Capital Markets For Retail In 2023 – Searching For More Economic Certainty
Inflation, the war in Ukraine and supply chain problems dominated the news for much of 2022. As a result of exceedingly high inflation (which peaked around 9%), the Federal Reserve (Fed) took unprecedented measures to curtail inflation by raising the federal funds rate seven times in 2022. Prior to that – since the Great Financial Crisis (GFC) of 2008 - the federal funds rate remained near zero, as the Fed worked to ensure that the economy would not collapse, and then to support recovery and growth. In part due to the Fed keeping rates close to zero, the economy, and the commercial real estate markets, saw unparalleled growth. When the pandemic occurred, the U.S. government then provided trillions of dollars of stimulus, much of which was essential for economic survival and stability. However, as the economy started to recover after the COVID shutdowns, the federal funds infused into the economy contributed to inflationary pressure, even with record unemployment levels. As a result, the Fed felt compelled to impose counter-inflationary measures by raising interest rates, which they did seven times in 2022. The Fed’s key lending rate stood at a range of 0% to 0.25% at the beginning of 2022 and closed the year at a range of 4.25% to 4.5%. These actions by the Fed, although not good for commercial real estate, have helped drive a significant slowdown in inflation.
Some economists believe that the U.S. economy entered a recession in the first half of 2022 in part due to the actions of the Fed, after having sustained two straight quarters of declining gross domestic product (GDP). However, if a recession did occur, other economic indices do not indicate a downturn: Unemployment claims are at their lowest levels since the 1960s and jobs are growing (although this growth seems to now be tapering off). Further, consumer spending was reasonably good throughout much of 2022.
Even though the actions of the Fed appear extreme to some, the Fed is setting interest rates closer to traditionally historical levels. Nonetheless, interest rate uncertainty over 2022 proved to be a major problem for the commercial real estate industry. When the Fed believes inflation is under control, and signals to the business community that it will no longer pursue a policy of planned interest rate increases, the commercial real estate markets should steady and begin to grow again.
In large part due to interest rate uncertainties, many retail real estate investors are viewing 2023 as a transitional year requiring changes in near-term investment tactics. A significant amount of capital likely will remain on the sidelines until there is greater clarity on pricing and future market conditions. However, retail investors actively seeking opportunities likely will pursue the safety of top-quality retail assets that are better positioned to withstand expected headwinds due to favorable demand fundamentals or strong demographic support. Once it becomes clearer that the Fed is scaling back on its interest rate increase program, and it becomes clearer that inflation is heading in the right direction, the retail markets should once again restart, possibly in a significant way.
Over the past decade, grocery-anchored assets and net lease retail opportunities have dominated the retail investment landscape. Even with interest rate challenges, many observers predict that this should not change in 2023. As has been the case for many years now, the best opportunities in retail remain grocery-anchored community and neighborhood centers—particularly those in primary or high-population growth markets.
Net lease retail should also continue to remain in high demand at potentially historically low cap rates, particularly fast-food properties with drive-throughs, assuming that long-term leases are in place to the very best of the national credit tenants. The challenge is one of available product, because investors are all chasing this product type.
There also is momentum from institutions to allocate capital to strategies that can take advantage of repricing in the retail market, either because of acute distress or simply adjustment in values. There is a view common among these institutions that the next couple of years may be an excellent time to utilize their capital. However, many of these institutions are currently analyzing whether the economy is close to creating an environment for these opportunities now, or whether it will take greater interest rate stability later this year to create a more conducive environment.
Investors that are still in the market are favoring value-add retail projects, in large part because of the opportunity to take advantage of selective stress or distress in the market, such as the need for recapitalization or gap equity. Most value-add investment opportunities have income in place, offering additional defensive characteristics in the existing economic environment. However, core retail assets likely will continue to be the foundation of most retail investors’ allocations. Many opportunities may exist today if investors have the patience and foresight to consider a longer time-period (say, three to five years) in assessing how a retail real estate project will perform.
As was stated by one retail institutional investor in 2023 Emerging Trends in Real Estate (published by pwc and ULI), “We anticipate an uptick in retail investment across the board in 2023. [E]veryone is chasing industrial and multifamily, and there is greater uncertainty emerging around office. Retail pricing is going to offer better returns, but you need to know what you’re doing. That said, I think there is greater clarity in retail now than there has been in a long time for investors.”
Since the GFC, lenders, for the most part, have been very careful in underwriting the acquisition of retail projects, or lending on new or completed retail projects. Although the recent steep rises in interest rates will impact retail development projects, lenders, for the most part, are not looking to take drastic measures such as foreclosure. Most lenders will work with their borrowers on loan modifications and extensions. However, for new developments, if the lender believes the development processes has been significantly mismanaged, it may take more drastic measures.
In terms of new loan originations for retail, lenders are in much the same position as buyers or sellers of retail projects; once they have a clearer understanding that inflation likely is under control and some certainty that the Fed will no longer aggressively raise rates, they will become more comfortable lending under the right circumstances. As in the years following the GFC, the majority of lenders likely will expect 50% to 65% loan to value ratios and well-heeled sponsors. Rates for construction loans should be between 300 to 400 basis points over SOFR with a floor, and with full to limited recourse required. For stabilized retail projects, lenders will most likely be willing to loan at fixed rates around 200 basis points over SOFR, with terms in the 5 to 10 year range.
Even with the uncertainty surrounding interest rates, inflation and supply chains, significant capital continues to exist for strong retail projects. The big uncertainty for retail real estate developers and investors is interest rates. The fundamentals for most retail projects still remain strong, and significant capital exists in the marketplace. The expectation is that retail sales and lending for retail developments will pick up substantially in the later part of 2023 as more certainty returns to interest rates, and inflation moderates.