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Retail Cap Rates Shoot ‘Through the Roof’ as Fundamentals Slide

Just when it seemed that retail fundamentals had hit historical lows and might begin leveling off, a second-quarter report by New York-based research firm Reis projects that neighborhood and community center vacancies will rise to 12% next year while capitalization rates are expected to continue climbing. (The higher the cap rate, the lower the purchase price of properties).

“Vacancy level projections will exceed any historical level Reis has on record by 2011,” Victor Calanog, director of research at Reis, said in a capital markets briefing on Wednesday. He projects that vacancies for neighborhood and community centers will peak at 13% by 2011.

“We do not see a recovery in the retail sector until 2012 at the earliest,” says Calanog. Meanwhile, rising cap rates reflect the decline in expectations about future net operating income and relative risk aversion toward retail property investments.

Like vacancies, cap rates have soared. Mean cap rates, calculated on a dollar-weighted basis by quarter, rose by 170 basis points in the second quarter to 10.1%, following a year of extreme volatility.

But there were wide swings in cap rates across geographic regions, however. On the whole, retail properties that traded hands in the Midwest in the second quarter sold at an average cap rate of 12.2%, although community centers in the same area registered an average cap rate of 10.2%.

Calanog emphasized the relationship between deteriorating fundamentals, lower transaction activity and cap rates. Average effective rents for neighborhood and community centers dropped to $17.01 per sq. ft. in the second quarter, from $17.20 in the first quarter. What’s more, effective rents have fallen from an average of $17.58 per sq. ft. a year ago.

Reis projects that effective rents will continue to decline through 2011, when they are expected to reach $16.13 per sq. ft., before rising slightly in 2012 to $16.23.

Meanwhile, the fluctuation of cap rates by region or submarket along with a 19.2% quarterly drop in transaction dollar volume indicated that a shifting mix of properties changed hands and buyers and sellers continued to disagree on property valuations, says Calanog.

The retail transactions occurred against a backdrop of sliding sales activity nationally for all commercial real estate property types. Year-over-year, the drop in transaction activity in the second quarter of 2009 compared with the same period a year earlier reached a staggering 71% decline in dollar volume, and an 89% drop from the second quarter of 2007.

That coincided with an ominous trend across commercial real estate sectors — a significant rise in mortgage delinquency rates, Based on data from the Federal Reserve and the Federal Deposit Insurance Corp. (FDIC), delinquencies (loans 30 to 89 days past due) rose from a low of 1% in 2006 to a current high of about 8% in the second quarter.

“The trend line represents a rather pronounced increase in a relatively short period of time,” says Calanog.

However, the national rate is weighted by the delinquency rate for construction and development loans, which rose to 10.92% in the first quarter of 2009, the most recent data available from the FDIC.

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