By Richard Kozak, MRI Real Estate Solutions

The retail real estate market continues to be among the most resilient of all property types over the past year. However continued growth is not consistent across all product types. Power Centers continue to be the most vulnerable while Super Regionals remain strong. The retail segment has consistently shown the most constraint in placing new product on the marketplace, which has served to bolster prices as demand for product has increased.

The 2nd quarter NCREIF property index of 2.09% was stronger in the 2nd quarter than in any of the past 4 quarters. This was the first quarter in the past year that the appreciation component (0.11%) was positive. The retail sector continued to lead all sectors with a 3.98% total return and a strong appreciation return component of 1.97%. However its income component of 2.02% was the weakest it has seen in the past 4 quarters.

The increase in the appreciation component is somewhat misleading. As the income return has fallen, one would logically question what has driven the increase in appreciation. This is by and large attributable to an abundance of monies being invested in retail real estate. REITs are consolidating through acquisitions and investors continue to invest in REITs and private funds. This has led to an oversupply of money chasing a finite supply of product. If income returns continue to remain anemic though, one might well expect a negative impact on property valuations at some point in time.

In 2002 over $25 billion was invested in retail real estate. This demand has caused cap rates to fall dramatically, which translated into an 11+% increase in selling prices, according to a study done by Real Capital Analytics. In 2003 sales of retail properties continue to outpace other types of real estate investment.

On the plus side, as long as there is a healthy spread between the cost of capital and property returns, investments in retail properties will continue. Retail REIT investment performance will be evaluated based on the spread between cap rates and their dividend yield, realizing that the quality of the investment also affects the cap rate.

Looking forward, though, we may be in for a softening of market prices. Marcus & Millichap sees a softening for retail leasing. A survey they conducted indicates a modest rise in vacancy rate from 10.5 percent in 2002 to 10.7 percent for the first half of 2003, although they optimistically forecast it to recede by year-end. This is most likely attributable to a continued softening of consumer demand affecting the retailers demand for space. Asking rents rose slightly in the first quarter of 2003 to 2 percent. Much depends on the anticipated economic recovery later this year. If consumer spending slackens and concerns over possible job losses rise, retail sales could be negatively impacted. The key component to an economic recovery is job growth, which continues to evade us.

As long as consumer demand persists and the prospect of a rise in interest rates is low, this fragile market sector should experience modest growth and continue to outperform other real estate classes.