20 percent of shopping centers on the market can be considered overpriced, says Koury. “Buyers who can't get debt to close the deal are a bigger issue than the bid-ask gap,” he notes.

Between the first half of 2007 and the last six months of the year, the volume of acquisition financing for retail properties plummeted 92 percent, according to Real Capital Analytics. The change was especially dramatic for national and international banks. Goldman Sachs, UBS Real Estate and Key Bank all slashed the volume of their retail acquisition loans by at least 95 percent.

What's worse, with the continued volatility in the financial sector, buyers can't be certain of the financing terms they will be offered at closing. That makes them predisposed to walk away from the table if the cap rate is not high enough.

Buyers have also started avoiding listings that don't feature an asking price, whereas over the past four years properties would go to market without a price tag, says Mower. The reason is they want to figure out whether an acquisition makes sense as quickly as possible and not waste time on an overpriced asset.

“A year ago, the buyers were paying more than the sellers expected,” Mower says. “You are not finding that happening at all now.”

As valuations continue their downward spiral (the average sales price slipped to 95.5 percent of the asking price in February, according to Real Capital Analytics, from 96.6 percent in July 2007), many potential sellers have chosen not to put their properties on the market. Koury estimates up to 50 percent of the owners who had planned to put their centers up for sale this year have decided to wait.

“Why would you bring a property to market if you can wait a year and get a better price?” asks Suzanne Mulvee, senior real estate economist with Property & Portfolio Research, a Boston-based independent real estate research and portfolio strategy firm.

Owners who are facing refinancing deadlines in 2008 might end up selling at a discount because they have no other choice. Everyone else, however, will try to hold off for another month or two, according to Mower.

The hope is that at the conclusion of this month's RECon convention in Las Vegas, the impasse might abate, says Ifshin. To begin with, the show will give people in the industry a better idea of what's actually going on in the market. Plus, with the third quarter looming, many of the institutional players that have held off putting their properties up for sale thus far might be forced to do so to meet their return targets.

“The sellers who held off selling in the first and second quarter have to come to the market sometime,” Ifshin says. “I've seen this happening many, many times — sooner or later, the sellers will have to sell.”