Kennesaw’s Ashford Capital Partners’ Managing Partner Matthew Riedemann brings you news you can use.
Our view generally is that the current transaction activities of public REITs appear to be driven by the quest for higher public valuations. Further, cap rates continue to compress due to increased competition for assets, which has been driven by low interest rates, increased inflows of capital and significant long term supply restraints. Both public players and private REITs continue to pace the market.
· Focus on portfolio transformation. REITs continue to be hyper-focused on like-kind portfolios and NOI growth. REITs are targeting ~2% annual increases to NOI for new acquisitions. These two criteria have been the primary drivers of dispositions of weaker performing non-core assets, and of the increased focus on assets in dominant retail markets with strong anchors and rental growth. The non-core assets being liquidated frequently have a declining NOI, causing a drag on a portfolio of higher quality assets with positive NOI and EBITDA growth.
New deal sourcing remains challenging given the increasing number of bidders in the market coupled with the limited number of Class “A” core assets available. In fact, the current market pricing causes many attractive deals to not be accretive enough for public players. As a result of the outbidding by private buyers, public REITs have mainly targeted “off-market” transactions, although they are increasingly difficult to find. In addition, public-to-public transactions are limited.
· Continued cap rates compression. The pressure from the continued inflow of investment capital spawned by a quest for yield and the lack of supply, continue to put downward pressure on cap rates. Over the last two years, the limited supply of Class “A” core assets in the market has contributed to broad cap rate compression. Class “C” assets have gained a lot of interest from higher-risk buyers, as well as investors seeking value-add opportunities. The middle 80% of the transaction curve, consisting mostly of investors searching for yield, has registered flat volumes. In today’s market, core market Class “A” assets are trading at high 4% cap rates to 6.0%, versus 6.5%-7.0% for Class “B,” and >10% for Class “C” properties, as buyers underwrite higher risk levels. Secondary and tertiary market asset trade at a meaningful discount to core market assets as investors continue to seek the security inherent within a major market. Current buyers in the market are underwriting sub-7% IRR hurdles with built-in rent bump assumptions and longer-term value creation potential.
· Long Term Supply Restraints – Lack of New Development and Change in Ownership Structure. According to ICSC new shopping center development in 2013 was less than 10% of new shopping center construction in 2006. The lack of new construction over the past five years has played a meaningful role in cap rate compression as newly constructed assets, with maximum lease term and no capital costs are typically targeted by the most discerning investors. However, with vacancy rates now lower than pre-crash levels in most major markets and cap rates at record lows, new construction will make economic sense and should increase moving forward.
Ownership structure and motivations have shifted over the past 20 years. Previously, pension funds, pension funds advisors and life companies were the primary owners of class “A” quality core assets. These ownership types frequently had a defined hold period, typically seven to ten years, and then they liquidated, causing a continual flow of “A” quality core assets to circulate through the market. Over the past 20 years, these owners made less direct investment in individual assets, opting for direct investment into REITs or REIT ETFs. Over the past 20 years, REITs have been the predominant purchaser of class “A” core assets. However, REITs do not maintain a mandated hold period and have gradually been removing class “A” core assets from circulation over the past 20 years.
· B Malls. It wouldn’t be the ICSC without talk of pruning portfolios of “B” malls. With multiple portfolios on the market, and even more potential sellers waiting to gauge buyer reception, the urge to liquidate slumping NOI assets with a shrinking number of tenants and high operating costs seems to be the highest in years. Valuations of “B” malls have been hurt by the large number of distressed assets over the past five years, in addition to the reluctance of many lenders and a general lack of demand by potential buyers. Concerns over JC Penney and Sears, the two dominant anchors of “B” malls linger like a dark cloud. Aside from tertiary market malls, the silver lining may be in waiting. Most “B” malls are fairly well located and could benefit from retailer expansion and a lack of new construction. Watch for large portfolio transactions to turn into multiple smaller transactions as a means to liquidate. Also, watch for more traditional strip center retailers to enter “B” malls in the coming year.
· Online-Sales impact overstated. The concern over the impact of e-commerce on retail centers appears to be overstated. In fact, online retail sales comprised only 6% of the total retail sales in the U.S. in 2013, according to the U.S. Department of Commerce. Further, online aggregators’ profit remains driven by their advertisement business. According to public retailers, online retail players are benefiting from inflows of capital that are the result of excessively high public valuations.
Conclusion. A lack of newly developed “A” quality core assets and removal of “A” quality core assets from circulation by asset collectors has created a lack of supply; while prolonged low interest rates and quest for yield have increased demand. The combination has caused for a supply/demand imbalance. However, these attributes also can serve as the impetus to drive new development which should cause for a movement toward equilibrium.
Interest rates have the most direct impact on cap rates and shopping center valuations. Interest rates have greater elasticity to the upside than to the downside, will remain volatile on a percentage basis and have been at historic low levels for a historically long time. While interest rates have arguably been held low by unnatural processes, the recent marginal movement in cap rates and valuations seem to be more predicated upon natural cyclical influences to supply & demand.
Michael P. Dillon, Executive Managing Director of NGKF Capital Markets details the key themes from his discussions at the ICSC Open Air Conference in Washington, D.C. and RECon in Las Vegas.
Come back tomorrow to www.AshfordCP.com/blog where Kennesaw’s Ashford Capital Partners’ Managing Partners Matthew Riedemann brings you news you can use.
