A new influx of money taking aim at the retail sector made 2021 a strong year for investment sales in the category. Factors like continued inflow of capital, attractive yields, reduced fears about the disappearance of the 1031 exchange and the opportunities for deals indicate that 2022 will likely follow in 2021’s footsteps as a high-performing year.
Don MacLellan, managing principal at Faris Lee, explains that since the beginning of the third quarter of last year, the company has seen a significant inflow of capital interested in retail investment properties, across all asset classes within retail. As businesses return to semi-normal operations in the face of ongoing COVID concerns, it became clear that the large amount of money previously sitting on the sidelines from investors has been pouring into the retail sector. MacLellan spoke to Shopping Center Business about trends and sources of capital for retail investments shaping the investment space this year.
New Capital Sources
In 2020, many investors temporarily paused their investments in commercial real estate due to fears about performance. Beginning in late 2020, these investors — many of whom were active in other asset classes — resumed or turned their attention to retail properties, particularly those deemed essential during the pandemic. This has made for an explosion in transaction volume, creating an imbalance of supply and demand in the retail sector.
MacLellan explains that the capital is coming from a variety of sources, driven mainly by the 1031 investor as well as by high net worth family offices, REITs and large private investment companies.
“Some of this new money has come from situations whereby people have sold off their companies and have created a venture capital fund for real estate,” explains MacLellan. “There’s a lot of this approach, whether it’s from tech or some other sector. They’ll sell their company for $500 million and want to buy $200 million of commercial real estate, including some allocated to retail assets.”
“There’s a number of investors searching for retail properties, including many who haven’t owned commercial real estate ever before. With office uncertain, retail has become the darling of new capital ,” MacLellan elaborates. “You can get an attractive return with long-term low interest rate debt. Many people are looking to invest in retail properties simply as an allocation of their investment management.”
Significant 1031 Capital Drives Cap Rate Compression
Because of negative retail perception, a great deal of institutions and investors flocked to multifamily or industrial at the start of the pandemic. This shift made cap rates more aggressive for those asset classes and created significant 1031 investment capital demand for the retail sector.
With post-COVID openings, the retail transaction volume increased significantly within all asset classes, and single tenant net lease (STNL) assets have seen cap rates at an all time low. MacLellan breaks down the investment environment: “The market is probably 85 percent 1031 exchanges to 15 percent new private capital, although we’ve seen so much unprecedented 1031 money lately that we’ve seen a supply/demand disequilibrium. There is so much demand and limited supply, plus there has been a tremendous amount of new capital.”
“As a result, we’ve seen properties being bid up,” notes MacLellan. “Typically, it has been investors in assets of up to $10 million bracket that have been interested in buying single-tenant properties. Especially post-recession, there was such a flight to safety that the cap rate compression in STNL is unlike anything we’ve seen before.”
MacLellan explains, “The demand for retail in general is really just cap rate arbitrage: I sell industrial or multifamily for 3 to 4 percent cap rate. I buy retail at a 6 percent cap rate. I finance it at 3.5 percent; and my cash return is pretty attractive. All this interest has been driven by alternative returns, lack of product and a significant amount of capital.”
Asset Types and Locations
“Essential” stores and those that cater to customers’ daily needs are obviously performing the best saleswise, but value-oriented tenants also seem to be thriving, especially national tenants.
Restaurant sales have been quite robust but have been impacted by the labor shortage, and higher labor cost have affected bottom line profits. QSR sales continue to exceed pre pandemic levels. Cap rates for high-quality single tenant asset net leases range from 3.5 to 4.5 percent for ground leases and QSRs, all time lows. Grocery-anchored centers are still highly favored by investors — MacLellan notes that Faris Lee sold a number in 2021, all with national grocery store anchors.
With assets like powers centers, MacLellan has not seen a lot of trading. “The issue with power centers is that lenders are still wary of big boxes, because there’s been a lot of downsizing and closures that’s become more widespread now. Retailers such as Kohl’s & Burlington are downsizing, and Bed Bath & Beyond is among retailers closing lower performing stores.”
Lifestyle centers are hard to finance now. “Right before COVID everyone was interested in experiential retail — theaters, fitness centers and restaurants. These were obviously all things that got hit the most due to COVID, and lenders are much more conservative with these spaces now,” says MacLellan. “I will mention that this assessment (like all of these assessments) can vary a great deal based on location.”
Because of limited supply in locations on the West Coast, Faris Lee is seeing investors move to secondary markets, compressing cap rates in these areas. Workers are leaving California but they’re bringing their lifestyle preferences to markets like Boise and Salt Lake City as well as more affordable markets such as Phoenix and Las Vegas, transforming these markets into hot areas for retail where borrowers can hope to obtain better cap rates than in the Golden State.
New Lenders, New Perspectives on Retail
MacLellan emphasizes the importance of working with and educating lenders, especially in light of how well retail has been recently faring. Many, he says, are fixated on the performance of assets like regional malls as the bellwether for the industry. However, the weaker mall properties have been a victim of the retail exodus and widespread closing of department stores, although Class A malls are performing well since the country emerged from the depths of the pandemic.
Still, explains MacLellan, beyond malls “A majority of our retail clients have fared very well during COVID, especially if they could provide daily needs for their neighborhood. We’re looking at 90 to 95 percent occupancies for these retail properties.”
Many retail landlords did deal with deferrals in the depths of the COVID pandemic, but sales have rebounded throughout the retail sector due to pent-up consumer demand, with some categories seeing their strongest retail sales in years.
MacLellan is positive about the opportunities for the retail investment business going forward, “Those investors with expertise in the retail sector can jump on opportunities. For the passive investor, the returns are more attractive than industrial or multifamily.”
— By Sarah Daniels. This article was written in conjunction with Irvine, Calif.-headquartered Faris Lee Investments, a content partner of Shopping Center Business. For more articles from Faris Lee, click here.