Broker Q&A: Retail Market Update
Over the past weeks, Slatt Capital President Michael Kaplan engaged with prominent retail investment sale brokers to discuss the retail market landscape as we progress out of the pandemic and into the 4th quarter and upcoming New Year.
Over the past 6-9 months, as COVID’s impact on retail has subsided, we have seen a vast increase in lenders’ appetite for retail properties. What are you seeing from an investor standpoint for retail, and how does volume look today compared to the last couple of years? Is there a particular product type investors are leaning toward or—in some cases—avoiding?
Demand for high-quality single-tenant net lease properties continues to exceed supply. Pressure is sustained on cap rates for this property type. There is extreme demand for high-quality car washes, given the desire for 100% bonus depreciation from some buyers.
The COVID impact on investor demand for retail properties was primarily felt in the first six months of COVID, while nobody had much certainty about the future of the pandemic. After that, demand increased across the board for retail investments except for the properties with tenants that struggled to emerge from COVID, like gyms and movie theaters. Initially, lenders knee-jerked away from retail because of the headlines. As tenant businesses survived and even prospered as we came out of COIVD, I think both investors and lenders rushed back to a product that has long proven reliable.
The pandemic assisted investors in refining their criteria for retail investments. Functionality and resilience in the face of regulatory and e-commerce challenges helped them understand what could and should work in the retail space for the long term. Additionally, the pandemic forced retailers to respond similarly – enhancing a landscape defined by the winners within given retail segments. The essential needs or drive-thru product saw a surge in investor demand through 2020 and early 2021; experience-oriented retail picked up on its momentum experienced pre-pandemic during the 2021 surge in development/leasing activity, and investors have begun to include these users again into their criteria. Investors are constantly driven to lease term and credit, and we continue to see this be the case in 2022. Even the box and department stores have fought off some pressures from e-commerce forces during the last few years as they hybridize their platforms and utilize their brick-and-mortar space to expand offerings their e-commerce competitors cannot. Investors have noticed that during the run-up in the market in 2021 and early 2022, nearly all retail offers were given strong consideration for purchase. That has changed with interest rates up in the second half of 2022. Investors have more choices with less competition and are chasing yield and functionality in primary markets yet again. Volumes were at all-time highs in 2021, and while liquidity remained high to start the year in 2022, volumes are decreasing quarter by quarter with the higher cost of debt and volatility in the markets overall.
Over the past several years, the demand for single-tenant net lease investment has gone through the roof. Although many of us have played in this space for a while and investment in this space is not new, what trends are you seeing today as the industry tries to absorb the significant increase in interest rates and movement away from the lowest cap rate environment we have seen in our careers? What does this STNL space look like today, and what do you expect it to look like a year from now?
We are currently not seeing much upward cap rate pressure on the single tenant net lease product. Much of it is still driven by lagging 1031 exchange capital that started the 1031 process before the recent rate hikes. There is speculation that by year’s end, we will see some pressure upward as the 1031 capital catches up. I think a year from now, we will see some pressure upward across the board for single-tenant product but less pressure for the high credit, capital preservation type of single-tenant investments. I expect the value to remain resilient for those top-tier triple net deals.
The majority of single-tenant inventory built over the last several years have been smaller and more functional buildings (due to e-commerce shifting the retail landscape in the previous decade); these smaller buildings have been trading at higher intrinsic values (price per square foot) than in years past, but because the total income annually on these properties are usually lower, they feature lower price points attainable to a broader audience of investors. These lower price point properties are less correlated to financing pressures; as higher interest rates have existed for nearly 9-10 months in 2022, we are just seeing the lag effect of pricing in the single tenant sphere start to take hold. It has taken 2-3 quarters to see this adjustment take shape. And this is mainly because there are more investors less concerned with financing these smaller price point single tenant investments. That all being said, the market is moving; CAP rates are increasing as interest rates have moved and sustained 150-200+ bps of movement upward this year. Anticipating continued upward pressure on CAP rates in the single tenant investment market through this year as the equities/bond markets work to find a “bottom.” Once values stabilize, we anticipate demand to find its footing and continue seeking quality and functional single-tenant assets; bonus depreciation benefits and tax-deferred exchanges will continue to push investors into a passive management category.
M&A activity within the car wash space continues to transform it, making it more desirable than ever. The pandemic has convinced many buyers that groceries, convenience stores, and quick service restaurants are the most desirable, stable property types to own. Again, if there is strong credit, good real estate, and a long lease term, rates have moved insignificantly for those properties due to high buyer demand. Alternatively, we see buyers bringing more equity to these transactions than ever before due to the low LTVs they can achieve on the underlying debt.
As we continue to see inflation play a significant role in the overall economic landscape, what do you see in the retail space as it relates to rent growth? How are retailers responding to developers’ current rent requirements and future rent bumps?
In the build-to-suit and shopping center development business, retailers have been pushed higher on rents due to inflated land and construction costs over the last handful of years. As a result, their going-in rents are the highest they have ever experienced. At the same time, developers and landlords look to hedge against inflation with annual increases in rent and CPI adjustment in some leases; retailers have fought back with lower return-on-cost rent structures. As interest rates are pushing CAP rates up this year, this is the major transition to keep an eye on in late 2022 and 2023; land owners, developers, and tenants will need to find sustainable ground for expansion and profit as yields change. Without compromise, there will come less growth and less revenue in the retail sector overall—something a potential recession will direct anyway.
We have seen a few deals fall out, but tenants are primarily adjusting their expectations in line with the construction cost. Tenants must if they want to expand. It is generally not a localized problem but something they are seeing across their footprint.
I have seen the impact of the recent inflation affect retail rents in a few ways. Developers are requiring higher rents to pencil new construction deals, and tenants seem to be at a resistance level on build-to-suit rents. In shopping centers, ‘mom and pop’ tenants with annual CPI-based bumps are pushing back on big rent hikes as consumer retail spending pulls back a little. Construction costs remain high and continue to push new construction rents.
With the uptick in rates, many investors are seeing the spread between cap and interest rates shrink, if not invert. This may be a short-term occurrence, but historically what is the typical spread between cap rate and interest rates that buyers/borrowers are traditionally comfortable with? How quickly are sellers adapting to that in today’s environment?
Most buyers believe this is a short-term trend, so they simply bring more equity to their transactions. The hope is they can refinance once inflation cools. That said, for transactions with middle-market credit, shorter lease term, or weaker real estate, the cap rates have had to push up and, in some cases, still do not trade. This is also likely a short-term trend. More attractive debt and DSCR must become more available with more attractive rates within the coming nine months, or cap rate expectations will likely shift with more of a sustained view. There is no traditional delta between the cap rate and the debt constant for the most desirable properties, although there typically is some clearance, maybe 50 to 75 bps. The delta generally is 150 bps or more for transactions with weaker fundamentals.
In the last three months, we have seen cap rates hold at ‘pre-hike’ levels which likely resulted from the wave of 1031 exchange capital that was still cycling through the market. We are just starting to see pricing pressure upward on cap rates. There is a lot of product in the market priced at lower cap rates that don’t pencil from a leverage standpoint. Sellers are not chasing the market down currently, and I think we need to see where we are as a market at the end of the year. We are also seeing some select lenders bring spreads in a little on specific sub property types to take advantage while other lenders are priced out of the market. This supports sellers being patient on a knee-jerk reaction to the market on pricing.
About our Participants:
Camille Renshaw is CEO and CoFounder of B+E, the world’s fastest-growing net lease real estate brokerage firm. Previously Renshaw was Head of Sales for Ten-X, a Google Capital company and leading online marketplace for commercial real estate that includes products like Auction.com. Prior to Ten-X, she founded the Stan Johnson Company’s New York office where she met her future business partner, B+E Co-founder, Scott Scurich. She has closed over $30B in transaction volume.
With over 20 years in the business and a top-tier transaction history, Dave orients his practice around professional shopping center owners and operators, partnering with them over time to manage their property portfolios. Clients count on him to take command of every aspect of the brokerage process, understanding their priorities and acting as a trusted advisor and true guardian of their interests.
Putnam has extensive experience representing developers, owners, and private capital clients on the sale of leased investment properties nationwide; with a focus on newly constructed commercial properties, he has completed nearly $4.0 billion in transactions totaling more than 12 million square feet.