The sector thrives as more people resume activities past COVID
Amid a market downturn, the retail space continues to defy inflationary pressures. Retailers seemingly didn’t get the memo of a softened market and are instead poised to continue opening storefronts and leasing space across the US.
How can this possibly be? Mortgage Professional America turned to Greg Friedman (pictured), founder and CEO of commercial real estate private equity investor and lender Peachtree Group for answers.
“There’s a couple of different factors playing out,” Friedman said during a telephone interview. “Retail obviously was greatly impacted over the last decade with the disruption of how people order stuff through the internet and so forth.”
But now, retail – the brick-and-mortar variety – is back, ironically partly as a result of that past deterioration of value: “Retail has really benefited from the fact there hasn’t been a lot of new supply built,” Friedman said.
While other areas languish, retail shines
Moreover, the sector is thriving even as other areas in the commercial space continue to feel the negative impact of a changed world. “Office has been disrupted because more people are working from home today versus pre-pandemic, and that’s caused people to reduce their footprint at the office,” Friedman said.
Then there’s the need for human interaction after a period requiring physical distancing in the dark days of a global pandemic: “More and more people are wanting experiences,” he said. “They want to go to retail stores and so forth, and that’s what is driving that business.”
Some retail elements are doing better than others – those Friedman deems as essential or critical. Think of it this way: When was the last time you got a haircut or got your nails done via the internet? “There’s certain pieces of retail that continue to function really well – the essential or critical retail. People have to go to the store - picking up items from the grocery store, or dry cleaners, or even going to the hair salon.”
It's all about the balance sheet
One of the biggest culprits in eroding value are higher interest rates that continue to have a significant impact on the commercial real estate market, Friedman noted. “Interest rates are having a huge impact across all commercial real estate assets,” he said. “Take away office which is going through distress, but most commercial real estate assets are performing really well. Most assets are hitting their budgeted numbers.”
So what’s the problem? “Where there’s challenges in most cases is on the balance sheet side because interest rates have risen so much.”
Think of it as something of a domino effect. “The 10-year Treasury rate today is about 4.4% over the last decade,” he said. “The 10-year Treasury rate has averaged around 2.2% and the 10-year Treasury rate is viewed as the risk-free rate. Ultimately, the cap rate is where commercial real estate is valued. There’s usually a risk-premium spread which, on average, is about 270/280 basis points above the risk-free rate. So with the risk-free rate moving up over about 220 basis points that directly correlate to the impact on the cap rate to these commercial real estate assets, as cap rates expand, values continue to deteriorate.”
Friedman believes interest rates will remain elevated for quite some time: “There was a thought process that interest rates are going to drop in the near term, so people weren’t fully pricing in on commercial real estate assets,” Friedman said. “The potential is for interest rates to stay higher for longer, which we expect. That means in many cases we haven’t really seen the full loss of value because you’re seeing a lot of assets that trade in the 5% to 6% cap rate range. I would argue that’s too low of a cap rate today when you look at general commercial real estate because it doesn’t follow the historical risk premium spread differential from the risk-free rate of the 10-year Treasury.”
That’s the assessment from Peachtree Group. Yet the internet still cannot cut your hair.
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