CREJ - Retail Properties Quarterly - February 2015
Strong job growth, a diverse and expanding economy, falling vacancy rates, increasing rental rates and a continued increase in demand from national and international investors made 2014 a good year to own a retail investment property in the Denver-Boulder metro area. As we head into 2015, the following top four trends will shape retail investment results for investors in Colorado: 1. The desire for yield will continue unabated as financial assets continue to produce very low yields. This will result in continued cap rate pressure as demand for retail real estate remains strong. 2. The oil price “collapse,” if sustained, will boost consumption, benefit retailers and increase retail sales, but will be a double-edged sword in some economies where energy employment is significant. 3. Continued improvement in job growth, reduced unemployment and increasing retail sales will result in increased demand for retail space, helping to reduce overall vacancy and increase rental rates. 4. A modest increase in new retail construction will result in positive net absorption and keep supply and demand for retail space in relatively healthy balance. In addition to the strong fundamentals, the continued low interest rate environment has resulted in considerable investor interest in purchasing and owning retail properties. Investment yields on traditional financial assets, Treasury securities, corporate bonds and savings accounts are very low by historic standards, resulting in investors across all spectrums seeking real estate investments to achieve higher rates of return. The result has been downward pressure on cap rates, as buyers seek retail investments financed at historically low rates, making deals attractive at cap rates that only a few years ago would not have made any sense at all. Post-recession investment sales of multitenant shopping centers in the Denver-Boulder metro area generally have seen the most velocity in grocery-anchored shopping centers and Class A power/lifestyle centers, which are heavily sought after by institutional buyers, on one end of the spectrum; and, distressed/valueadd properties, generally targeted by more entrepreneurial investors, on the other end. In 2014, Class A properties generally sold at aggressive cap rates as interest rates fell (80 basis points over the course of the year), loans were available with increasing leverage at very low rates, and additional demand was created by an influx of national and international institutions. Noninstitutional, private-party investors and investment groups, which had been active multitenant retail investors for years, generally have been disappointed at the small number of distressed or valueadd opportunities with achievable upside available over the last few years, and either have withdrawn from the market or substantially reduced their transaction velocity. Some have begun targeting smaller redevelopment projects in densely populated, infill areas. Recently we also have seen these “upside” entrepreneurial investors attempting to acquire Class B and C properties for existing cash flow, without an obvious value-add angle, but these properties remain a small portion of the post-recession market due to a very limited supply. A part of the market that has seen a sizeable increase in demand recently is the market for smaller multitenant properties leased to high-quality tenants. The 1031 exchangers who flock to singletenant properties with long-term leases in place increasingly have been discouraged by the low capitalization rates that these properties command. Many of these buyers have turned to small multitenant retail strips with two to five tenants, and have very low management requirements due to the discrepancy in capitalization rates. This increase in demand has put downward pressure on capitalization rates for these properties, but small multitenant strips still remain a good value in comparison. What remains true across all spectrums of multitenant retail properties is that the supply of such properties is limited relative to demand, and there is an abundance of buyers chasing the properties that are properly marketed. It is very much a seller’s market. The dramatic drop in oil prices (under $50 a barrel when this article was written) will result in an increase in disposable income. Consumers will have more money to spend on discretionary items, and the boost in overall spending is expected to benefit the retail industry and shopping centers in general. This silver lining for most, however, does have a potential downside in certain areas where “fracking,” drilling and exploration make up a significant percentage of the employment base. Negative impacts could substantially outweigh the positive ones in areas such as Weld County and the Western Slope. Between January 2008 and yearend 2014, the Denver metro area was among the top 10 metro areas in the nation for job creation. For 2014, the Denver-Boulder metro area is on track to create over 42,000 jobs, increasing employment by 3.2 percent (7 percent above prerecession levels). Moving forward, Leeds School of Business at the University of Colorado Boulder is projecting that Colorado will be among the top 10 states in 2015 with respect to job growth. It is projecting 61,300 additional jobs at the state level. Declining oil prices will negatively impact job creation in the energy exploration sector, which could be an issue particularly for communities heavily reliant on the recent energy boom. New job creation and increased consumer spending, fundamental drivers behind retailer’s demand for space, have spawned the reduction in vacancy rates. Metro Denver’s vacancy rate peaked soon after the 2009 recession ended, and has been on a steady decline since then. Overall retail vacancy rates in the Denver-Boulder metro area have declined from 6.5 percent at the end of 2013 to approximately 5.8 percent by the end of 2014. Much soughtafter retail space in the DenverBoulder metro area, especially the Colorado Boulevard/Cherry Creek submarket, has a vacancy rate of 2.4 percent, while vacancy remains the highest in the northwestern suburbs, about 8.5 percent at the end of 2014. We are projecting an overall retail vacancy rate in the low 5 percent range at year-end 2015. The number of new retail developments has been limited to a great extent by tightening credit requirements from lenders. Lenders are requiring developers to have some “skin” in the game, to have more signed leases from creditworthy tenants in hand and, in general, are not making loans on “spec” developments. Loan-to-value ratios are also more conservative. This has led to more disciplined decision making by developers, and an emphasis by a number of them to focus on redeveloping and rehabbing older, infill shopping centers. As a result, construction deliveries of retail square footage were limited to approximately 850,000 sf in 2014. In comparison, Denver metro area’s historical average of retail square footage delivered annually over the last 32 years is about 3.6 million sf, according to CoStar. Limited supply of new product coupled with declining vacancy rates have led to increasing asking rental rates. Average overall rental rates peaked in 2008 in the mid-$17 per sf range, and troughed in 2011 at close to $15. The 2014 year-end average rental rate is approximately $15.75, an increase of 2.5 percent over the previous year, and a 6 percent rise since bottoming out during the recession. While average asking rents remain lower than their prerecession highs, it appears asking rental rates have turned a corner after remaining relatively flat for several years. To recap our 2015 Colorado retail forecast for the Denver-Boulder metro area, we believe that new construction will be muted, with very little spec space being built, and most developers will concentrate on infill redevelopment and upgrades to existing properties. Overall vacancy will decline 75 to 80 basis points to almost 5 percent, and rental rates will increase 3.2 percent to $16.33 per sf. On the transaction side, demand for properties will continue to outstrip supply, resulting in a seller’s market; cap rates will continue under pressure, with cap rate compression in secondary and tertiary areas, as well as with B- and C-quality properties, so the difference in cap rates between top properties and others will narrow considerably. Demand will continue to be strong for larger, high-quality institutional properties and groceryanchored centers. One risk to our forecast is that if interest rates were to increase abruptly, the red-hot high end of the investment market likely will be tempered until sellers and buyers adjust to the new equilibrium the higher interest rates would create. Additionally, if the oil price decline is foretelling of a much softer economy than currently anticipated, employment, growth and retail sales could be affected.