Retail Rocketship

Singling out any product type in commercial real estate as being over-inflated compared to other types at this point is like trying to describe the difference between a 9.0 and a 10.0 earthquake. They both are bad. That being said, I believe that retail property investing has become particularly risky and current cap rates of 6.0-6.5% in no way compensate for this risk. (Compare these cap rates to long term averages of 8.5-10%.)

Risks of Retail

1. The past 5 years have seen record growth in consumer spending, which is driving retail property rent growth. However, job growth and wage growth have been essentially flat. The primary source of consumer spending has been increased leveraging, particularly of consumer's homes. Even if home prices continue to rise there is a limit to the amount of leverage people can take on and as we approach that limit increases in consumption driven by borrowing will decelerate. If interest rate rise without corresponding wage increases consumption will be reduced the increase debt servicing costs. Americans are not saving (current savings is less than 2% of disposable income), therefore increased debt service will automatically lead to reduced consumption. Reduced consumption will hurt retail rent growth.

2. Retail tenants are operating businesses. Therefore every year some are likely to fail and not pay their rent. There is little room with a 6% yield to have too many vacancies.

Retail Returns

A retail property trading at 6% cap rate typically has rent growth of about CPI +.5%. Therefore real return is:

Real Return = 6% + CPI + .5% -CPI = 6.5%

Currently a 10 year T-bond is at 4.10% (5/19/2005)
Therefore risk adjusted return is:

risk adjusted return=6.5%-4.10%=2.4%

2.4% spread over 10 year Treasuries seems like a very meager return for the amount of risk associated with investing in a retail property. Of course, if you leverage that up 95% by using debt and preferred equity maybe that becomes a worthy return. Then again at those heights if the property hiccups an investor could wipe out half their equity.