Over time, our investments in real estate limited partnerships have shifted from mainly investing in apartments to open-air shopping centers. Prior to the rise in interest rates in 2022, high-quality shopping centers were trading at cap rates between 6-8%, and financing was available long-term at 2-4%. The spread between the un-levered yield and funding cost was healthy. While there was always some turnover related to retailer failures, such failures were mostly accounted for in our underwriting process.
Overall, our experience investing in retail real estate has been fruitful. During a challenging time for yield investors, retail offered double-digit yields with relatively stable assets and associated revenues. However, the current environment appears materially different, largely due to higher interest rates.
Recently, I received a pitch from a sponsor I like for a portfolio of shopping centers being sold by a real estate investment trust (REIT). The assets are considered high quality on the retail spectrum, with cap rates in line with the past but with simple property improvement opportunities that have not been pursued by the REIT. This is because the REIT is in liquidation. The value-add is as simple as answering tenants’ calls for leasing or re-leasing. It’s simple, boring, and generally what I should be looking for.
However, the issue I grapple with is the spread between funding and un-levered yield in today’s environment. In the past, one could secure a spread of 2-4% going in, and even closer to the higher end. Today, the spread appears to be more like 1-3%, and closer to the lower end. While the stabilized spread may end up at more like 3-4% after improvement plans are completed, that assumes everything goes according to plan. Simply put, the selling prices or gross incomes haven’t changed to the same degree as funding costs have, a phenomenon common throughout not only real estate but many other rate sensitive industries as participants grapple with future expectations of funding costs.
Outside of real estate, non-bank financials’ equity is priced as if unemployment has already pushed over 5% (figuratively speaking), while they have prepared their balance sheets for worse. Energy infrastructure companies may never trade similarly to high-quality real estate or utilities, and rightly so, but the degree of conservatism baked into their business valuations today offers substantially more cushion to weather a wider band of outcomes, versus real real estate today.
In conclusion, while I generally like the idea of adding to my portfolio of retail real estate, now is not the best time to do so, based on my comfort level with other investment options. It’s important to note that what’s best for me may be the opposite for other market participants. Ultimately, investment decisions are like snowflakes – unique to each individual’s goals, risk tolerance, and interests, as well as the particular investment being considered.