The search for yield is pulling more investors toward the retail real estate sector and this has led to a pop in values. According to the CoStar Commercial Repeat Sales Index (CCRSI), retail asset values appreciated more than those of any other property type in 2013, with prices rising 15 percent. Growth in office building values was far lower at almost 9 percent, and apartment growth the weakest, at 6 percent.
Despite its stronger showing, retail remains cheaper than other property types; NCREIF implied cap rates for retail properties are closer to 6 percent than 5 percent, the average rate for apartment and office assets. In the broader transaction market, many retail assets are trading at an even wider spread to apartment and office properties. Therefore investors are looking harder at the retail sector as a yield pick-up play and, more recently, are testing value-add and opportunistic strategies.
An opportunistic strategy is particularly attractive on paper, as the bifurcation in the marketplace is extreme. Vacancy is concentrated in a few assets. For example, 69 percent of neighborhood center space is less than 10 percent vacant, while 17 percent of neighborhood center space is on average more than 40 percent dark.
However, “fixing” these centers is difficult. First, aggregate demand in the retail sector remains muted. Store closures have slowed, but some former credit tenants continue to close stores by the dozen. Fewer tenants are expanding today, and those that are may not target the same shopper profile that a previous tenant did, or worse, may be unwilling to pay the same rent. Second, consumer patterns shift after a center experiences a substantial dive in occupancy—consumers reroute shopping habits to more attractive centers and it is hard to rewire them to return. Third, investors remain particularly cautious about the retail sector. To date, only the best retail properties have had values recover. The retail CCRSI in prime markets is back to prerecession highs, but the national index is still down 16 percent from the peak of the previous cycle.
Meanwhile, the discount for properties with high vacancies has blown out from as little as 35 percent pre-recession (2005–06) to 85 percent today, which may accurately reflect the high risk of investing in these troubled assets. Many are not viable based on local trade area demographics and investors are aware of this. Our research has shown clear delineation in pricing by both market and local trade area demographics; attributes that are near impossible to “fix.”
Value-add strategies face the same challenges, though the hurdles are not as high. A group of class-B assets continues to carry a more manageable overhang of vacant space; for example, about 14 percent of neighborhood centers have an average vacancy rate of 14 percent. Vacancies have been slowly but steadily falling for two years now, suggesting that these centers remain viable. The same observation cannot be made about lower quality centers. The pricing discount for assets with vacancy in the 10 percent to 20 percent range today is about 40 percent, but they had no discount during the boom years (2005–06). And improvement in pricing is evident for these class-B assets, although it is early days.
At this point in the cycle, with little probability of recession and a slow but steady increase in risk taking, capital will continue to move toward higher-yielding assets. The weight of this capital should lead to declining cap rates in second-tier assets and help to push values up. This should be a nice tailwind for investors, once they tame the headwinds.
This article was republished with permission from National Real Estate Investor.