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Has the slowdown in retail real estate sales hit bottom?

Not yet, say wavering observers who predict that won’t occur now until the second quarter of 2009 when cap rates on retail properties will fall between 8 percent and 10 percent.

In the second quarter of 2008, significant retail sales transactions amounted to only $5 billion, according to New York City-based Real Capital Analytics. That represented a 63 percent drop from the second quarter of 2007. More alarming was the fact that the figure was a 30 percent drop from the first quarter of this year, when properties worth $7 billion traded hands, says Real Capital Analytics’ July report.

The slowdown continues in part because there is still not enough financing available for new acquisitions, cited Robert Bach, senior vice president and chief economist with Grubb & Ellis, a Santa Ana, Calif.-based commercial real estate services firm. With no new commercial mortgage-backed securities issuances in either July or August, year-to-date volume remains at just $12 billion, according to Commercial Mortgage Alert, an industry newsletter, down 93.6 percent compared to the same period in 2007.

Wall Street now accounts for just 1 percent of acquisition financing for commercial properties, according to Real Capital Analytics. From January 2006 through June 2007 it accounted for 33 percent of the market. At the same time, major banks slashed their lending volumes by 18 percent, finance/management companies by 4 percent and regional savings banks by 2 percent.

Over the last 12 months, average cap rates on strip centers moved up 40 basis points, to 7.0 percent, reports Real Capital Analytics. Cap rates on lifestyle centers went up 80 basis points, to 7.3 percent, and on power centers 50 basis points, to 7.0 percent. However, with buyers forced to put more equity into each transaction because of troubles in the credit markets and a grim prognosis on the state of the economy, the increases have not been enough to break the impasse in the sales sector.

When investment sales in the retail real estate sector first came to a halt, in the fall of 2007, market observers said they would rebound in the first quarter of this year. The forecast was then amended to the second half of this year, after the ICSC RECon convention in Las Vegas. Today, sellers have dug in their heels on pricing and buyers anxiously wait for the market to bottom out.

The lack of readily available financing is forcing some buyers to walk away from deals even when they are happy with the valuation, says Joseph C. French, national director of retail properties, at Sperry Van Ness, an Irvine, Calif.-based investment brokerage firm. But in the past few months, the lack of available credit has taken a back seat to another concern for prospective investors—the dire state of the retail sector.

This year, ICSC expects store closings to reach a 14-year high. Retailers are entering bankruptcy and announcing store closings almost daily. Now, retail acquisitions seem very risky, so buyers want to make sure they are getting good value for their money, says Gary Bringhurst, CEO of DBSI, a Boise, Idaho-based real estate investment firm.

“The slow-down in the retail sector has caused many buyers to stop purchasing retail centers altogether. This, [along] with financing, has contributed to the escalating cap rates,” says Bringhurst. He notes a reasonable cap rate for a well-anchored center in a core market today could be more than 8 percent.

Sellers, however, have not yet reached the point where they are willing to accept the notion that cap rates will only continue to rise, says Bernie Haddigan, national director of the retail group with Marcus & Millichap Real Estate Investment Services, an Encino, Calif.-based brokerage firm. He estimates it will not be before the second quarter of 2009 when the bid-ask gap will finally close and cap rates will stabilize at a level that’s more in-line with market fundamentals—somewhere around 8 percent for class-A assets and upwards of 9 percent for class-B and class-C properties.

The change, says Arthur M. Milston, managing director in the New York City office of Savills a global real estate services provider, will put short-term investors looking for “financial engineering” out of the market for good. But it will bring the marketplace back to a healthier place, where people who purchase retail properties do so for the value of the real estate and not for a quick speculative gain.

DBSI plans to spend $1 billion on commercial real estate acquisitions this year, including retail. But the firm will only consider class-A and class-B centers built since the late 1980s with occupancies above 80 percent in markets with either stabilized or positive space absorption trends.

“Cap rates of 3 percent and 4 percent [do not make] a healthy market,” says Stephannie Mower, executive vice president and managing director of national investment services with PM Realty Group, a Houston-based real estate services firm. “It’s a happy market, but it’s not a healthy market and now it’s going to be a market where buyers and sellers can trade with confidence as opposed to playing a game of musical chairs.”

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