CREJ - Retail Properties Quarterly - May 2018
One year ago, we contributed an article to CREJ’s Retail Properties Quarterly that emphasized the strength of the consumer. Negativity surrounding retailer bankruptcies and store closures were grabbing headlines, and changing shopping patterns and impacts from e-commerce were well documented. But, the consumer was strong – and still is. Retailers with the right products, services or experience find plenty of discretionary income to capture within the Denver market. This year, we would like to shift the focus to the investors of retail real estate. In similar fashion to retailer headlines, record-breaking transactions and the rumors of “crazy pricing” get all the buzz. Deals that feature a historically high price per square foot, or the lowest of capitalization rates, are what people talk about. You’ll often hear the cynics say, “I can’t believe they paid that price!” “The Denver market is too hot right now.” “I’ll wait to buy it next time.” And, so it goes. But there is a lot of investment taking place that doesn’t grab the headlines or break any records. Only the passage of time will allow us to know if it’s the buyers or those on the sidelines who were correct in predicting the future. Our assessment of the present market is that it is in balance and sustainable. In my opinion, investors are more disciplined in the assessment of risk than in any prior market cycle. We are seeing buyers scrutinize every aspect of the shopping centers brought to market. Characteristics including location, creditworthiness, demographics, access, visibility, market rental rates, occupancy cost, profitability, retail sector risks, debt implications and residual value of the land or improvements. All of the variables lead to value conclusions with the widest spread in cap rates in the last 15-plus years. The investments viewed as the safest and most sustainable have received cap rate pricing slightly below 5 percent. Conversely, open air centers with risk can become nearly illiquid or trade in +/- 9 percent range. Currently B malls are the most contrarian of all retail investments and can trade well into the teens on a cap rate basis. Generically, cap rates range from 5 to 9 percent for stabilized multitenant retail. Prior to the recession (2004-2007), the generic cap rate range was tighter and closer to 6 to 8 percent. The lessons learned from 2008-2011 included the reality that the best centers, with the most fundamental strengths, will prevail. So, while there are a select few record-breaking transactions, the market is in balance and the valuations properly reflect the risk profile of the investment. Debt drives the market and is the primary component of the capital stack. Even when investors are tempted to stretch in their valuations, lenders are remaining disciplined, which is leading investors to soften pricing in the most recent quarter. Current loan to values have been ranging from 60 to 70 percent. Interest rate spreads remain almost double what was being offered prerecession. And, the majority of acquisition financing is being secured with prepayment capabilities (noncommercial mortgage-backed securities), which will provide for a more liquid market moving forward. The debt market will fluctuate with macroeconomic events, but the current disciplined issuances leads us to believe that the debt market is helping to govern more sustainable property values. Denver’s population growth has been a primary contributor to retail success. Every person who moves here is the drop of water that creates the ripple effect in our economy. The city of Denver surpassed 700,000 residents in 2017. After five consecutive years of over 2 percent growth, the pace has slowed; it was 1.6 percent in 2017. Consumer spending increased year over year in every month of 2017 as compared to 2016, second only to Houston, which had unique circumstances. Unemployment reached a low point of 2.3 percent but is now slightly above 3 percent. The point is, Denver’s economy is extremely strong and the drivers of retail sales remain strong. Transaction volume hit a peak in first-quarter 2016, due to record-setting cross-border transactions and the culmination of post-recession recovery. Since then, sales volumes have cooled. Two property profiles are receiving the strongest buyer interest and premium pricing support. The first is grocery-anchored centers with supportive sales volumes. The second is value-add acquisitions with lease up and management opportunities and shorter-term hold intentions. Extremely safe or extremely profitable leads to current pricing strength. Our company recently conducted a survey of the top shopping center owners in the United States. A few interesting trends emerged: 1. Ninety-one percent of owners hope to acquire more in 2018, while only 47 percent intend to sell more in 2018. 2. Seventy-two percent believe power center cap rates will increase, while only 21 percent believe grocery-anchored cap rates will increase in 2018. 3. If/when interest rates increase 50-100 basis points, pricing will be significantly impacted. There are headwinds that can’t be ignored, such as property tax assessments, increasing gross rental rates, costs of tenant improvements, a rising interest rate environment and the continuous evolution of e-commerce. However, investors are smart and sophisticated, they understand all of these threats and more, and many learned hard lessons a decade ago. Investors understand how to utilize information and experience to guide future investment probabilities. As a result, we believe the market is in balance, lenders and investors are disciplined and overall retail property values are sustainable.