Motivation is one of the prime drivers in any market cycle. Some markets are affected by interest rates and others by inflation. One way or another, however, a retail investment and its returns need to provide an investor a reason to stay active regardless of the state of the market.
Scott DeYoung, senior managing director at Irvine, Calif.-based Faris Lee Investments, notes that for sellers in today’s market, it can all come down to timing.
Scott DeYoung, Faris Lee Investments
“There will always be transactions because every investment has a horizon,” he explains. “There is usually a catalyst, such as an estate or partnership being dissolved, a specific fund at the end of its holding period, near-term loan maturity or non-strategic centers within a portfolio. But every investment will have a horizon, which means you can be certain there will be transactions. There will always be deal flow.”
This certainly holds true for today’s retail investment market. DeYoung knows the market won’t halt simply because interest rates and cap rates have risen. He also knows, however, that retail investors need to stay in the game to be successful even as the real estate market is quickly changing. The savvy investors know how to view risk accordingly and come up with a strategic business plan to maximize value.
DeYoung’s colleague, Don MacLellan, managing principal at Faris Lee, can point to at least one motivating factor that has kept the market moving.
“The retail investment space will always be active because, regardless of the market, investors need to put their money to work to continue to grow cash flow and asset value,” he says. “Retail is a good investment because there has not been any significant new development other than mixed-use related since the Great Recession. We have healthy occupancy throughout the country and the retailers that persisted through the difficulties of COVID have come out stronger.”
Who’s Buying?
Factors like these have led private REITs, sponsors and syndicators to raise significant capital for retail investments.
“It’s amazing,” MacLellan continues. “These private and institutional sponsors are raising hundreds of millions of dollars and, as a result, have to put the equity out and acquire assets.”
The larger institutional investors (REITS/pension funds) continue to maintain a strong appetite for grocery-anchored centers, the pair notes, but there have also been new sponsors solely focused on acquiring well-located strip centers. Strip centers offer an array of goods and services that are Internet-resistant, service-oriented and conveniently located near dense suburban areas.
“Strip centers used to be a faux pas in that only mom and pops bought strip centers,” MacLellan adds. “But there is limited risk because if a small tenant vacates there will be strong demand for those ideal units. There are two specific sponsors that have raised funds from private and institutional capital targeting strip centers and are now looking to buy $500 million to $1 billion worth of product in the next three years. That tells you something.”
Many of the attributes that have made strip centers popular today have done the same for single-tenant net lease (STNL) investments. Namely, they are leased to highly successful daily needs operators and well located.
“STNL has become its own asset class within the commercial real estate industry,” DeYoung says.
MacLellan adds STNLs have had a “forever foothold” since 2009, with investors appreciating the asset class’s stability and passive nature now more than ever.
Though strip centers and STNLs are both popular, their difference comes down to who’s buying what.
“Long-term leased STNL retail properties with a strong credit rating are well suited to the 1031 exchange passive investors,” DeYoung says. “Investors are able to visit their brick-and-mortar retail locations on a daily basis and are able to understand the consumer and investment thesis behind these companies.”
Investors who look for the stable nature of STNL properties have been paying aggressive prices for ground lease offerings due to the strong intrinsic value and low-risk nature based on the tenants building and paying for all building costs.
“We’ve seen a huge demand from passive commercial real estate investors purchasing properties where the tenant is ground leasing the premises,” DeYoung continues. “Since the tenant is responsible for the building construction, property management and property expenses, it is the most simplistic form of a commercial real estate asset that passive investors prefer. These asset types are typically selling at a lower price point to their build-to-suit counterparts, which gives investors potential inherent value if the current tenant vacates and a new tenant occupies the building at a much higher rent.”
DeYoung and MacLellan recommend working with retailers that have had strong store growth over the past several years with solid same-store sales growth.
“With the decline in sales volume caused by the sudden increase of the cost of capital, there are fewer 1031 exchange requirements,” MacLellan notes. “In addition, we have seen investor’s down legs hit snags in the escrow process due to the change in the market.”
MacLellan notes the firm’s most active buyers in 2021 and 2022 were apartment sellers selling at 3 to 4 percent returns, as well as industrial sales and residential entitled land sellers.
“Retail has become the preferred asset class based on the ability to increase cash flow by 100 to 200 basis points above apartment and industrial yields,” he continues.
Who’s Selling?
Today’s sellers consist of a variety of ownership profiles. We are seeing certain REITs selling non-core assets, private family offices liquidating due to estate issues, private investors selling to focus on other asset classes, near-term loan maturity issues and finally those owners who have new long-term leases with maximum value today.
The problem DeYoung sees is that there’s still a gap in the expectations of buyers and sellers. Buyers are underwriting based on todays’ capital markets and the future projected interest rate hikes from the Fed while certain sellers are still pricing at rates from early 2022 prior to the rapid rise of interest rates.
“Sellers are still looking at sale comps from three to six months ago,” he explains. “Those comps were based on lower interest rate debt, so they’re looking at non-comparable values. It was much cheaper to finance earlier this year as the 10-Year Treasury was anywhere from a 100 to 150 basis points lower at that time.”
For these reasons, DeYoung implores sellers to look at their deals from the potential buyer’s perspective.
“The 10-Year Treasury today is around 3.5 percent,” he continues. “That has had an impact on where buyers can finance their current deals. New loans today are typically in the high 5 to 6 percent range, which equates to a loan constant in the low 7s. With today’s cap rates expected, many investors are experiencing negative leverage, which impacts their desired cash-on-cash returns.”
It’s that positive leverage that the seller must highlight if they plan to motivate a current buyer, MacLellan adds.
“Your goal as a seller and as a seller’s broker is to really position the asset in the best light,” he says. “There’s less demand from 1031s and more supply of product, so it’s critical you can show a buyer how to make money and preserve capital. You have to differentiate your offering and focus on the strengths moving forward.”
Some of today’s sellers are the borrowers of yesteryear. This includes investors who financed between 2012 and 2014.
“Back then, the rate wasn’t at a historic low, but at extremely low rates,” MacLellan explains. “Now the loan is coming due, and you have to refinance at 150 basis points more than your existing loan. You either have to put more money in or sell because the cash flow doesn’t meet the required debt service.”
Though there may not be significant amounts of new retail development throughout the country, it is happening, particularly as suburban populations grow. This presents more buying and selling opportunities as developers get projects off the ground. Such was the case in McAllen, Texas, a border town with a swelling population. DeYoung and his colleague, Jeff Conover, represented a local developer there who was building a 65,000-square-foot Floor & Décor on an outparcel of La Plaza Mall.
This will be the first Floor & Décor in the Rio Grande Valley, providing all the motivation some buyers needed. A local private investor in a 1031 exchange picked up the long-term, triple-net ground lease at below-market rent for $7 million. The transaction closed in February at 100 percent of the list price, representing a 5 percent cap rate.
No one can predict where interest rates — and the market — will go from here. But there are a few things we know for sure: there will always be change and retail investment activity will continue regardless. It’s simply a matter of providing the creativity, ingenuity and opportunity buyers and sellers need to see to participate in the current real estate cycle.
— By Nellie Day. 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.