The Search for Yield…June 14, 2013
Currently I have been working on several purchase requirements and as I read a recent article from our Research Director I found it very relevant. In the article, Garrick Brown discusses some of what is happening in the investment markets. I would agree that investors are both looking for yield but they are also still very adverse to risk. This is still creating a lot of demand for core assets. If you are willing to take risk then you’ll look outside of the core to increase your yield but if you are not willing to take risk then it can be difficult to achieve an acceptable return. For a good read on some current trends in the investment market, read the enclosed article on Searching for Yield…
One of the best articles of the past week was Elaine Misonzhnik’s piece in National Real Estate Investor, “Investors Start Looking Beyond Trophy Malls in Order to Complete Acquisitions.” This article encapsulated something that we have been seeing play out over the past few months in the investment arena, not just for retail trophy assets but for nearly every other property type as well.
After the low-water mark of 2009 when investment sales activity virtually disappeared, buyers have been returning to the commercial real estate marketplace. Initially, what we saw were two types of assets selling—core (or core plus) assets and distress. Certainly, this “trophies vs. trash” dichotomy has remained with us since 2010… but there have been some changes in the meantime. The majority of distressed assets have largely been worked through. They have either traded or, in some cases, secured refinancing or otherwise improved their situation as economic fundamentals have slowly come back. Sure, there are still opportunities out there—but most of the jewels in the rough are long gone.
And investor interest has spread beyond its initial focus on trophy properties—mostly in first-tier gateway cities. But this interest has largely just spread to core properties in secondary markets—the classic Class A shopping center in a Class B marketplace. But outside of the markets where the economy is performing best, we have not seen a huge move towards Class B assets or value-add properties. Meanwhile, the supply of available trophy assets has dwindled while prices have skyrocketed and cap rates compressed to near record levels.
In key gateway markets like Boston, San Francisco, Washington DC, New York or Los Angeles, it is not uncommon to see trophy shopping centers moving at cap rates in the 5% range or less. The same holds true for office product in these same markets, while top multifamily projects in these markets have been trading at even lower cap rates. For example, we are routinely seeing institutional-grade product moving in the 4% range in some of these locales.
And that is the problem… with cap rates this low, many investors are largely betting on rental rate growth in order to create the yield they need to justify these purchases. In some cases, these might be reasonable bets. For example, most office leases are still written with five year terms and deals that are set to renew over the next couple of years will largely be those written at the height of the recession… so we probably will see an upward reset of office rents in the strongest U.S. markets in the years ahead. But this trend is certainly not a given for office space or any other commercial real estate space in the years ahead. The health of local markets, levels of current development and other factors will come into play. In the case of shopping centers, exposure to e-commerce will likely be one of those.
Of course, against this backdrop, it is only natural that investors would start looking elsewhere for better yields and though their appetite for risk may still be low, the 7% cap rate on a Class B property in a primary or secondary market may seem worth it when the only trophy alternative comes with a 4.5% cap rate.
But the news is not so simple as there is a mere shift in investor preferences underway. The fact is that risk tolerance remains low. The good news is that improving leasing fundamentals across the board are playing a role in bringing investment interest to properties that have not fit into the “trophies vs. trash” paradigm over the last few years. The bad news is that confidence on the investor side remains shaky, even as it is rising on the seller side. And so, we are starting to see pricing stalemates in many areas of the marketplace and this is negatively impacting sales activity.
Again, in the case of retail, much of the concern on the buyer side remains exposure to e-commerce and so those property types deemed most least susceptible (net leased investments and strong occupancy grocery or drug-anchored neighborhood centers) are seeing the most interest. Meanwhile, with many major mall owners looking to offload their non-core holdings, questions remain as to what will happen to these Class B and C properties.
The trends are still being shaped in the marketplace and economic performance over the next few months will largely determine what happens. A strong summer could translate into a more normalized investment landscape while a weak one could mean stalemate. But keep in mind that the eventual increase in interest rates is a major factor starting to influence decisions as well. While I don’t expect this to happen for at least another 15 months, this is increasingly going to be a deal breaker for properties seeking sub 6% cap rates—even those trophy assets that are deemed completely bulletproof in the strongest of local economies.