Changes in the Retail Market
November 2022 | Article
by Sean Tufts, CPX Managing Partner
Everyone has their own idea or forecast as to what is going to transpire during the next 12 months. As CRE investment brokers, interest rates are the most obvious disruptor to deal flow and values. The current rapid doubling of effective interest rates on retail investments has created chaos in the overall market. At this early point, the difference we’re witnessing from previous cycles is that sellers are reacting more quickly than we’ve seen historically.
Every real estate cycle is different, caused by different factors and the influences vary in degree and causation. This time around, there is so much more information available at such a rapid pace, and the reasoning behind the changes is being felt by everyone through everyday inflation. Hard to believe, but Twitter was barely a thing during the Great Recession; now it's owned by a billionaire that purchased it for $44B. Rapid news cycles and massive amounts of information have contributed to the speed at which we are seeing the market adjust.
The question for commercial retail estate investors becomes: How long will it take for the nationwide hiring freezes, layoffs, and downsizing to shock the system enough for the Fed to ease up? Macroeconomics is the hardest discipline to master and predictions are just that. We could be in it for the long haul or another global disruption changes everything and resets our current beliefs. Our hope is that inflation continues to temper, as reports recently suggest, and that the Fed will begin to back off the aggressive increases as job losses mount and consumer impacts are felt.
As it relates to the retail investment sector specifically, we do not believe this to be a repeat of ’08 -‘09. Underwriting standards and investor preferences coming out of that recession have mitigated overleverage with LTVs on residential and commercial loans nowhere near levels seen leading up to 2008.
Retail cap rates were not nearly as compressed as other asset classes during the last run up. Rent growth has been tempered (outside of new construction), driven by longer-term leases with fixed increases and national retailers’ efforts to keep operating costs down. Leasing activity from the most active retailers has not skipped a beat along with minimal new retail construction, especially in the Northwest; we still believe there is upward potential in near-term NOIs. Retail vacancies are at their lowest levels in 15 years and effective rents are only 16% higher than five years ago, whereas multifamily and industrial rents have seen multiple years with that level of rental growth.
None of this will directly overcome the doubling of debt costs, but if the pandemic was any indicator, retail is more capable of navigating and adapting to success than has been the case in decades. We expect more opportunities for cash or low-leverage buyers in the near term to secure better opportunities than have been available in many years. Retailers hate moving and will do whatever they can to avoid it. Public retailers fear reduced store counts and getting hammered by Wall Street. For every quality vacancy or site right now, there are multiple users competing. Bad retail is bad retail, but in many urban and suburban cases, there is a higher and better use for that parking-lot-to-building ratio.
The Fed is burning through massive amounts of wealth printed over the last few years. No doubt there will be pain across all product types; however, retail is not facing the extreme changes or value resets as we expect in other sectors. Hybrid work and shifts away from urban settings could fundamentally change the office sector. The skyrocketing rents we’ve seen in multifamily and industrial, coupled with extremely low going-in yields over the past few years, will need to correct.
We don’t claim sunshine and rainbows in the forecast, but, for once, maybe retail will be the softest landing back toward historical norms, and could serve new and existing owners well.