What to Expect from the Retail Sector

What to Expect from the Retail Sector

Now that the first quarter is almost over, retail property owners have had a chance to assess how well property valuations performed in the fourth quarter, and what trends await them in the years ahead.

Average retail cap rates, which had been on a steady decline since the recovery, might be heading for flat terrain, according to the Moody’s /RCA Property Price Index. For the month of January, the retail sector saw its first monthly price decline in six years, according to Moody’s/RCA report.

Seven of the 10 component indices in the Moody’s/RCA PPI recorded declines in January. Price levels for the three core commercial property types—office, retail and industrial—declined by an aggregate of 0.8 percent. The results suggest that investors remain committed to holding on to institutional quality real estate assets, but they might not be willing to push prices higher for the time being.

Unless the commercial real estate industry gets a big outside shock, pricing is likely to remain at current levels, according to Jim Costello, senior vice president at Real Capital Analytics (RCA), a New York City-based research firm.

For a while, property pricing remained robust despite lingering post-recession troubles. From a bird’s eye view, average retail cap rates have generally been on a downward trend since the recovery in 2009, according to the CBRE’s “National Retail Cap Rate Report.” In the fourth quarter of 2015, the national average cap rate was 6.48 percent, a 20 basis point dip from the previous quarter. The trend hit every region of the country, with the Eastern region taking the biggest hit, a 43 basis-point drop.

Such a price performance put the retail sector on par with office properties in central business districts (CBDs).

“If you look at institutional cap rates, retail is priced very similarly to office, its closest corollary over history,” says Suzanne Mulvee, director of research and real estate strategist at CoStar Portfolio Strategy, based in Washington, D.C. “Where it is lagging is where retail itself is struggling. That tends to be the exurban or suburban areas, where the pain of recession is being felt still.”

At the same time, properties in infill locations are seeing rents 5.0 percent to 6.0 percent higher than where they were at the market peak of the last economic cycle, Mulvee notes.

“Those cap rates reflect a full-priced market,” she says.

A fully-priced market doesn’t necessarily mean that prices will immediately retreat, however. The six major metropolitan areas: Boston, Chicago, Los Angeles, New York, San Francisco and Washington, D.C. are all still very attractive to institutional and global capital, according to Tad Philipp, director of commercial real estate research at Moody’s. Commercial property prices in major markets increased by about 2.1 percent over the three months leading up to the fourth quarter. That outpaced growth in non-major markets, where prices increased by 0.6 percent, according to an earlier edition of the Moody’s/RCA CPPI report.

In fact, office and retail properties in CBDs saw the biggest gains in price growth in 2015, with gains of 25.0 percent and 19.0 percent respectively. The CBD office sector started 2015 strong, but growth decelerated over the last half of the year. Retail, on the other hand, posted a particularly strong performance in the last six months of the year.

Such strong pricing has been supported by solid economic fundamentals, according to Mulvee. In CBDs, incomes on a real basis are up by 8.0 percent, compared with suburban incomes on a real basis that are down by 8.0 percent.

“You can blame the recession for accelerating this,” Mulvee notes, “but it is an ongoing trend.

Moody’s researchers note that the retail sector remains hot, even amid recent bankruptcies and the impact from e-commerce competition. The latter is highlighting the differences in performance between strong shopping centers and weak ones.

However, “The long period of cap rate compression might be nearing an end,” according to Philipp. “Prices are likely to go sideways than up from here.”

Going forward price appreciation on retail properties will likely be driven by income improvement, specifically increased rent revenues. Retail remains a strong asset class, along with CBD office and hotel sectors, in the aggregate of major geographic markets, Philipp notes.

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