By Taylor Williams
“The greatest victory is one that doesn’t require a battle.”
Ancient Chinese military strategist Sun Tzu penned that line as part of The Art of War, but in applying the expression to the (almost) equally cutthroat business of developing and investing in retail real estate, there is some wisdom to be gleaned. In simple terms, sometimes the best decision, at least temporarily, is to do nothing.
Passivity does not come easily to commercial builders and buyers. Where their investors are concerned, these companies often have strict timelines for deployment of funds and even stricter benchmarks for guaranteed returns. When market conditions are favorable, these groups are pressured to maximize growth, in terms of both direct mandates from shareholders and indirect obligations via competitors being aggressive in the market. For better or worse, the market sentiments surrounding real estate development and investment embody classic principles of capitalism, and that’s unlikely to ever change.
But if there is one thing developers, investors, lenders and operators across all asset classes can likely agree on, it’s that market conditions in 2024 have not been favorable. Yet the push for growth has merely slowed, not disappeared. New product must get developed to meet demand of growing populations, and sales must proceed, at the very least, for owners with looming debt maturities, estate plans or fund life expirations. Activity cannot simply be put on hold indefinitely just because interest rates have risen aggressively and a monumental presidential election has taken place. This is not COVID-19.
For those reasons and others, Texas retail owners and brokers generally expect 2025 to be a year of elevated deal activity following a sluggish 2024. In fact, this turnaround may already be underway: the Mortgage Bankers Association recently reported that commercial loan originations for retail assets were up 82 percent year-over-year in the third quarter.
“The past year has been difficult in terms of investment sales, but we have bullishness on 2025,” says Matt Rosenfeld, senior vice president in the Dallas-Fort Worth (DFW) office of Weitzman. “The [September interest] rate cut had a positive impact, but it’s not across the board yet. Some groups have become sellers again, and some have become buyers again. The situation has improved, but we still have a ways to go before everyone really gets back into the market.”
Other sources also agree that the Federal Reserve’s 50-basis-point interest rate cut in mid-September, while welcome, is unlikely to yield instantaneous results. The same is largely true for the 25-basis-point cut that was handed down in early November.
“The rate cut was already baked in for the most part,” says Jeff Pape, managing director at GBT Realty Corp., a developer based in the Nashville area that is active in Texas. “Everybody expected something to happen this year, but even so, there was a sense that no matter what happened with interest rates, everybody was going to wait to get through the election and holidays and reassess. The expectation was always cautious optimism and that market conditions wouldn’t drastically change, and so the focus remains on 2025.”
“Anytime it’s an election year, especially one that’s so divided, you can expect further economic uncertainty, which can lead to a pause in transactions,” adds Will Volk, executive vice president at MIMCO LLC, a shopping center owner based in El Paso. “Now that it’s settled, that should help set the table for 2025 and hopefully give investors a better understanding of where we are heading.”
“There’s still a substantial amount of commercial debt set to mature over the next couple of years, and interest rates are forecasted to continue to come down,” he adds. “So we’ll hopefully see a more elevated transaction environment than what we’ve experienced recently.”
Paces of retail development and investment will, of course, vary by submarket and subcategory of product. Owners will continue to face challenges in assessing seller motivations, cap rate movement, bid-ask deltas and replacement costs. Those variables all factor into larger strategies, and the parameters that govern them have shifted over the course of a very turbulent year.
“At the peak of the market, we could’ve sold a new shopping center at a 5.25 cap rate, then there was a point when you couldn’t sell that same center at a 6.5-cap,” says Rosenfeld. “Now you’re starting to see newer shopping centers sell in the 6- to 6.5-cap rate range depending on the tenant mix, how big the center is and how much [lease] term [is left]. But overall, there has been some downward movement on cap rates since the Fed made its cuts, and people are anticipating further cuts.”
Analysis of Fundamentals
In less than a decade, brick-and-mortar retail has survived two seismic events — the normalization of e-commerce in American shopping and the widespread shutdowns brought on by COVID-19 — that might’ve spelled death for the sector. Instead of crumbling, the asset class has responded with record levels of physical occupancy and rent growth.
“It turns out that the internet didn’t kill brick-and-mortar retail; COVID didn’t kill brick-and-mortar, and the cherry on top has been that we stopped overbuilding,” says Chace Henke, principal at Houston-based Edge Realty Capital Markets. “Vacancy dipping below 5 percent in many areas, rents growing attractively and co-tenancy and exclusivity clauses getting reworked — all of this has contributed to the stability and resilience of the asset class.”
According to third-quarter data from CBRE, the national retail vacancy currently stands at 4.7 percent. Direct availability has not exceeded 6 percent since the third quarter of 2020 — the height of the pandemic — despite various bankruptcies from big box users and redevelopments of regional malls that decrease total retail square footage.
Supply growth bears some responsibility for this dynamic. According to CBRE, roughly 4.3 million square feet of new retail space was completed in the third quarter, a 49 percent decrease from the preceding period and the lowest quarterly volume of new deliveries in more than a decade. Net absorption for the quarter was 3.9 million square feet.
Over the past decade, retail rents have grown nationally by an average of just under 2 percent year-over-year,
according to CBRE. But between the third quarter of 2023 and that of 2024, average asking rents grew by 2.5 percent. The average asking rent across all U.S. markets now stands at $24.36 per square foot.
Fundamental statistics are especially strong in Texas, where no amount of whims from the Federal Reserve or political divide can slow the influx of jobs and people. CBRE’s report breaks down the numbers market-by-market.
With 821,000 square feet of retail space absorbed in the third quarter, Dallas (not DFW), was the second-leading U.S. market for this metric behind Philadelphia. Consequently, average asking rents in Dallas are up 4.2 percent, and vacancy has compressed by 20 basis points to 4.6 percent on a year-over-year basis.
“Retail in DFW has never been better,” says Rosenfeld. “We’re seeing investors that a couple of years ago only wanted [to invest in] industrial and multifamily now wanting to get back into retail. We also expect to see institutional capital jump into the mix to a greater degree in 2025.”
With about a third less inventory than its metroplex neighbor, Fort Worth has an even lower vacancy rate — 4.4 percent to be exact — although that market’s rents remain considerably below the national average. Houston also saw positive absorption of retail space in the third quarter to the tune of 589,000 square feet, yielding a 10-basis-point compression in vacancy from 5.3 to 5.2 percent. And despite posting negative absorption in the third quarter, Austin remains the tightest Texas market of all: 3.7 percent vacancy and average asking rents that exceed the national average at $27.83 per square foot.
For all of those reasons, sources agree that the rise in cap rates for retail assets in recent years has largely been driven by interest rate hikes at the macroeconomic level, not by factors that erode valuations at the microeconomic level.
“In the low-interest rate environment, retail did not experience the same degree of cap rate compression/price inflation as other product types,” explains Henke. “As a result, retail continued to experience higher transaction volumes and trade at historically strong cap rates deeper into the rate hikes than other asset classes. This was also driven by smaller deal sizes coupled with a prevalence of available capital, which helped avoid reliance on debt.”
“The fundamentals of [retail real estate] have actually kept cap rates from going higher than they otherwise might have,” adds Pape of GBT Realty. “We saw it a little bit in 2009 to 2011; we thought cap rates would go even higher, but they held because good fundamental real estate represents safe harbors in the storm. A grocery-anchored center with a good operator and location will have people pushing the envelope, subsequently keeping those cap rates lower because it’s a great long-term investment.”
GBT Realty recently broke ground on Burleson Commons, a 50,632-square-foot neighborhood retail center on the southern outskirts of Fort Worth. Phoenix-based grocer Sprouts Farmers Market will anchor the center with a 23,256-square-foot store that is scheduled to open next summer.
In addition to its new store in the Fort Worth suburb of Burleson, Phoenix-based grocer Sprouts Farmers Market will open a 23,000-square-foot store in Kyle, a southern suburb of Austin. The Kyle store will be located within a larger neighborhood center known as The Shops at The Brick and Mortar District. GBT Realty Corp. is developing both Sprouts-anchored projects.
A Tough Sell
It is ironic that the establishment of such healthy fundamentals in the retail sector has coincided with paltry deal volume, but it is not hard to understand why.
As retail fundamentals have rebounded, the capital markets have become awash with uncertainty and caution such that debt and equity providers have not been willing or able to grease the skids for more sales.
The logic goes something like this: If a seller does not have a major life or capital event coming up, why part with a property that is stabilized, flowing cash and growing in value due to healthy demand and minimal new supply growth? And if a buyer does not have a fund life expiring or other shareholder obligations to meet and must finance the purchase at an elevated interest rate, why push to acquire?
Brokers — at least those interviewed for this story — stated unequivocally that although it may mean less money in their pockets, they are generally advising clients to heed these pieces of logic.
“As brokers, we sometimes have to be counselors,” says Rosenfeld. “Every buyer and seller has a different situation, so you have to get down in the weeds and hope that they open up to you on where they stand so you can provide the best possible advice.”
“We’re advising many clients not to list today but wait until the first quarter of 2025 to see what happens with rate cuts,” agrees Michael Kaplan, vice president in the DFW office of retail brokerage firm SRS Real Estate Partners. “There are a lot of benefits to holding a little longer if you can. This cycle has taught us the importance of being advisors and considering things from ownership perspectives and being strategic with long-term decisions.”
“The majority of our business is seller representation, so our biggest challenge has been to overcome the inevitable question of ‘why we should sell in this market if we have to turn around and buy in this market?’” reflects Henke. “It has required a lot of creativity and off-market transactions and interactions for clients to not only get comfortable with new buyer underwriting, but also to find short- and long-term solutions on where to place capital.”
Needless to say, all of these market conceptions led to significant slowdown in trades between early 2023 and mid-2024. Volk of MIMCO has experienced the mentality firsthand.
“Most of the deals we’ve evaluated or taken a run at have had some sort of capital situation such as a loan maturity or estate planning [behind them],” he says. “We’ve also seen some transactions resulting from private equity funds that are at the end of their terms and need to harvest. So that’s generated some opportunities for properties that have to come to [market], but overall, there aren’t a ton of deals out there.”
In recent weeks, however, investment sales activity has shown signs of starting to pick back up, according to
Kaplan.
“Prior to rate cuts, beyond a slowdown in deal activity, there was a level of uncertainty, and that was the hardest thing to navigate,” he says. “Once the Fed flatlined for several quarters, we had a playing field in which we knew what the rules of the game would be. That allowed cap rates to stabilize and for buyers and sellers to know the parameters of debt markets and to basically hit a floor for cap rate stabilization. That allowed us to start playing ball in the ensuing six to eight months such that deals were penciling [out].”
Other sources concur.
“In the months leading up to the [interest rate] cut, we were already seeing the market’s anticipation of the rate cut and the corresponding impact on treasuries which improved investor sentiments and deal economics,” says Henke. “But ultimately, the rate cut buoyed the hope that debt markets are starting their journey toward terms that will encourage deal flow at volumes that are more in line with historical norms.”
Another factor that has disincentivized sellers from listing their properties or pulling the trigger on sub-optimal offers stems from the historically high prices that were recorded in the pre-rate-hike era. The realization that this record pricing is a thing of the past is helping some sellers get back into the market, even if they have no pressing need to transact. This is especially true with stabilized retail properties or assets with light value-add potential.
“Because compressed cap rates [for retail assets] went a little deeper into the era of interest rate hikes relative to other asset classes, there were still a few worn-off trades that were keeping seller expectations optimistic,” says Henke. “But now, enough time seems to have passed in this depressed transaction market that sellers are starting to get over the idea that ‘COVID pricing’ is not achievable.”
Edge Realty Capital Markets recently negotiated the sale of Westheimer Plaza, a 24,000-square-foot shopping center in Houston. The center features a mix of national and local retailers as well as a strong contingent of food-and-beverage users, and the sale comes as larger indicators of rebounding deal volume are beginning to take shape in Texas markets.
Still, pricing discrepancies take time to resolve.
“The bid-ask difference creates challenges for current owners, and until that delta comes back down and debt gets easier [to obtain], we will continue to see sellers holding onto assets longer than they may have intended to,” says Kaplan.
Why Build?
Real estate has many adages, but perhaps none so simplistic as the notion that “developers develop because that’s just what they do.”
In retail, that maxim has been thoroughly tested in recent years, and not just due to the usual suspects of high land and construction costs. Yes, those capital inputs are not doing developers any favors, but a more subtle inspection of the dearth of new retail development inevitably invokes the concepts of replacement costs and exit cap rates.
When it comes to assessing replacement costs — the amount of money it takes to replace an existing asset with a similar one at current market prices — the decision usually comes down to basic math. Setting aside land and construction costs and higher interest rates on construction loans, other variables in the formulas for calculating the cost to build versus buy are making the numbers harder to pencil out, sources say.
“Today, to develop a new center from the ground up, with all the TI (tenant improvement) allowances and commissions, you’re looking at close to $400 per [square] foot,” says Rosenfeld. “But if you can buy an existing center — older product that is — at $200 to $250 per square foot, you’re well below your cost-to-build basis.”
“With the exit cap rates for new construction — meaning 2020 and beyond — you’re looking at dispositions in the low $400s to the low $600s per square foot,” adds Kaplan. “So buyers looking at replacement costs view anything built after about 2018 as null and void. But if you’re looking at assets built between 2000 and 2010, you can find product in the high $100s or low $200s [per square foot]. The basis is healthier; the center has had a long cycle and is maybe on the second or third tenant turn — that’s where people see real value.”
Kaplan also cites $400 per square foot as the high-end point on the spectrum of what it likely costs to develop from the ground up in 2024. But without the escalating inputs like TI allowances that derive that end-all, per-square-foot number, owners will never be able to tenant the space, he says.
Henke of Edge Realty agrees that TI allowances are getting out of hand and making new construction deals harder to pencil out.
“We’re watching landlord and tenant rep activity with regard to tenant build-out costs very closely,” she says. “We’ve always reaped the benefits of having limited development due to high construction costs and other factors, which has improved fundamentals. But when it comes to TIs, we’re hearing more about commitments being impacted by those build-out costs. The sky is not the limit on what tenants can pay on those.”
But as previously noted, there are not many deals for sale, and those that are listed will likely require premium offers, hefty debt and stubborn equity — or all of the above. So while it has made more sense for retail owners to buy than build over the past couple years, that dynamic may be starting to reverse course.
“The theory that it’s too expensive and there are too many headwinds to new development is correct [relative to buying], but the challenge is that with everything that’s happened in the current environment, there’s very little product for sale,” explains Pape.
“Owners of existing assets know that if they sell, they’ll have to finance into a new deal at a rate that’s double what they have now,” he continues. “So theoretically, owners should be able to buy cheaper with cap rates elevated, but it’s hard to find deals, though that does vary among the subcategories of retail.”
Other Factors
In addition to compelling reasons within the basic business of real estate that dictate passive growth strategies, there are other capital markets-based factors behind why retail investment sales activity has remained so muted for much of the past two years. However, they can be easy to overlook.
At a basic level, there is the general risk-averse stance of the investment market, which is common in election years and post-inflationary environments.
Banks are currently offering investment vehicles with yields that are comparable to returns on real estate transactions with significantly less risk. The same holds true for 10-Year Treasuries, yields on which have been exceptionally volatile this year and have further bucked historical norms by rising in the aftermath of the Fed’s first rate cut. Yields on
10-Year notes further spiked following the election of Donald Trump as the 47th U.S. president.
“You can put your money in a CD (certificate of deposit) or money market and get a comparable return of 4.5 to 5 percent, though that’s going down due to the rate cut, and there’s not a lot of additional incentive to go buy a shopping center and take on those headaches,” explains Rosenfeld. “That’s why the retail deals being chased are those with opportunities to roll existing tenants or increase existing [rental] rates and upgrade the center.”
“Changes in interest rates create a domino effect; rates go up, capital pulls back and realizes it can invest in a money market and get a decent return with much less risk,” concurs Pape.
Much has also been written about the willingness of banks to work with borrowers to extend and modify loans to avoid massive defaults, foreclosures and further failings of banks at the regional and local level, where the majority of commercial debt is held. But that is not the full story. Sources say that banks will also avoid taking back the keys to properties because they are not equipped to service them while in receivership.
“In 2007, foreclosures on commercial and residential assets were at an all-time high outside of the savings and loan crisis,” explains Kaplan. “Today we have banks sitting on the sidelines. But there’s also a realization that if they foreclose and take back properties, they don’t have the resources to work on these assets and deal with the receivership and special servicing on the small, regional bank side.”
A recent report from financial services ad bond ratings agency Moody’s found that the median percentage of modified commercial real estate loans rose to 48 basis points in the first half of 2024, up from 18 basis points in 2023. Among the 39 banks analyzed, modification rates varied significantly — some banks had no modifications, while others modified more than 2 percent of their portfolios.
In addition, the Moody’s report stated that because interest rate cuts, which were originally predicted by many to begin as early as March 2024, were unmet until September, banks were forced to implement modifications as borrowers faced increased financial strain. By mid-2024, banks had modified roughly 1 percent of their total commercial loans.
“A lot of lenders have become really aggressive in renegotiating terms with owners and stretching terms out to get past this challenging period and create some runway to avoid taking properties back because they just can’t work them,” Kaplan continues.
“Banks have restructured debt to make it favorable and fair to them but also to give borrowers enough runway to either continue to stabilize or to grow rents. The goal is to get debt service coverage ratios to a point where the lender is comfortable or unload at a cap rate that makes sense for all parties.”
— This article originally appeared in the December 2024 issue of Texas Real Estate Business magazine.