Cap rates sank 63 bps in the last year due to limited supply

CHICAGO—Developers across the country have been careful about building new retail outlets even though the recession officially ended several years ago. This lack of new construction has pushed down cap rates for net lease product that does hit the market as investors line up to make bids.

“Cap rates in the single tenant net leased big box sector compressed from the fourth quarter of 2012 to the fourth quarter of 2013 by 63 bps,” according to latest report from the Boulder Group, a net lease firm based in suburban Chicago. The decline from a 7.73% cap rate last year to 7.10% by the end of last quarter parallels a similar decline in other retail properties. As reported last month in, Boulder found that rates in the net lease retail market sank from 7.02% in the third quarter to 6.85% in the fourth, the data show, and the first time in the past decade that sector’s rate fell below 7.0%.

In its latest report, Boulder notes that “the decline in cap rate was primarily due to the limited supply of big box properties available within the net lease market. Investor demand was driven by institutional investors and real estate funds targeting higher dollar valued properties to reach acquisition goals after a record fundraising year.”

Many big box retailers that plan to expand have discovered they still have the option to occupy second generation real estate at a low cost, further cutting into the need for new construction. “Typically, rents for a new construction freestanding big box property exceed second generation rents and tenants can occupy second generation space quicker,” the report says. Furthermore, big players such as Costco, Target and Wal-Mart frequently own their own real estate, taking large blocks of retail space out of the net lease market.

Boulder expects that investors in big box retail will continue to bid most aggressively for properties tenanted by investment grade companies. Cap rates for big box properties with investment grade tenants hit 6.25% in the fourth quarter, 125 bps lower than those with non-investment grade tenants. This significant gap has led some investors to change their “acquisition criteria to include non-investment grade properties, like Academy Sports, Best Buy and Hobby Lobby, as higher yields can be achieved,” Boulder notes. “The supply of investment grade properties only made up 25% of the big box market in 2013, a 5% decrease from a year ago.”

Boulder expects that in 2014 developers will continue to produce new big box retail at a limited pace. However, “the low supply of new construction assets should be offset by maturing CMBS loans. Property owners with maturing debt will have the option to either refinance at low interest rates by historical standards or sell and take advantage of the low cap rates available in today’s net lease market.”