Retail Investments Dry Up As Buyers Can't Figure Out What Cap Rates Should Be

As landlords wait and see which retail tenants will be paying rents, real estate investors are facing their own uncertainty: How to determine a cap rate on a potential shopping center investment if rents are not a guarantee during this pandemic.

The coronavirus pandemic has put most potential retail sales on hold, especially as investors eye which tenants pay rent — or which will even survive — over the next 90 days. April anxiety about how much income properties will actually generate is complicating a fundamental instrument in determining a property's value, especially when they are filled with restaurants and nonessential retailers.

“The rate is going to be determined by who will survive and who will pay their portion of the rent,” Marcus & Millichap First Vice President John Leonard said. “The length of this [pandemic] will determine the depth of it.”

Capitalization rates are the metric used by commercial real estate investors to determine the premium they are paying for a property's current rent roll. That number is shown as a percentage of the total rents: The lower the percentage, the more money the investor is paying for existing rents.

For sellers of retail real estate, by and large, modern times have been very good. Cap rates across the country have been shrinking, especially in key metropolitan markets with strong population and job growth since the Great Recession. In Atlanta, cap rates for retail were ranging between a high-6% to a low-7% last fall according to Marcus & Millichap.

At the end of last year, the median cap rate across the U.S. for shopping centers was 6.5%, according to the National Association of Realtors' February report, down more than a full percentage point in the past few years. COVID-19 threw that paradigm out the window.

“I don't think a cap rate is relevant,” Stan Johnson Co. Managing Director Margaret Caldwell said. “We got definitely three months ahead of us before we even know. But who knows, right? Could be longer than that.”

That is a shift in tone among investors from even a month ago when Caldwell said investors were eyeing more reliable retail real estate properties, such as grocery-anchored shopping centers, in light of the pandemic at that time. Now, deals are just in a holding pattern if they were far along in the negotiation process. Marketing new properties to investors could be considered a fool's errand.

“Basically, nobody's really buying. Most people, they don't know what's going to happen with their tenants, who is going to pay,” Caldwell said. “How do you underwrite an asset today to understand where the bottom is?”

Not all deals are on hiatus.

Some smaller investors are under a time crunch to have to buy something because their capital is part of a fund or because investors are needing to redeploy the money into another real estate deal to avoid having to pay taxes. 

Investors in 1031 exchanges are fairly active and especially eyeing net leased retail, typically a stand-alone store where the tenant pays not only the rent but most or all of the taxes and maintenance fees.

“They're buying more of the stabilized corporate real estate with long-term leases,” Bull Realty Retail Group President Will Young said. "But they're buying it for the long term."

Atlanta-based Newburger-Andes Real Estate Investments, which buys net-leased retail deals for a host of high net worth investors, is still in the process of closing the purchase of an Advanced Auto Parts store in Canton, a suburb more than 40 miles north of Atlanta, Senior Vice President Steve Farrar said.

The firm asked for investor interest two weeks ago, as the pandemic was accelerating its hold on the U.S. and many cities and states were issuing shelter-in-place orders, but the firm nonetheless received more than enough interest to buy it for $2.3M.

“As people started seeing their stock portfolio and 401(k) get depleted by 25%... within the first week or two of the pandemic happening, it made them realize the surety of the bond-type returns that these triple-net companies provide for them is appealing,” Farrar said. “It's sort of flight to safety. It's looking for yield. It's looking for mailbox money in a very, very uncertain time. You can sort of bank on Dollar General or Advance Auto Parts rent showing up the first of the month.”

Not all net-leased retail deals are immune to COVID-19's economic fallout, Newburger-Andes Chief Investment Officer David Andes said. He is seeing single-tenant retail stores owned directly by small franchisees or backed by private equity firms balking at paying rent this month. 

“Some are dictations that they are going to stop paying us rent. Some are, 'What relief are you offering?'” he said. “We're dealing with each of them one-by-one.”

The pandemic has obliterated an idea that any commercial real estate investment could be recession-proof, Leonard said.

“I don't think any product type is immune to what we're going through here,” he said.