Retail: Good Looking And Popular
Strong retail property performance attracts a crowd.
Bernard J. Haddigan

Retail has enviably been the only property sector with growth in net income over the past 3 years based on national averages. Given this strong performance, investors have flocked to the retail sector, driving up prices and compressing cap rates. For baby boomers nearing their retirement years, and for institutions seeking to meet the cash-flow demands of their investors, retail offers promising returns. Cap rates are forecast to likely rise in the next 12 to 18 months as interest rates climb higher and siphon off some of the pent-up demand; however, evidence suggests that yields will remain low compared to the previous norm, with institutional and private investors willing to trade in the potential for higher returns for low-risk reliable cash-flow opportunities. Compared to other commercial real estate sectors, retail has proven itself to be the most stable and in many cases is less management-intensive. Price appreciation is anticipated, although it is not expected to match levels achieved in recent years. Expect investor demand for retail properties to remain strong through 2005.

Consumer Strength Lifts Retail

Consumer spending has held up the economy in the last few years. In 2004, for example, retail sales grew by more than 7 percent, but personal income growth was slightly less than 5 percent. Since 2001, consumers have pulled $460 billion of equity out of their homes, of which about 25 percent went toward discretionary spending. Additionally, the average credit card debt carrying a balance is now estimated at approximately $13,000 per household. In 2005, cash-out refinancing activity is forecast to decline at least 30 percent as interest rates continue to rise. With less cash on hand, retail sales growth should decelerate to 4 percent. But as rising interest rates are expected to dampen refinancing activity, job growth is forecast to accelerate to 2 percent; and inflation is expected to remain mild. These factors will help counteract the effects that rising interest rates will have on consumer spending power.

Moreover, corporate profits are returning to a healthy state, capital expenditures are back on track and productivity is running at high levels. Professional and business services, and education and health care services, are forecast to account for over half of the 2.6 million new jobs projected for 2005. The creation of well-paid positions bodes well for the retail sector.

Retail Ranks High on Investors' Shopping Lists

The nation's retail investment market is going strong, fueled by a deep buyer pool, price appreciation, and the modest improvement in vacancy and rent growth recorded last year. While private investors have dominated sales over the past few years, the investment landscape is changing with institutional capital now fully engaged and buyers willing to take on additional risk. Private investors continued to support sales velocity in the single-tenant and strip center sectors, while REITs and syndications through tenancy-in-common (TIC) have been the most active buyers of larger retail centers. Foreign investors have increased their presence as well. Led by Macquarie Bank of Australia, foreign interests spent nearly $2.5 billion on retail properties last year.

Looking forward, despite some near-term risk to retail fundamentals, we expect continued high transaction velocity and modest price appreciation. While private investors' competitive edge will begin to be squeezed by rising interest rates, the re-emergence of institutional capital and ongoing presence of public/private REITs and syndicates are expected to fill the void this year. With price appreciation forecast to slow in 2005, we expect an increase in the availability of quality assets as investors look to redeploy equity into higher cap rate property sectors, such as office. Additionally, investor appetites for value-added and re-tenanting opportunities in good locations will be satisfied as a result of major retailer consolidations, such as Sears/Kmart and CVS/Eckerd. Velocity will further be supported by activity recorded in secondary and tertiary markets as investors continue to migrate from overheated metros.

Institutions and pension funds will shift from net-sellers to net-buyers in 2005, as the availability of quality assets increases and private investors' competitiveness is squeezed by higher rates. We expect the number of net-leased properties on the market will rise this year as investors who acquired these assets begin to take profits. Investors will target the best of the Class “B” malls in secondary and tertiary markets as well as underperforming mid-tier properties in core markets. The average cap rate for multi-tenant properties fell 70 basis points to 8.1 percent in 2004, while single-tenant properties traded for an average cap rate of 7.5 percent.

The number of sales rose slightly in 2004, registering a 2 percent gain over the 2003 level. Single-tenant properties supported the gain as investors closed 6 percent more transactions in 2004. Value appreciation continues to support healthy returns. As measured on a 1-year and 5-year basis, retail properties have returned 19 percent and 74 percent, respectively.

Retail Market Characterized by Stability

Vacancy is forecast to remain relatively unchanged in 2005, though it could surprise on the upside should consumers prove more resilient than expected. Rent growth will total 2.5 percent for the year. Markets in Southern California and the Southeast are outperforming the U.S. average, a trend we expect will continue over the next year.

Retail stability can be attributed largely to controlled levels of speculative construction in the sector. Construction has remained tenant driven, as many of the major chains have shown a strong preference for build-to-suit space. In 2004, 25 million square feet of neighborhood and community center space was completed, up from 23 million the previous year. Mall construction totaled 4 million square feet last year, compared to 3 million in 2003. Asking rents kept pace with inflation in 2004, rising 2.4 percent. Effective rents posted a similar gain for the year. Overall vacancy declined by an estimated 20 basis points in 2004, as healthy retailers maintained somewhat aggressive expansion plans.

During 2005, developers are forecast to deliver 27 million square feet of neighborhood and community center space. Mall construction will ease slightly to 3.8 million square feet. In addition to new construction, several aging regional malls are currently being renovated/re-tenanted. With construction driven primarily by demand, vacancy is forecast to post a minor 20 basis point decrease to 9.9 percent. Both asking and effective rents will post similar growth rates of approximately 2.5 percent this year, keeping pace with inflation.

Wal-Mart Changing the Grocery Industry

As Wal-Mart opens its new supercenters nationwide, the company is rapidly gaining market share. It is forecast that by 2008, traditional grocers will capture less than 50 percent of food sales, as consumer now have several options in which to shop for food and household goods, including warehouse clubs, dollar stores and drugstores. Already, some grocers are pulling out of areas where Wal-Mart has an established presence, such as Texas and various regions in the Southeast. It is estimated that for every Wal-Mart Supercenter opened, two traditional grocery stores will close. Many traditional grocers, however, are expanding their product lines and services to battle the Wal-Mart threat. Overall, vacancy for community centers, which typically are anchored by grocers and other general merchandise retailers, such as discounters, is at a healthy 7.2 percent, up only 110 basis points since 2000.

Top-Performing Retail Markets

Marcus & Millichap recently released its 2005 National Retail Index (NRI), which ranks 41 retail markets based on a series of 12-month forward-looking supply and demand indicators. The markets at the top of the index rankings typically exemplify retail stability, thus garnering investors' attention, and report such strong characteristics as low vacancy, strong retail sales, favorable demographics, high incomes and, for the most part, stringent barriers to entry.

The highest ranked markets in the 2005 NRI include Southern California, Washington, D.C., South Florida, San Francisco and New York City-Manhattan. Also of note, a number of tech-heavy markets made significant upward moves in the rankings due to positive economic indicators. Above-average incomes and renewed job growth support strong retails sales in Denver, which climbed six spots. Other tech markets such as Seattle, Portland, Austin and San Jose all moved up in the rankings as well.

San Diego received the Number 1 ranking in the index, moving up two spots from last year. The San Diego retail market is expected to lead the nation in rent growth, post the second-lowest vacancy rate, and boasts top-10 marks in both retail sales and household growth. San Diego's average rental rate is projected to increase 5 percent to $24.94 per square foot in 2005, while the vacancy rates clocks in at 3.4 percent.

Orange County, California, secured the Number 2 ranking. Growing retail sales are luring more retailers to the market, evidenced by Orange County's vacancy rate of 3 percent and its annual rental increases of 3 percent to 4 percent. The Washington, D.C., market remains a favorite of investors based on its strong economy, below average vacancy (6 percent) and high personal income. Fort Lauderdale and West Palm Beach, Florida, round out the index's top five, based on expectations of continued strong employment and household growth. The two South Florida markets are projected to record employment growth of 4.5 percent and 4.3 percent, respectively.

Bernard J. Haddigan is the national director of Marcus & Millichap's National Retail Group, which focuses exclusively on the brokerage of retail investment properties. Haddigan can be reached at bhaddigan@marcusmillichap.com.