Reis Inc.'s message from last week's fourth quarter 2007 capital markets briefing was, "Worry. Don't panic." The New York-based commercial real estate information firm confirmed that cap rates for commercial properties inched upward in the final stretch of 2007, and thatactivity slowed across all sectors. The trend is expected to continue in 2008, but the drop will be less dramatic than in the last half of 2007, said chief economist Sam Chandan.
The shift will be due primarily to the exit of speculative investors, rather than deteriorating fundamentals, Chandan said. Faced with a tighter credit pool and an uncertain economic climate, buyers focused solely on price appreciation have backed away from acquisitions. At the same time, investors who see retail properties as stable income-producing assets are trying to determine the appropriate cap rates given the environment, leading to longer negotiation periods and, in some markets, a dearth of deals.
Considering the industry is coming off an historic high for transaction volume, there won't be lasting damage, Chandan said. The one thing that could upset the sector in 2008, he said, would be a sudden influx of discounted for-sale properties from a newly bankrupt retail empire.
"Fundamentals remain exceptionally stable," he noted. Compared to the previous two downturns, the industry has not seen significant building because the boom lasted only a few years and rising construction costs curtailed over-building. But, Chandon said, "pressure on prices of distressed sellers will become a significant factor later this year."
Cap rates for retail properties rose 10 basis points on a national basis in the fourth quarter, to an average of 7 percent, according to Reis statistics, while the total dollar volume of $33 billion remained on par with 2006. Chandan anticipates the number of deals to decline in 2008. In January, just $2.2 billion worth of retail properties changed hands, the lowest level in four years, according to Real Capital Analytics, a New York-based provider of real estate and transaction data. Meanwhile, $4.9 billion worth of properties went on the market during the month, signaling a disconnect between buyers and sellers. In February, sales transactions registered a slight increase to $2.5 billion.
The lack of financing has been a major contributor to the drop in deals. Specifically, after reaching a record high of $38.5 billion in March 2007, issuance of U.S. commercial mortgage-backed securities (CMBS) ground to a complete halt in January. February was just a little better with $1.2 billion in issuance, down from $21.1 billion in February 2007, according to Commercial Mortgage Alert, an industry newsletter. There is little demand for these bonds from investors and therefore conduit lenders aren't out originating new loans to repackage into securities offerings. Bond investors are insisting on greater transparency, Chandan said. Overall, the volume of issuance of new CMBS bonds is expected to reach between $85 billion and $90 billion in the U.S. this year, down from $230 billion in 2007.
Another factor affecting deal volume is the drop in interest from international investors. For example, Australian investors accounted for 67 percent of all cross-border investment in retail real estate in 2007, in large part due to Centro Property Group's acquisition of New Plan. That is not likely to occur again this year considering the refinancing woes Centro is facing as a result of that deal. Other foreign investors aren't jumping in to fill the void either. A recent survey by the Association of Foreign Investors in Real Estate, a Washington, D.C.-based non-profit organization, found that 85 percent of respondents had no plans to boost their U.S. acquisitions this year.
As a result, the majority of active buyers in the market are value investors looking to boost properties' income-producing potential. Such buyers are far less likely to overpay for assets, Chandan said. Instead, they are more focused than ever on determining cap rate levels that correspond to the assets' true value.
"It's not that prices are dropping, it's that in the past few years the risk premium has been taken out of the market and now it is being put back in," says Bernie Haddigan, senior vice president and managing director of the national retail group withfirm Marcus & Millichap Real Estate Investment Services. "Buyers still want to buy, but they are assessing the properties differently."
That means that in primary markets with high demand, such as Seattle and New York City, cap rates will not show a significant increase, while less desirable areas will simply experience fewer deals.
But, Chandan added, if the owner of a large retail portfolio is forced to sell several billion dollars worth of centers on a single-asset basis in secondary and tertiary markets, the current equilibrium might be upset.