When comparing this year’s retail investment sales market to last year’s, the main difference is the dramatic increase in the cost of capital. Naturally, this has led to a decrease in transaction activity and a disconnect between buyers and sellers.
Over the past year, the Federal Reserve has raised the federal funds rate nine times for a total of 475 basis points to tame inflation. These actions have led to a sharp rise in commercial mortgage rates, which have a significant impact on pricing. The average mortgage rate on loans closed in the fourth quarter of 2022 across all commercial real estate asset classes was 5.3 percent, according to CBRE, up from 3.3 percent in the fourth quarter of 2021.
Additionally, according to the Federal Deposit Insurance Corp. (FDIC), 2023 represents the largest year in bank failures in terms of total assets since 2008. In March, the FDIC took the reins at two regional banks, Silicon Valley Bank and Signature Bank, after massive bank runs.
“Many would-be sellers are on the sidelines due to the downward pressure on pricing, leading to lower transaction velocity,” says Matt Hazelton, senior director with JLL Capital Markets in Minneapolis.
“Property values have decreased about 10 percent as a result of higher interest rates that are now in play. Investment sales are understandably lower than they were last year, but this is due to a lack of supply rather than demand,” says CJ Jackson, a first vice president with Marcus & Millichap’s Columbus office.
“We had an 18-month window (January 2021 through June 2022) where debt was extremely low and available, and therefore values were able to be pushed to peak levels,” continues Jackson. “Now that has passed, and seller and buyer expectations have not quite met. However, we are starting to see that change now that the market is getting more used to this new normal of rates.”
Sources interviewed estimate that retail transaction volume in the first quarter of 2023 decreased roughly 30 to 40 percent compared with the same period a year earlier, but retail fared better than some other asset classes. Hazelton’s takeaway is that despite the current economic headwinds, retail remains in favor with investors.
Zachary Turner, senior advisor with Marcus & Millichap in Columbus, Ohio, echoes this sentiment saying that the market remains strong with an abundance of buyers seeking deals.
“Overall sales volume has tapered off from an all-time high in 2021 and early 2022. However, we are still seeing strong numbers,” says Turner. “From a historical perspective, property values on a macro basis are as strong — or stronger in some instances — as pre-COVID levels. Barring a situation like a recession, the investment market should in theory continue to be robust. Buyers are still very well capitalized and willing to pay strong pricing to sellers.”
In March, the Consumer Price Index increased 5 percent, representing the smallest year-over-year gain since May 2021, but still well above the Fed’s goal of 2 percent inflation. Also in March, U.S. retail sales fell by 1 percent from the month prior, according to the Commerce Department. One major reason: U.S. average hourly earnings have failed to keep up with inflation for 24 straight months, according to the New York Post.
What Buyers Want
Grocery-anchored shopping centers and unanchored strip centers are both in high demand from a wide variety of investors, states Hazelton.
“Grocery and other necessity-based retail tend to perform well through varying cycles. The thought is that any center featuring a grocer or other necessity retailer provides stable customer traffic to other tenants and financial stability to the center’s rent roll,” says Hazelton.
“The unanchored strip center investor is focused on the diversity of revenue, strong revenue growth profile and low capital expense needs. The strong rent growth in smaller strip centers justifies buying at lower going-in yields given the opportunity to grow net operating income.”
Hazelton and his colleagues recently brokered the sale of Crossroads Center of Roseville, a 357,115-square-foot retail center in the Twin Cities suburb of Roseville, Minnesota. Built in 1985, the property was 97 percent leased at the time of sale to tenants in a variety of industries such as fast casual dining, cosmetics, sporting goods and fitness. HJ Development acquired the asset.
Marcus & Millichap’s Turner says that Class A and B strip centers have historically been on the lower price-point range of retail real estate, which opens them up to a larger audience ranging from private individuals up to large companies and funds. These types of properties are generally the easiest to manage and are made up of small shop space, which are often easier to re-tenant and perceived as low risk.
Turner cites the recent sale of Copperleaf Village in Blue Springs, Missouri, as an example. The asset generated buyer interest and an aggressive price. The 32,978-square-foot property sold for $6.9 million. Originally built in 1973 and extensively renovated in 2003, the asset was 82 percent occupied at the time of sale by medical, dental, restaurant, convenience, fitness and insurance users.
The sale also included two developable pad sites on the north and south ends of the property. A local owner sold the asset to a private West Coast-based 1031 exchange buyer.
“The seller achieved a great price, but the deal also offered an abundance of upside opportunity for the buyer, so both parties had great results,” says Turner.
Brett Berlin, vice president with Quantum Real Estate Advisors Inc. in Chicago, states that buyers are highly interested in value-add retail product. They are pursuing assets with some vacancy, rolling leases or the opportunity to build outlots. “At the end of the day, for someone to buy a stabilized asset and not really have any upside, that’s tough,” says Berlin.
Ben Snyder, executive vice president and national director of shopping centers with Matthews Real Estate Investment Services in Cleveland, says that value-add grocery is the hottest type of asset investors are currently seeking, but well-positioned multi-tenant centers are still trading as well.
“There is yield in retail that investors can’t find anywhere else,” says Snyder. “The rising rents that supported multifamily and industrial are moderating, so the risk-adjusted return of retail is very compelling.”
Emily Gadomski, vice president with Mid-America Real Estate Corp. in Chicago, states that there is still investor demand across most retail product types. However, the deals getting done are typically smaller and require that the cap rates make sense given the rise in interest rates. She says most activity is coming from private capital buyers in deals that are $30 million or below.
Gadomski recently brokered the sale of Waukegan Plaza, a 211,190-square-foot community retail center in the Chicago suburb of Waukegan, Illinois. At the time of sale, the property was 89 percent leased to tenants such as Ross Dress for Less, Burlington, dd’s Discounts, rue21, Shoe Carnival, Family Dollar, Rainbow, DTLR, Citi Trends, Cricket Wireless, GameStop, Subway, USPS and Aaron’s Rental. A private seller sold the asset to a West Coast-based 1031 exchange buyer.
Peter Block, executive vice president with Colliers in Rosemont, Illinois, says that buyers are looking for creditworthy tenants. Consequently, corporate guarantees are important. In the restaurant space, examples of tenants that investors are seeking include McDonald’s, Chick-fil-A and Chipotle. Buyers are also actively pursuing pharmacies, dollar stores and auto shops.
Buyers Outnumber Sellers
The appetite for properties is bifurcated by investor type, says John Feeney, senior vice president with The Boulder Group in Wilmette, Illinois. “The prototypical 1031 exchange or private capital buyer is targeting top-tier credit tenants in top 10 metros with long-term leases.”
Feeney believes that the market is split between private and institutional buyers. But regardless of investor profile, the one commonality in the current environment is that low-leverage or cash buyers are winning the lion’s share of closed transactions.
Loan-to-value ratios across all commercial real estate asset classes averaged 58.2 percent in the fourth quarter of 2022, a decrease from 63.4 percent in the fourth quarter of 2021, according to CBRE.
Marcus & Millichap’s Jackson says that the majority of sellers are either looking to capitalize on a scenario in which they have acquired and stabilized assets or are seeking to cash out rather than refinance a maturing loan. “There are significantly more buyers than sellers right now, as there is still a significant amount of capital sitting on the sidelines and a distinct lack of inventory.”
This lack of inventory is contributing to lower transaction volume and higher prices. “Deals that are for sale get immense buyer focus and, in turn, higher pricing than what they might otherwise get,” explains Turner.
“Right now, if sellers don’t have to refinance then they aren’t going to contemplate a sale,” says Quantum’s Berlin. “There’s still a disconnect happening in the marketplace, even though there’s a ton of capital that is looking to put their money to work.”
In late 2022, Berlin and his colleague represented a private Illinois-based fund in the sale of a 13,000-square-foot retail property in the Chicago suburb of Oak Lawn, Illinois, for $3.5 million and a cap rate of 7.5 percent. Built in the mid-2000s, the asset was fully leased at the time of sale to tenants such as Chiro One, Miracle One and Cold Stone Creamery. The Illinois-based private buyer completed a 1031 exchange.
Private sector purchasing is often a byproduct of a 1031 exchange or an abundance of capital seeking a home or transition from alternative investments, notes Turner.
In 2022, private investors were the most active buyers and sellers of retail assets in the Midwest, ultimately accounting for more than 80 percent of all acquisitions, according to Hazelton. Institutional investors and REITs were net sellers in the Midwest in 2022, acquiring just under $500 million in assets and disposing of nearly $1.2 billion. Hazelton expects private capital to continue to be active in 2023.
Groups that jumped into retail investment during the pandemic looking for yield are still around, but they are having more trouble finding financing, Snyder points out. “Retail is a nuanced asset class that requires strong relationships and experience,” he says. “The established groups with deep banking relationships are best positioned to execute right now.”
Cap Rates Rise
The consensus among sources is that cap rates for retail are trending upward due to rising interest rates and borrowing costs. But some industry experts argue that the increase in cap rates is not nearly as much as one might expect given the volatile capital markets and the choppy economy.
“The Midwest and multi-tenant retail in general have always both had higher cap rates, so we have not had to push them up as much compared with other property types or geographies,” says Jackson. “Compared with a year ago, cap rates are up anywhere between 50 and 75 basis points.”
Gadomski says the level of cap rate increase depends on the specific retail product type. “We’ve seen traditional regional and power center cap rates increase 150 to 200 basis points, while cap rates for grocery-anchored centers have increased to a lesser degree, ranging from 100 to 150 basis points. Cap rates for unanchored neighborhood shopping centers have risen 75 to 125 basis points,” she states. “Single-tenant assets have generally seen the most nominal adjustment.”
The Boulder Group, which specializes in single-tenant, net-lease properties, recently released its net-lease market report for the first quarter. The firm noted that national asking cap rates for retail increased to 6.05 percent, an increase of 10 basis points over the prior quarter. This figure represented the highest level since the third quarter of 2020.
Feeney and his team recently brokered the sale of a Burger King-occupied property in the Chicago suburb of Buffalo Grove. Burger King has occupied the 3,000-square-foot property since its construction in 1977. The asset was listed at $1.3 million, representing a cap rate of 5.25 percent.
“Even in a challenged investment market, we were able to source a full-price offer that closed in less than 30 days,” says Feeney. “The buyer was attracted to the long-term history of the tenant as well as the low rent level.”
This article was originally published in the May 2023 issue of Shopping Center Business magazine.