NEW YORK CITY—Pockets of the retail sector have seen waning demand in the past year. Has this had an impact on the approach investors are taking towards retail acquisitions? If it’s a question of how they asses risk and reward, the paradoxical answer is yes and no: the attention to risk hasn’t changed, but the type of risk under scrutiny has. That’s according to Patrick Toomey, senior managing director of Faris Lee Investments. In the following guest column, he breaks down the way the new ways risk is being considered. The views expressed below are his own:

I was recently asked by a client what trends I was seeing in the retail property market, and my response was, “The best thing I can share with you is what I’m seeing in the trenches after having transacted about 350 deals in the last 12 years: buyers are still asking all the right questions, and still checking every assumption, and being extremely careful in purchasing property; I am not seeing reckless purchases but buyers both institutional and private being very careful in their approach to purchasing real estate.”

The commonality that I’ve observed in the market is that buyers are looking for a respectable risk-adjusted cash-on-cash return on their equity from day one, with some opportunity for growth in that return. This may actually be a “Darwinian” consequence in that investors following good discipline in their acquisitions are still in the market, and those that don’t are either on the sidelines, or relinquishing their properties to lenders or new partners, among other things.

While there was a period of time before the financial crisis of 2007-2008 when it seemed that buyers were less cautious of risk, in my 30 years of experience, there has always been a focus on risk when purchasing an asset.

Every sale is a transfer of risk, and buyers, particularly private investors, are looking at all facets of risk prior to investing in their next purchase.

The areas of risk most commonly reviewed include:

• Lease expiration dates – Buyers universally want to know what tenants’ intentions are relative to upcoming lease expiration dates, even leases that do not expire for another three years or more. Although tenants may have multiple renewal options, such options do not guaranty longevity of any tenant. Buyers want to know if these tenants will stay.
• Lease rate compared to market – Are rents readily replaced and what concessions or contributions are required to maintain occupancy in a center? What are market lease rate trends?
• Competition – What is the competitive landscape of the trade area and are there more attractive locations for tenants?
• Tenant health – Measure by rent as a percentage of sales and overall occupancy cost as a percent of sales. How are sales trending? Is the occupancy cost reasonable? For most tenants being in single-digit rent as percent of sales is healthy, however, the metrics for each type of tenant vary.
• Deferred maintenance – How much immediate capital will need to be invested in the property after the sale?
• Demographics – What are the demographics in the trade area and what are the growth trends?
• Financing – What kind of financing can I place on the property? What issues will a lender focus on during escrow? Can I refinance my loan when it matures?

The above are just a few examples of risk concerns that seem to be on the minds of buyers most often.

The market therefore takes on a “barbell” shape, where there is a heavy weighting of buyers on “A” quality real estate, and a heavy weighting on high-risk, opportunistic real estate, and fewer in-between. What I mean is that buyers are willing to trade a lower return for a perceived low-risk property (“A” location, high-credit tenant(s), excellent sales, strong market, etc.), or will take a high-risk asset (lower quality location, high vacancy, questionable tenant mix, questionable longevity of tenants, deferred maintenance, etc.) in exchange for a higher return. However, for assets that are neither “A” quality, nor “value-add, high risk,” there are fewer buyers and more varied outcomes.

For my clients, I encourage careful assessment of all factors of risk in determining a strategy for their assets. Every owner should assess his or her portfolio periodically and determine if it is time to hold, sell or recapitalize the asset. While one’s real estate holdings are affixed to the earth and are not at risk of going away, value can shift away without proper and regular monitoring of property fundamentals.

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