Quality Counts
Jul 1, 2007 12:00 PM, By Jennifer Popovec
In March, Developers Diversified Realty Corp. put a portfolio of 63 assets up for sale. In recent years, such a collection of assets would have been snatched up in no time at prevailing market rates as investors' insatiable demand for retail real estate seemed to know no limits.
But that's not what happened this time around.
In June, Developers Diversifed struck a deal with an unnamed private equity fund that put the portfolio under contract for about 50 basis points above where shopping centers are currently trading, working out to a 7.25 percent cap rate.
Why was the cap rate so high? Joe Padanilam, Developers Diversified's senior vice president of acquisitions believes it was because the assets are largely class-B and class-C assets. And the cap rate illustrates that interest in such properties has cooled. A year ago, he says, the same portfolio would have fetched a 7 percent cap rate or lower.
In fact, Padanilam says the cap rate could have been even higher had the properties been sold on a one-off basis. But because many funds want to deploy large amounts of capital, they are willing to pay a bit of a premium for portfolios.
That's not to say investors are backing off of retail. Far from it, in fact.
While Developers Diversified wrestled with divesting class-B and class-C assets, competition for higher quality properties remains cutthroat. Pricing for class-A assets — especially grocery-anchored strips and power centers in hot markets — is getting more aggressive and some predict that cap rates on these properties may hit new lows.
During the Kimco Realty Corp.'s presentation at NAREIT's REIT Week conference in New York in June, CEO Milt Cooper noted that he would not be surprised if cap rates in areas with high projected population growth, such as the Southwest, moved from the current 6 percent range down to 5 percent or even as low as 4 percent. “On an adjusted basis, cap rates are currently not too low. They have room to go lower,” he said.
When you look at the numbers for retail as a whole, cap rates are holding steady — and even sliding down in some markets and on certain property types. In the first quarter of 2007, retail properties traded at an average price per square foot of $172 and an average cap rate of 6.7 percent according to Real Capital Analytics, near all-time records.
Underneath that a more complex picture is developing. Brokers and investors say a pricing spread between asset classes is working itself back in the market, much as what existed before the run-up in asset values that began in earnest in 2002. For years, cap rates on retail assets moved in concert, dropping across the board with only a very slim spread in pricing between asset classes. As long as it was retail and producing income, investors were willing to fork over their money.
That's no longer the case.
Padanilam, and others, say today there are fewer buyers looking for non-institutional quality retail assets. “In addition to the fact that we've had a pullback on the pricing, we're also seeing pullback in the number of participants,” he says. He believes that Developers Diversified's portfolio, which received only a couple of offers, would have generated interest from 10 or more buyers just 12 months ago.
The main reason for that is debt. The crash in the sub-prime residential mortgage market has had a chilling effect on the CDO and CMBS markets. Investors who got burned by sub-prime backed bonds are not eager to get hurt elsewhere. They are demanding pools with less risk. So conduit lenders that supply the loans to the pools have tightened underwriting standards. Concretely, that has meant an end to 10-year interest-only loans and high loan-to-value deals. And pricing is also going up with some borrowers saying they are being quoted rates 150 to 400 basis points higher than what were available earlier this year.
At the same time, 10-year Treasuries are closing in on their 5-year high. After hovering between 4 percent and 5 percent for a long stretch, they cracked the 5 percent mark in mid-June and were trading comfortably above that level at press time.
“Interest rates are the catalyst,” Padanilam says. “I think the rate movement really woke people up and forced them to realize that there should be a spread between A-quality properties and those that are lower quality.”
Gerard Mason, executive managing director of Granite Partners LLC, agrees. Until recently, asset quality didn't factor as highly into investors' equations. “People justified low cap rates because they were juicing their returns with interest-only money and low interest rates,” he says. Investment decisions were interest rate plays.
And because these sorts of deals were most prevalent on class-B and class-C properties, the market has cooled. Meanwhile class-A, where more all-cash buyers operate, has been less affected. And, if anything, there has been a renewed “flight to quality,” which has kept pricing on A assets steady and even driven cap rates down in some markets.
Anecdotally, brokers say that lower quality assets are trading at cap rates 30 to 50 basis points higher than they were 12 months ago and some believe they have softened as much as 100 basis points in some areas.
“We're seeing much more discernment for the quality of the credit, asset and location,” says Bernard Haddigan, senior vice president and managing director of Marcus & Millichap. “Demand still exists for all properties, but the risk premium is being priced back in for lower quality properties.”
