Archives for November 2022

Deal flow slowed and pricing slumped across major commercial real estate asset classes as the third quarter ended — and that’s prompted some experts to wonder if the sector will continue to hew to its historical trend of “fourth quarter comebacks.”

Average price increases across major property types slowed to 14% year over year in August, a 260 basis point slump below July figures, according to MSCI Real Capital Analytics data. And while transaction volume from a dollar standpoint has been at all-time highs for much of this year, fewer properties are trading.

According to experts from SVN International, that indicates “price-growth is currently being driven more by supply shortages rather than a demand-spike.” Analysts there point to MSCI data showing that transaction volume tends to perform better in the second half of the year compared to H1 in both dollars and total properties sold. Generally, total sales on average are 19% higher in Q3 and Q3 over the first two quarters and pricing tends to be up 16% in the same period.

But “while history suggests that CRE should have the wind at its back entering Q4, weather predictions have been a dicey undertaking in recent years,” SVN analysts note in a new report. “Recession signals are escalating, with modest warning signs already flashing in the latest real estate data. During August, US commercial property transactions continued to climb, but at the slowest rate so far.”

What happens next is at least partially dependent on further action by the Federal Reserve, which continues to raise interest rates in an effort to tamp down inflation. And “the Fed won’t blink” if a recession come, says Marcus & Millichap’s John Chan, noting the Fed has “basically suggested they’re done front-loading rates.”

“We may be facing a bumpy road in 2023 but if the Fed’s plan works, inflation will come back down and the economy will enter a new growth cycle,” he predicts.

Source: “Q4 Comeback Unlikely for CRE As Recession Fears Mount“

When people discuss the cost of real estate, they might point to lack of inventory, high financing rates, and the desire for owners and investors to make their projects pan out fiscally. But most people from the outside don’t see how big one component, the cost of building, has become.

The Producer Price Index for October was up 0.2%, seasonally adjusted, and final demand prices were up 0.2% in September. “On an unadjusted basis, the index for final demand advanced 8.0 percent for the 12 months ended in October,” the Bureau for Labor Statistics wrote.

That would seem like good news at first blush. “Producer prices rose a slower-than-expected 0.2% in October, and September’s increase was revised lower,” Oxford Economics wrote in a note. “Core producer prices also rose 0.2% last month, slightly slower than the downwardly revised 0.3% increase from September. The more moderate pace of gains cooled the inflation rate for the fourth straight month; headline inflation fell a significant 0.5ppts to 8.0% y/y, while core PPI declined a more modest 0.2ppts to 5.4% y/y.”

But then there was this from the BLS: “In October, the rise in the index for final demand can be attributed to a 0.6-percent advance in prices for final demand goods. In contrast, the index for final demand services decreased 0.1 percent.”

As Oxford noted, “The goods advance was attributed to the volatile final demand energy category, which increased 2.7% on the month. Core final demand goods, meanwhile, decreased 0.1%.” Although a drop in vinal demand trade services prices helped a broad-based services decline.

But move beyond the headlines and the specific data for construction is hardly comforting. From October 2021 to October 2022, materials for construction were up 11.3% and components for construction rose by 12.8%. It is an improvement over the picture in September, when the numbers were respectively 13.1% and 15.2%.

The results for final demand construction—new buildings and maintenance and repair sold to those that want it—are worse. Overall, the category was up 19.6% year over year. Construction for government saw a jump of 17.4%, while for private capital investment it was 20.7%. Drilling down a bit more, new warehouse building was 20.5%; office building, 21.2%; industrial, 22.1%; and healthcare, 19.4%

These are increases on top of all the others. Materials and components are significantly higher than they were pre-pandemic and don’t seem on a path to level off in the near future.

Source: “PPI Shows Some Relief but Reality Is Still Hard for CRE Construction“

All through the pandemic, industrial properties have been among the most desired by commercial real estate investors. But in the current market environment, are industrial assets holding up just as well?

In fact, demand for industrial properties is down considerably from the first quarter of this year, says Chris Riley, president of U.S. industrial & logistics capital markets with real estate services firm CBRE. “While the market for investment sales is uneven, there remains a small contingent of investors that possess a ‘motivation of the moment’ to acquire properties,” he adds, noting that CBRE National Partners closed 18 transactions in October—evidence that the market is still active.

Following another bump in interest rates and continuing economic uncertainty, overall industrial deal volume in the U.S. fell 18 percent year-over-year in the third quarter, reports data providers MSCI Real Assets. But at $35.5 billion, that volume was still 48 percent above the quarterly average recorded between the third quarter of 2015 and 2019, which totaled roughly $23.9 billion.

Acquisition activity in the industrial sector began tightening along with the upward pressure on interest rates this summer and has continued through the fall. Single-asset sales declined by 21 percent year-over-year in the third quarter, while portfolio and entity-level sales declined by 14 percent, according to MSCI.

But higher interest rates weren’t the only thing causing investors to pause before picking up new assets. Ultra-low cap rates in the industrial space—averaging 5.1 percent in the third quarter, according to MSCI—added to the challenges. A year ago, the spread on cap rates for industrial assets relative to 10-year Treasuries averaged 230 basis points. That figure has shrunk to 20 basis points in the third quarter of 2022. As a result, while investors can still complete transactions, they are facing more obstacles in underwriting assets and making their desired yields pencil out.

With higher borrowing costs, investor demand has cooled, notes Aaron Jodka, national director of capital markets research with real estate services firm Colliers. “Ultra-low cap-rate deals from 2021 and early 2022 are no longer economically feasible, as they would be in a negative leverage situation,” he says. “This has caused the market to stall.”

As a result of quantitative tightening and the ensuing credit crunch, a number of deals involving industrial assets experienced repricing and/or have been dropped altogether, according to CBRE’s Riley. “This has been centered around the timing of the Federal Reserve’s raising of the Federal Funds Rate and the ensuing increase in cost of debt capital (fixed or floating), causing a temporary spot cap rate bid-ask spread.”

Lease terms and asset location are driving pricing differences, notes Jodka. In general, prices have come down at least 10 percent, he says. Assets with strong market-to-market rent upside remain the most liquid. The Commercial Property Price Index (CPPI) tracked by MSCI shows that prices on industrial properties still went up by 1.9 percent in the third quarter compared to the quarter before. But there was definitely a slowdown from the increase of 18.1 percent year-over-year.

There is a greater gap between sellers’ expectations and buyers’ reality than usual right now, which is what is keeping cap rates so low, according to Adrian Ponsen, director of U.S. industrial analytics at real estate data firm the CoStar Group.

“Buyers are looking at industrial mortgage rates that are twice as high as what was available at the end of 2021,” Ponsen says, adding that investors want higher cap rates to help compensate for the higher cost of capital. “But most owners are holding properties that are performing very well from an occupancy and rent-growth perspective, giving them limited motivation to sell. Ultimately, it is the buyers who have capitulated most over the past few months, though that could change if trends in the economy worsen.”

CoStar estimates that industrial sales in the third quarter totaled roughly $46 billion, significantly down from a peak of nearly $96 billion in the fourth quarter of 2021, but almost in-line with the volume recorded in the fourth quarter of 2020.

While there are definitely more constraints in the debt market than there used to be, financing is still available for quality industrial assets, although the depth in the market is fairly shallow and rates have risen significantly, adds Val Achtemeier, CBRE vice chairman of capital markets. He notes that industrial and multifamily assets are faring better in terms of access to financing than most other property types, but says that “debt capital is more precious and lenders are more selective now.”

Investors also have fewer industrial properties to choose from, especially in the most desirable markets. “The number of properties offered for sale in the fourth quarter is lower than a year ago, when the market was experiencing optimum operating fundamentals, combined with a wall of equity and debt capital for investment,” says Riley.

Source: “Industrial Sales Not Immune from Impact of Higher Interest Rates“

The trend of rightsizing by resizing stores is picking up steam. Many retailers are now incorporating small-format stores into their fleets.

Retailers can tailor these small-format stores to target a specific demographic, create a personalized shopping experience, or experiment with a new brand direction, according to a new report from Placer.ai.

Small-format stores can also serve as fulfillment centers for click-and-pay shopping and as a location for returns, all while fostering brand awareness and customer engagement.

And thanks to their smaller size, these stores can help companies expand their reach in urban centers and other highly priced real estate markets while lowering overhead costs.

Placer.ai’s Smaller-Footprint Examples

DSW became more operationally efficient after it created a small-format store, dubbed “Warehouse Reimagined,” in Hedwig Village, Houston. This concept is about 15,000 sq. ft. – or about two-thirds the size of a traditional, 25,000 sq. ft. DSW location. The smaller-format DSW store is attracting significantly more visits per square foot than neighboring DSWs, according to Placer.ai.

Target, known for its super-sized stores, operates over 150 small-format stores, and 25 of which are located on or near college campuses and cater specifically to students. These campus-oriented Target stores range from around 13,000 sq. ft. to 40,000 sq. ft. and carry products a typical college student might need – grab-and-go food, dorm room furnishings, toiletries, and school supplies. Additionally, they serve as e-commerce pickup points for students.

Greenwise Market by Publix carries a highly curated product selection while offering a premium shopping experience with details such as carts with cup holders that allow customers to “sip and shop.” These stores are divided into “experience zones,” including CARE – a beauty and wellness department, and CUTS, a hormone-free meat and sustainable seafood counter.

Market by Macy’s is a small-format department store launched by Macy’s in 2020 as part of a larger restructuring strategy. Market by Macy’s offers a curated array of merchandise with the goal of creating a streamlined shopping experience that gives customers the advantages of department-store shopping in an easier-to-navigate configuration. Unlike Publix’s small-format Greenwise stores, which are designed to promote a more luxurious, and longer-visit shopping experience, Market by Macy’s aims to make shopping “quick & easy.”

Using the Location as a ‘Touch Point’

Virginia Maggiore, Principal, Store Planning, RDC, tells GlobeSt.com, “We have several retail clients that are smaller brands or DTC brands going brick-and-mortar for the first time.

“They are using their physical retail locations more like showrooms, with larger sales floors and a limited back of house,” Maggiore said.

“Customers use the location as a touch point to interact with products firsthand and make decisions on products with customizable options.”

Purchases are shipped directly from the brands’ distribution centers.

“This efficient use of the retail space allows brands to showcase maximum assortment, but not waste valuable space for inventory storage,” she said.

“I have seen a shift in the size of tenant spaces, with landlords now offering a variety of smaller spaces that weren’t available a few years ago. This is making it easier for brands to find lease locations that suit their needs.”

Maintaining Direct Customer Engagement is Key

Laurel Shimamura, Senior Vice President, The Madison Melle Agency, tells GlobeSt.com that where efficiency is paramount and customer loyalty is a core focus, supplementing brick-and-mortar stores with e-commerce platforms can greatly impact the success of retail clients.

For one of her wellness clients, IntoMeSea, the in-person aspects of a traditional spa experience are supplemented by a strong online marketplace.

“Rather than completely scaling down and doing away with the traditional in-person experience altogether, strategically sizing down and building a robust e-commerce presence to support, all while maintaining direct customer engagement, is key,” Shimamura said.

“For The Agency, directing the focus and resources of retailers and merchant shops through strategic and curated initiatives allow our clients to target wide consumer demographics in creative ways.

An example of including diverse initiatives in strategic and bespoke ways can be seen for one of its recent clients Sona Home.

“Bringing the iconic restaurant experience and beloved products into the home supported the expansion of brand awareness and revenue streams, playing on both the brick and mortar and e-commerce aspects of the business.”

Online Sales Require Smaller Footprint

David Larson, partner, Legend Partners, tells GlobeSt.com he’s unsure if the smaller stores are being implemented to increase activity or are a function of increased online sales not requiring the bigger retail footprint.

“Retailers may need to have smaller stores (in their fleet/portfolio) to expand, given the increased cost of construction and escalating rents. These economics are preventing the larger old formats from being economically feasible,” Larson said.

“The uncertainty about what retail will look like in the future continues to challenge retailers as they try to continue to grow their store count. However, given that— implementing a new program today will take a couple of years to see if it works. By the time new formats are open and have some operating history, the retail landscape (and more importantly the customer) may have shifted in a completely new direction.”

Larson said that many big box retailers are also evaluating fewer stores, (even larger formats) and placing them in strategic locations.

“The bottom line is that retailers must experiment with new ways to drive sales,” he said. “Retailers who continue to do what they have always done in the past will experience lackluster annual sales—which never attract public or private investors for future growth.”

Split Spaces Work for Simon Property Group

Laura Schwartz, Regional Vice President of Leasing for Simon Property Group, tells GlobeSt.com that the demand for retail is very strong and vacancy rates are very low, so Simon Property Group is working to maximize big department stores, reduce tenant footprints when necessary, and continue to lease up.

“We are really seeing the benefit of this, allowing malls and tenants to take a larger space and split it into two or three rentable spaces, or even change the use completely into something that is performing stronger overall,” Schwartz said.

“Burlington Mall and Northshore Mall are two great examples where Simon Property Group decided on the major redevelopments of two former Sears box stores – using the new space to add nontraditional tenants such as fitness brands, office spaces, and food and beverage amenities. The goal is to ensure that these projects last long term and stay relevant for years to come.”

Broad Assortment of SKUs Unnecessary

Corey Bialow, CEO, Bialow Real Estate, a national retail tenant representation firm, works with a variety of retail/restaurant tenants across the country such as Indochino, Pet Supplies Plus and Sleep Number; and “eatertainment” including PuttShack and Museum of Ice Cream.

He tells GlobeSt.com that his team is also the go-to for franchisees and corporate concepts such as Teriyaki Madness, Goldfish Swim School and Chill’n Nitrogen Ice Cream.

“We’re seeing many of our clients scaling down their prototype store size,” Bialow said. “Those with an online presence are finding that they no longer need to carry such a broad assortment of SKUs as they’re able to convert existing customers to online shoppers.

“We’re even finding our service-oriented clients are going smaller as a result of extremely high construction costs and rising rental rates.”

Source: “Retail Embracing Rightsizing by Resizing“