InterFace Panel: Interest Rate Movement Raises New Questions for Retail Investment Strategies

by Taylor Williams

By Taylor Williams

Retail owners are facing critical questions about whether to sell or hold their properties in the current environment, which is still defined by uncertainty about whether interest rate hikes have truly peaked and investment sales prices have actually bottomed out.

Investment sales decisions frequently hinge on analysis of cap rates, defined as a property’s net operating income divided by its sales price. Generally speaking, higher cap rates indicate lower sales prices and are therefore sought by buyers, whereas lower cap rates reflect higher prices and are preferred by sellers.

Cap rates are fluid and tend to move linearly with interest rates. Thus, the Federal Reserve’s campaign of 11 interest rate hikes totaling 500 basis points over the last 20 months has caused cap rates in all asset classes to rise, or as industry folks say, to decompress. The extent to which this cap rate movement influences an investor’s sell-or-hold dilemma varies from deal to deal, but the common denominator is that it complicates all such decisions.

At the inaugural InterFace Houston Retail conference, a panel of capital markets professionals delved into the numerical analysis and anecdotal evidence that investment sales brokers are relying on to guide clients through this environment. But in the absence of a crystal ball that outlines the Fed’s next move, definitive conclusions were bound to be limited.

The panelists therefore focused on clearly defining the market conditions that are most relevant to delivering safe, intelligent analysis to their retail clients.

“Today, we’re in an environment in which the spread between borrowing [costs] and cap rates is incredibly tight, and in some cases even inverted,” began Kris Von Hohn, director of retail investment advisory at Cushman & Wakefield’s Houston office. “One of two things has to change in that equation — either cap rates decompress further and widen the spread, or rates come down. But we don’t see rates coming down in the near term.”

Von Hohn qualified his statement by saying that he did endorse the notion that rate hikes could soon be ending. Such a definitive signal by the nation’s central bank would encourage more would-be sellers to bring their deals to market, thus allowing for more price discovery, he said.

Price discovery is indeed central to rebounding deal volume. Buyers and sellers both need to feel comfortable about the likelihood of getting their number(s) in order to transact. But despite the fact that interest rates have been trending upward for nearly two full years in a bid to stave off decades-high inflation, it remains unclear just how close to the trough the market actually is. That leads to more stalled negotiations over pricing as well as more flamed-out deals.

“Repricing discussions are much more prevalent today, often occurring before due diligence has even ended, as you see buyers feeling for the bottom,” Von Hohn said. “And while we don’t know what’s going to happen in the future, the question we should be asking on these buy-sell decisions is ‘what is our hold horizon?’”

Marc Peeler, senior vice president of investment sales at NewQuest Properties, which both develops and markets retail properties in the Houston area for sale, was the next panelist to weigh in. In keeping with the previous theme of price discovery, Peeler noted that the market was beset with retrades at present.

Retrades refer to deals in which purchase prices are initially agreed upon but then renegotiated at a lower level due to the buyer seeing or perceiving some change in the broader capital markets.  

“In terms of pricing expectations, 24 months ago, we could probably hit within two to five basis points of our sellers’ ask[ing cap rate],” Peeler said. “Now we’re letting the market tell us what the price is, then finding the buyer that comes in at the right price, knowing that there’s strong potential for retrades. And that makes it tough.”

Burdette Huffman, executive vice president at locally based brokerage firm Blue Ox Group, generated a silver lining in the discussion when he noted that the Houston retail market is not bereft of buyers. The hitch, of course, is that buyers of all profiles are constrained by the debt markets. Further, there are only so many buyers that can close deals with capital stacks that feature high — or entire — proportions of equity.

“We field so many calls from people looking to buy $2 million deals at 8-caps — we could sell those every day,” Huffman said. “But you have to consider the debt and equity components, and the debt markets are pretty much locked up. We put two deals under contract in the last week — one at about $3 million and the other at $5 million — and both should close at or close to all equity with very low loan-to-value ratios [on their debt].”

While buyers grapple with the immense challenges of securing semi-affordable debt and/or raising significantly more equity than in years past, sellers are contending with issues on the operations side of the business that are adversely impacting valuations. These headwinds are offsetting some of the positive momentum that the retail sector has recouped in the post-COVID era, during which time supply growth has been minimal and consumer spending has held firm.

Panelist Drew Reinking, a senior associate on CBRE’s retail investment sales team in Houston, elaborated further on this subject.

“We’ve seen a couple deals die this year over insurance — we recently closed a deal in which insurance went from 84 cents per square foot to $2.85 per foot,” he said. “If a property has any vacancy, the landlord eats that [portion of the insurance cost]. Property taxes are also going up.”

“Conversely, we are seeing healthy demand and leasing activity, as well as a lack of new supply,” he continued. “So we expect rents to rise in the short term until construction costs and land prices either come down or stabilize.”

Suffice it to say that brokers who advise these buyers and owners have their work cut out for them.

You may also like