Looking Ahead (and Back) at the Retail Capital Markets

The data speaks for itself; equity and commodity markets are up, interest rates are down, the US economy continues to add jobs and the unemployment rate has been below 5% for most of 2016 (that's about .5% higher than in Germany and .5% lower than in the UK).

GlobeSt.com: What other factors point to a strong real estate market going into 2017?

Voorhees: As an attorney friend of mine often reminds me, “Just because it's self-serving does not mean it's not true.” The following market facts point to strong investment real estate fundamentals, particularly when compared with investment alternatives.

• Interest rates are near record lows and show no signs of increasing. A Fed short-term rate increase should have little impact on the longer-term 10-Year Treasury Yield that substantially responds to global perceptions of risk. The relationship between current yield and risk is that they increase in correlation to one another. A higher current yield should be accompanied by a higher level of risk. And, the lower the yield, the lower the perceived risk. Given that the German Treasury is now in negative territory despite better economic, political and energy prospects for the US, it makes little sense that the US 10-Year Treasury Yield is comparatively so high. The same risk adjustment comparison is applicable to Japan, Spain, Italy and other countries as well.
• Debt financing is abundant and at historically favorable rates and terms, particularly at modest loan-to-value levels—and from all sources including banks, life companies, debt funds and even CMBS debt. (Yes, CMBS effectively took a break during the first quarter, but regained composure in Q2 and continues gaining momentum at the end of Q3 with effective rates still higher than bank or life insurance company debt, but once again a viable alternative for many investors.)
• There is fiscal prudence. Underwriting remains stringent, with scrutiny on historical property data, borrower credit, debt-coverage ratios, market-area fundamentals and reserves. In general, the resulting lower LTVs match investor preferences for stronger cash flow and security (as opposed to max leverage).
• The cap rate to the 10-Year Treasury spread is nearly as wide as it's ever been, providing a superior leveraged cash-on-cash yield opportunity (particularly considering the lack of yield elsewhere). For example, if the “best” core grocery-anchored center in the West sold for a 5.25% cap rate in April of 2007, and the 10YT was 4.65%, the cap rate/10YT spread was just 60 basis points. At present, with the “core” grocery-anchored cap rates around 4.25% with the 10YT at 1.65%, that spread is now 260 basis points—four times wider.
• We have healthy pricing/cap-rate spread. In this market, the cap rate spread between “A” and “C” assets is wide. If best-of-type “core” assets in a primary market are fetching low- to mid-4% cap rates in coastal counties, “C” assets in secondary markets can easily trade at 8%-plus cap rates in the West. This differentiation is not only healthy, it also points to a tremendous leveraged cash-on-cash yield opportunity in secondary and tertiary market areas—arguably the best in decades.
• Rents are comparatively low. Outside of key markets in the West (Marina/Playa del Rey, West Side L.A., etc.), retail rents still lag behind peak levels of the last cycle. Compared to the peak of the last cycle, Q12008, retail rents outside of major markets are still down 7.65%.
• There is limited development. Retail development remains at a fraction of historical levels, just 10% to 15% of peak levels. No oversupply problems here, particularly in the West where investor demand for institutional-quality retail properties remains exceptional. In fact, REITs, pension funds and advisors have become vaults for the best retail properties in the West—properties go in but never come out. With a limited supply of replacement investments available, it makes no sense to sell exceptional centers.

Retail evolves. The death of retail remains greatly over-hyped. Retail, like life, is an evolution. New developments pivot toward more restaurant, beverage, service and light-medical uses, and retail stalwarts accelerate implementation of omni-channel and Internet-leveraged retailing solutions. This year, for the first time ever, Americans spent more money eating out than at grocery stores. (It bears noting that it's not just retail changing as a result of the Internet—office space per worker has never been less, and hoteling or “hot-cubing” is now common practice.)

IRVINE, CA—If optimism was the theme in 2015, it must be uncertainty in 2016, Phil Voorhees tells GlobeSt.com. Whether it's the election, interest rates or global economic concerns, as well as a host of other issues, the retail market comes with a list of financial questions. We spoke exclusively with Voorhees—an EVP and a member of CBRE's National Retail Investment Group, responsible for retail properties in the Western US—about the state of the retail capital markets as of Q3 2016 and what he sees for this sector moving into 2017.

GlobeSt.com: What is your outlook on the retail capital markets as of Q3?

Voorhees: Fall is my favorite time of year, always has been. It's a great time to take stock of the year, to consider what can be accomplished between now and year end, and to look forward to the year ahead. Not to mention, it's the best weather of the year, particularly in the West.

The year 2016 started with a thud as the equity markets pulled back decisively in January through mid-February (the S&P dropped from 2,043 to 1,829, a 10.5% decline; -10.1% for the Dow), triggering investor concern and trepidation that has proved tough to shake. Granted, 2015 was a brilliant year for retail—the highest transaction volume and best retail year ever. However, uncertainty has thus far tamped down retail investment volume in 2016.

In the first half of 2016, national retail transaction volume was down about 19.74%, from $45.6 billion at the first half of 2015 to $36.6 billion thus far. The number of retail transactions in the West was down, too, from 846 at mid-year 2015 to 684 presently, a 19.15% decline in retail transactions greater than $5 million in size, according to Real Capital Markets. The steeper decline in the West was likely due to supply constraints. The West is a target market for nearly all investors, although those that own retail properties have been reticent to sell. By now, it's no secret that, outside of “core” retail properties (the top several centers in every primary market area) and true value-add opportunities (properties with good locations, strong real estate fundamentals, viable vacant space to lease, under-rented space to recapture, etc.), bidders are fewer and pricing is less competitive and harder to predict.

GlobeSt.com: How would you sum up retail capital-markets sentiment for this year?

Voorhees: If optimism was the theme in 2015, it must be uncertainty in 2016: Clinton or Trump? Interest rates—up or down? Will China's slowed growth trigger a global recession? Does it feel late in this real estate cycle? What horrific terrorist event will strike next? Is California overdue for a ginormous earthquake? It seems nearly every positive event is offset by fear mongering or a corresponding bad event.

But take heart, and do not let the headlines get you down. In reviewing and comparing economic and real estate transaction data from the end of Q315 to Q316, one thing seems clear: despite uncertainty, economic and real estate fundamentals in the Western US remain strong. It's a record market for sellers (particularly of “core” or “A” assets), and arguably one of the best times ever to be a buyer taking advantage of modest leverage, record-low fixed-rate debt to achieve cash-on-cash yields superior to those in nearly every investment alternative.

The following chart compares a number of capital-market benchmarks, Q3-15 vs. Q3-16.