Retail Real Estate Set to Recover in 2011

ELAINE MISONZHNIK

If you need a sense of how the retail real estate market has changed over the past 12 months, all you have to do is take a close look at a deal that Faris Lee Investments, an Irvine, Calif.-based retail investment brokerage firm, closed this fall.

The sale involved a recently completed project in Corona, Calif. The center is anchored by a Vons supermarket, but most of the shop space has never been filled. The center is located in a growth area, and Rich Walter, president of Faris Lee, estimates that it will likely take from two to three years to lease the vacant shops. Yet the buyer was happy enough to get a property with a grocery anchor to close the deal at a 6.5% cap rate (a calculation based on net income divided by sales price) on the current income stream.

“It's a risky transaction because you are trying to forecast when the rental market will come back in a market where you don't see it,” Walter said. “It's not that it's not going to be leased at some point. The question is when. But they are happy enough with the return to be willing to sit on it over time.”

Back in 2009, this kind of logic would be unfathomable to most industry insiders. But as a result of the record low interest rates and increasing liquidity in the market, real estate investors can suddenly afford to gamble. When debt is priced at 5%, it's possible to accept cap rates in the 6% to 7% range, said Dan E. Gorczycki, managing director in the New York City office of Savills LLC, a real estate services provider.

Granted, in 2010, most investors were trying to play it safe by chasing grocery-anchored strips in primary markets like New York, Washington, D.C., and San Francisco. But the supply of those centers is limited, and the capital that has been amassed in the past few years has to be deployed. Low interest rates are adding fuel to the fire. That's why in 2011, investment sales brokers expect an increased level of activity on class-B and some class-C real estate assets.

“The availability of funds will cause the market to have more transactions,” said Walter. “Financing availability has caused cap rates to compress on the core properties. The cash on cash return is better, and people can get into properties without having to pay a lot of cash. In 2011, this will eventually drift down to lesser quality assets.”

Dan Fasulo, managing director and head of global research with Real Capital Analytics (RCA), a New York-based research firm, forecasts that in 2011 retail investment sales volume will reach anywhere between $30 billion and $40 billion, a level of activity last seen in 2004. It would be double the total projected retail sales activity in 2010, which Fasulo estimated would total between $18 billion and $20 billion.

FUNDAMENTALS IMPROVE

Fundamentals in the retail sector got better throughout 2010. Leasing indicators finally began to improve in the third quarter, which marked the first time since 2007 that vacancy rates either remained flat or declined. At the end of third quarter, the vacancy rate for community and neighborhood shopping centers stood at 10.9%, the same as the quarter prior, according to Reis Inc., a New York City-based research firm. The vacancy rate for regional malls fell 20 basis points, to 8.8%.

There are still some concerns that vacancies may rise during the first six months of 2011 before finding firmer footing. But with limited amount of new space in the pipeline, if consumer spending remains stable, retail vacancies should continue to shrink, said Chris Macke, senior real estate strategist with the CoStar Group, a Bethesda, Md.-based research firm.

At any rate, even the appearance of improving leasing fundamentals serves to calm investors' fears. There is a feeling in the marketplace that the retailers that escaped the Great Recession are, as a group, in better financial shape than they were pre-2007, said Alan L. Pontius, senior vice president and head of the national retail group with Marcus & Millichap Real Estate Investment Services. And the lack of new development is an added bonus, according to Christopher J. Decoufle, Atlanta-based senior vice president, capital markets, with CB Richard Ellis' national retail investment group.

“The fact that there is no new competition is very important for anyone on the acquisition side because it removes a lot of ambiguity from your underwriting,” Decoufle said.

At the same time as the leasing outlook began to improve, the third quarter of 2010 marked a turning point for investment sales activity. The quarter was the strongest for investment sales since the downturn began in the fall of 2007, according to RCA. Retail volume reached $5.5 billion, an increase of 131% over the same quarter a year ago and almost double the figure recorded in the second quarter.

Through November of last year, retail investment sales volume totaled $13.4 billion, overtaking the $13 billion recorded in all of 2009, according to Fasulo. A lot of the activity is currently focused on grocery-anchored shopping centers in primary markets.

Part of the reason grocery anchors were in demand in 2010 is that they are necessity-based and perform well regardless of the economic environment. It's also easier to line up financing for grocery-anchored centers, Decoufle explained. Today, virtually any lender, including banks, life insurance companies and conduit lenders, will provide loans for grocery-anchored strips in primary markets. With a loan-to-value (LTV) ratio under 60%, the interest rates on such properties can start at 4% on five-year fixed-rate loans.

This is an excerpt from an article that was first published last month in Retail Traffic, a sister publication of SN. Elaine Misonzhnik is associate editor at Retail Traffic.