New Darling Asset Class: Retail Deals in Demand

As seen in the Colorado Real Estate Journal , the August 16 Retail Properties Quarterly newsletter, "New Darling Asset Class: Retail Deals in Demand".

Retail New Darling Asset Class

During the course of our professional careers, there have been moments when we’ve jokingly lamented that we should have focused our investment sales careers on apartments, industrial, or self-storage instead of retail. These segments of the commercial real estate landscape benefitted from a seemingly endless bull run that resulted in significant new construction, shorter hold periods, and a higher velocity of transactions. Retail as an investment sector has experienced its share of ebbs and flows, but one thing is clear today, retail is one of the most sought-after asset classes for commercial real estate investors. The remarkable speed of this paradigm shift is understandable after a thorough analysis of the fundamentals. Better than expected consumer durability, successful retailer adaption to the e-commerce environment, and relatively low level of available inventory has resulted in vacancies near all-time lows, increasing rents, and competition over anchor and junior anchor spaces that sat vacant for years.?

Pandemic Made Retail Great Again

During the pandemic, the U.S. government injected an unprecedented $5 trillion into the economy.?While elevated consumer activity from the stimulus initially resulted in the share of retail sales made online jumping roughly three years ahead of the pre-pandemic long-term growth trend, as time has passed much of that spending has shifted back to brick-and-mortar locations. Core retail sales have increased 30% since the onset of the pandemic and are up 5% year-over-year.?

As overall consumer spending continues to grow, retail has successfully reinvented and repositioned itself to draw a closer connection between physical storefronts and online marketplaces. Prominent examples of this omnichannel evolution include in-store pickup and return, integrated inventory management systems that allow online consumers to see local store product availability, smartphone apps that improve the consumer experience, and leveraging social media to expand reach.?The benefit of omnichannel to retailers translates to

property owners. We recently sold a net leased Denny’s in Thornton, CO that had a percentage rent component in their lease.?After Denny’s rolled out two app/delivery-only ghost kitchen concepts, this location reported store sales 29.55% higher than in prior years, resulting in a 23.78% increase in the property’s NOI.?

In the post pandemic world, consumers have spent more time in their homes and neighborhoods and avoided central business districts when possible. This has led to a substantial increase in tenant demand for retail space in these neighborhoods and communities, resulting in vacancies being leased that sat vacant for years. We recently sold an outparcel to the Colorado Mills Mall (Promenade at Denver West) that had a stubborn vacancy for years due to difficulty finding the ‘right’ tenant. A corporate veterinary lease was signed last year, and the property closed around the same time the veterinary was opening for businesses.?

Unlike the office sector, neighborhood retail has managed to thrive in the post-covid investment climate. The Wall Street Journal, who was one of many financial periodicals trumpeting the death of retail only 4-5 years ago, recently published an article titled “The Hottest Real-Estate Play is in Your Neighborhood”. They noted that REITs with holdings concentrated around neighborhood retail (both grocery anchored and unanchored) are trading at a valuation of 17% above their five-year average, while office REIT valuations are running 26% below the historical average.

Smaller Buyer Pool Requires Diversity of Capital Sources

Over the last decade, 1031 exchange buyers exiting multi-family properties were often the winning bidder on investment sales offerings of retail and net lease properties. However, apartment sales were down year-over-year by 75% in Q4 2022, 74% in Q1 2023, and 71% in Q2 2023. With the decline in multi-family 1031 exchange Buyers entering the market, achieving transactions at the most competitive pricing tiers demands a more expansive approach. This involves reaching a broader array of cross-product investors from across the country.

For example, we recently sold a net lease King Soopers fuel station in Littleton, CO at a 4.50% cap rate along with a net lease Starbucks in Colorado Springs, CO at a 4.80% cap rate to a 1031 exchange buyer that had sold their long-held family ranch.?A few weeks ago, we sold a multi-tenant retail strip to a local private

investor who sold two small warehouse properties in California, as they wanted to upgrade the quality of their holdings, while also having an asset they could manage more easily from their homes. Within the same center, we sold a net leased Chipotle at a 4.25% cap rate to an out-of-state high-net-worth investor who was not in a 1031 exchange. This investor aggressively pursues trophy assets in growth markets and had been unsuccessful in pursuing previous listings of ours. Ironically enough, one of the properties that he was unsuccessful in pursuing was ultimately sold to an investor who had sold excess land at his walnut farm in California.

Increasing Clarity Should Help Reduce the Bid/Ask Spread

As indicated by their recent comments, the Federal Reserve is not expected to consider cutting the fed funds rate until well into 2024 at the earliest. However, we are clearly in the advanced stages of this tightening cycle, and it seems that the dire recessionary forecasts that were a concern earlier in the year will likely be avoided. As the market gains clarity and confidence in the economy's stability, lender competition will intensify. The increased competition will lead to spread contraction, resulting in more favorable financing options becoming available long before the Federal Reserve initiates rate cuts. At the same time, Sellers have begun to realize that 2021 pricing is not returning, and disposition decisions are being made accordingly. The convergence of these two factors should lead to more transactions in the second half and as we move into the first quarter of 2024.