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Cap-rate compression puts the squeeze on investors

“Deal heat” is an expression that Jack Welch, the outspoken and colorful former CEO of General Electric, likes to use to describe a bidding war for a company or an asset on the selling block. “You've got these investment bankers who only eat what they kill. They've got to make the deal at all cost.” Welch's humorous remarks, delivered with a thick New England accent, came before a packed audience of several hundred people during the International Council of Shopping Centers (ICSC) annual convention in Las Vegas last month.

The legendary executive's comments were certainly timely as evidenced by the more than 40,000 attendees at this year's show. Today's shopping center investors are encountering deal heat at every turn, and no one is more aware of that trend than Joseph Cosenza, vice chairman and director of the Inland Real Estate Group of Cos. Inland ranks as the fifth largest owner of shopping centers in the U.S. Already this year, Inland has acquired nearly $2 billion worth of properties involving 70 transactions. That's on top of the approximately $4 billion in acquisitions and 168 deals completed in 2004.

Thanks to a large network of broker-dealers, Inland is able to raise a whopping $10 million in capital per day for its various retail REITs, which focus on grocery-anchored and community shopping centers. “The most important thing facing retail investors today is high prices, lower cap rates, and the thought that interest rates are going to be trending up, which will start squeezing returns,” stated Cosenza during a “Retail Trends 2005” session hosted at ICSC by brokerage Marcus & Millichap. If cap rates trend any lower, Cosenza emphasized, “something is going to have to give.” Depending on the market and the individual property, cap rates are as low as 5%.

Marcus & Millichap reports that on a state-by-state basis, cap rates on retail centers average 161 basis points higher in California than Texas. “As you go across the country, you will find better cap rates on properties in the Midwest and the Carolinas,” said Cosenza. “The cap rates on the East Coast were very good until about 12 months ago. Those are starting to go down now more and more.”

With so much capital chasing deals and the 10-year Treasury yield hovering at a paltry 4%, the prospect of higher cap rates and lower prices doesn't appear imminent. Such pent-up demand for real estate will only enhance the deal heat.

Wealth management

Much like institutional owners, many individual real estate investors with holdings in shopping centers and other property classes have benefited greatly by soaring property values. In some cases, prices have doubled over the past five years.

As Harvey Green, president and CEO of Marcus & Millichap, noted during an interview on the ICSC show floor, the real estate industry is embarking on an important evolution. “We're moving out of hard-asset real estate, in my opinion, and we're beginning to move into wealth management. Whether we want to or not, that's where our industry is going.”

Rarely do I hear real estate professionals talk about wealth management, but Green's comment makes perfect sense. Depending on their age and financial goals, high-net-worth investors in commercial real estate face some critical choices. Should they enter into a 1031 exchange to effectively trade up? What property type should they exchange into? Or should they sell and pay the capital gains taxes? Much depends on their estate planning needs. For these investors, the issues on the table are certainly a high-class problem.

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