Investors Are Underweight in Retail. Here’s Why That’s a Mistake

The retail asset class is gaining more attention because of its strong fundamentals — low vacancies, limited new development, and rising rents — not to mention higher going-in cap rates, according to a new report from Colliers.

Retail drove 18% of all sales volume in Q3, the highest share since 2018, Colliers said.

But perhaps that share should have been higher. “Investors are likely ‘underweight’ to retail exposure,” according to the report.

“While it is unlikely that retail will see a 30% share as it did in the early 2000s, there is room for it to take on a larger share of the investment market in the near term.”

A Bifurcated Market 

But it is important to understand how bifurcated the retail investment sales market has become, says Chad Littell, national director of capital markets analytics at CoStar Group, who tells GlobeSt.com there is a sharp divide between deals under $5 million and the rest.

“Historically, half of all retail investment transactions were for less than $5 million, and most of those deals were even smaller, under $3 million, Littell said.

Specifically,  transaction volume for retail assets under $3 million has been the most active segment in retail capital market sales representing 36% of all transaction volume through Q3 2023, according to Christopher E. Maling, principal-retail capital markets with Avison Young. The next most active segment is $3 million to $10 million representing 24% of the transaction volume, he said, and the next segment is $10 million to $25 million representing 25% of the volume. Lastly, the over $25 million volume is 15% of the sale transaction volume.

It is the low end of the retail investment sales market that grows during economic downturns, CoStar’s Littell said. “The buyers in this space are driven by tax deferral and long-term estate planning, not necessarily persuaded by the most effective way to allocate capital at a given snapshot in time, and therefore, the low cap rates seen today can appear to be detached from alternatives in the marketplace.”

Things change once you reach $20 million to $30 million, according to Littell.

“Considering power center sales above $30 million as a market sliver, total sales volume in this space is down 97% from the market top in the fourth quarter of 2021.

“Investment sales in this area haven’t been this sluggish in over 20 years. Meanwhile, grocery-anchored neighborhood centers are thriving, and high single-digit rent growth is still occurring in many Sun Belt markets such as Phoenix.

“In certain instances, as late-cycle narratives go, retail vacancy is worth more than occupied space where the mark-to-market story is still strong.

Littell said that after more than a decade of underbuilding, the retail market is at all-time low vacancies and is still seeing 3% annual rent growth compared to office and multifamily, where they’ll be “lucky” to stay positive in 2024.

Retail Versus Multifamily, Industrial 

Another appealing aspect of the retail investment market is the nominal level of yields that can be achieved compared to multifamily and industrial properties, he said.

“Where those two property types offer going-in yields in the 5% to 6% range today, a large swath of larger retail properties can be acquired in the 6.5% to 8% range, depending on the product type and location. A 200 bps to 300 bps swing in yield is material and will likely draw new capital into the sector in 2024 as NOI growth turns negative in office and multifamily,” Littell said.

“So, investors will be rewarded by segmenting the retail market into size and vintage and scrutinizing the quality of the property’s rent roll. The high-end consumer is still flush with cash, and those at lower income thresholds are showing signs of weakness.”

On a relative basis, next year should see a positive environment for retail capital markets, but it will not be uniformly positive, according to Littell.

“Loan maturities increase in 2024 and 2025, and owners will have to deal with the reality that borrowing costs have risen from the mid-3% range to the mid-7% range, which will pose challenges to those unprepared to respond accordingly.”

The Growth of Unanchored Strip Centers 

Grocery-anchored strip centers are the most actively traded sub-type by volume YTD at $6.1 billion, but unanchored strip centers are gaining fast with $4.3 billion in transactions, according to JLL. 

JLL Senior Managing Director, Capital Markets, Americas, Danny Finkle tells GlobeSt.com he expects to see unanchored strip retail centers become the hottest asset class in retail for 2024.

“The unanchored strip center is considered an appealing investment for several reasons, including its necessity-centric tenant base with a higher retention rate, the diversity of income, the lack of reliance on a single-anchor tenant, the lower CapEx as a percent of NOI compared to other retail sub-types, the above average historical and forecasted rent growth and the highly fragmented and non-institutionalized ownership profile.”