Retail Traffic

Surprising Upside

Marcus & Millichap sees retail as commercial real estate's dark horse.

There's no question that retail real estate is on the mend after a few tough years. But, by and large, it is still not seen as a favored class among all commercial real estate property types.

In compiling its 2011 National Retail Report, Encino, Calif-based Marcus & Millichap Real Estate Investment Services found that the outlook for the sector may be better than many investors imagine and it could end up being an outperformer.

“The headline takeaway to me is that retail is definitely the dark horse among the property types,” says Hessam Nadji, managing director of research and advisory services for Marcus & Millichap. “It is expected to be laggard, expected to be worse, but it seems poised to surprise everyone by its outperformance. After apartments — which are clearly well into recovery — when we look five years from now, we'll say that retail was the second most promising sector in 2011.”

Marcus & Millichap provided Retail Traffic with an exclusive sneak peek at its findings and Nadji sat down to discuss the results.

Retail Traffic: Why does the outlook for retail look so much better than expected?

Nadji: The consumer came back a lot faster than anyone anticipated. And that's reflected in the retail sales numbers being higher than they were pre-recession. That's a huge statement. Core retail sales are now above where they were in 2007.

The other factor that is behind this, is that as it turns out, the sectors that were hurt the most are the minority of the retail industry, not the majority. So you have the outlying construction that followed housing that went bust. You have aging class-B or class-C malls that are still very much lagging and hurting because retenanting them is very difficult. And you had the department store consolidation, which in the beginning was hurtful, but the survivors came back fast, particularly Macy's, JC Penney and even Sears. Concerns that those [factors] would drag down the sector didn't materialize.

RT: What will this mean for the investment sales picture?

Nadji: Our forecast is for a 25 percent to 30 percent increase in sales activity.… That will put us on par with about 2004, which was a strong year.

There are two things happening with investors. The first movers back into the marketplace were institutions and REITs. Their preference was higher quality assets, where there was a unique window of discounted pricing available to them because of the crisis. They were quick to take advantage and moved in very aggressively. That kind of activity dominated the second half of 2009 and most of 2010.

Now the cap rates on those top assets have compressed by 100 basis points from the middle of 2009. So it's harder to underwrite the same kind of approach.

In the last three months, we've seen a much bigger appetite on the part of institutions and private capital. They are still seeking large assets in good primary markets, but they now have a lot more tolerance for older centers or centers with higher vacancy rates. They are looking at more in class-B centers. We're not quite yet to class-B-minus or Cs. But there definitely is a downward movement in tolerance.

RT: What about on the private side?

Nadji: The private buyer has two different angles. Even during the worst of the crisis, private capital for single-tenant net lease properties continued to flow. We have this massive population of private investors that want to get a yield on their money that didn't have the usual alternatives. Therefore, single-tenant net lease — with predictable cashflows for credit tenants — was where the action was in 2009 and 2010.

As the recovery takes hold, because the private investor is really putting his or her own capital at risk, they tend to wait longer to get conviction that the worst is truly over. Now it's time to get back in on the market.

The other thing that kept them on the sidelines longer than normal is that they were anticipating a lot of distress sales like in the 1990s, when you could buy quality assets for 40, 50 or 60 cents on the dollar. Those levels of discounting never materialized for the kinds of assets they were looking for.

Now that we know what is distressed and what is not, that capital is frustrated and ready to come back in the market. They're not going to buy properties at 5.5 percent cap rates, but they will go into class-B, class-B-minus and maybe some value-add opportunities.

RT: How do interest rates affect things?

Nadji: The baseline foundation for the recovery in investment sales is low interest rates. The 2.5 percent yield on 10-year Treasury bonds that we had for a bit last year was abnormally low. The reduction to that level was an aberration. There was a lot of reaction when the rate jumped 100 basis points. But really, it came up from a low that should never have been achieved. Going forward, I don't think the yield will break 4 percent.

Meanwhile, anytime we've seen more than a 400 basis point spread between retail cap rates and interest rates, it has turned out to be an incredibly good time to buy. Previously, those periods were 1992, 1998 and 2002. And now we have that situation today. If that's not a strong buy signal, I don't know what is.

RT: How is lending shaking out?

Nadji: We're seeing more commercial banks come back to the market. If anything, commercial banks and even Wall Street banks want to lend more on commercial real estate — including retail — than there is currently demand for. So the lender side is improving dramatically.

Underwriting is still very tight. Debt capital isn't looking to just finance anything. So they still have a high sensitivity to quality of property, rent rolls, turnovers in the next two to three years and the quality of the buyer. So they're crossing their T's and dotting their I's. And loan-to-value ratios are holding at 60 to 65 percent. So they're not easing their criteria, but there is far more willingness to come back in the market. Ultimately, this further separates the market for good quality properties in good quality areas from the low-end product in the hardest hit spots. That gap is actually widening.

RT: Were there any surprises in your market rankings this year?

Nadji: The surprises came in Florida and Texas. Florida's economy hasn't really kicked into gear yet. It has lagged job growth. It disappointed in job creation in 2010 and our forecast in 2011 is better, but still not the robust numbers one would expect. Florida historically always has been a recovery leader in terms of job growth. That has yet to kick in.

So we didn't anticipate a big kick up in numbers. But some markets really did move up. Miami (+5), Tampa (+5) and Orlando (+8). It's not so much because of the economy. It's because so little supply of shopping centers was delivered to those markets. In addition, population losses have really leveled off.

Texas, meanwhile, has a notorious reputation for overbuilding. It still has high vacancy rates. But right now we have this rare window of time when the pipeline has emptied.

So you take a combination of a two-to-three year run of terrific job numbers and little new construction underway and the next couple of years could really be amazing. So as a result Austin (+5), Dallas (+5) and Houston (+6) all jumped in the rankings.

Other bright spots include Philadelphia, Portland, Denver and Northern New Jersey.

On the downside, you would expect Phoenix to be leading the recovery. But retail fundamentals are so bad that it will take longer than 2011 before you see a big pop. The same thing is true with Atlanta and with Riverside-San Bernardino, Calif. Another disappointment is Chicago. It's just kind of stuck right now.


2011 Rank 2010 Rank
Washington D.C. 1 1
New York City 2 4
San Diego 3 2
Los Angeles 4 6
Orange County, Calif. 5 7
Austin, Texas 6 11
San Francisco 7 3
Boston 8 9
San Jose, Calif. 9 13
Seattle 10 8

Sources: Marcus & Millichap Research Services, CoStar Group, Inc.

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