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Rising Caps

The retail real estate industry feared this moment for the past three years, but everyone knew it would come. The first hints arrived early this summer, when class-B and class-C retail assets started trading at cap rates higher than 7 percent, above last year's sector-wide average of 6.9 percent. The reported increases ranged from 30 basis points to 100 basis points, depending on the region.

At the time, brokers talked of a bifurcated market. Because of the assets' higher quality and because buyers of class-A real estate don't rely on debt as much as buyers of B and C assets, pricing would hold up, the reasoning went. But today, as the subprime mortgage meltdown continues to rankle debt markets, some brokers are saying that offers for A assets are declining and cap rates may rise. Even the most hopeful are coming to the conclusion that the long boom in commercial real estate is ending.

In July, investors closed the smallest number of commercial real estate deals since August 2006, at 930 transactions valued at more than $5 million, Real Capital Analytics researchers told Bloomberg. Stephannie Mower, executive vice president with PM Realty Group, a Houston-based real estate services firm, reports that this July the firm experienced a 14 percent drop in sales activity across all asset classes, the worst performance in five years.

She says many of her institutional clients are purposefully staying away from acquisitions right now, not because they don't have the cash, but because they figure that prices will soon begin to drop on even the best quality assets. Across the board, they expect to see a discount of 15 percent before year's end.

Troubles in the debt markets are crippling leveraged buyers. Conduit lenders especially have stumbled, unable to sell loans they originated at terms they used six months ago into a secondary market suddenly squeamish about risk. From 2006 to August 2007, spreads to 10-year Treasuries for AA-rated fixed-rate CMBS loans, for example, more than doubled, jumping 122 basis points in all to 211 basis points from 89 basis points in 2006, according to RBS Greenwich Capital.

Bernard J. Haddigan, senior vice president and managing director of the national retail group with brokerage firm Marcus & Millichap Real Estate Investment Services, says CMBS lenders also no longer play fast and loose with their underwriting. They won't grant investors interest-only mortgages, nor are they willing to hike up the loan amount to cover small property defects, such as a vacant space, in a core asset. In the past year, the acceptable loan-to-value ratio dropped to 60 percent; in 2006, investors still closed deals at 95 percent loan-to-value. The tighter lending standards in turn have sapped the pool of potential buyers, with cash-rich institutional funds still going strong, while the more debt-reliant individual investors struggle to find deals that work.

“People have been asking when the cap rates are going to go up and the answer is about eight weeks ago,” says Philip D. Voorhees, senior vice president of retail investments with CB Richard Ellis.

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