Guest: Karly Iacono
Topics: Competition, brick-and-mortar retail

Transcript:

Chris Ressa 0:00
This is Retail Retold, the story of how that store ended up in your neighborhood. I’m your host, Chris Ressa, and I invite you to join my conversation with some of the retail industry’s biggest influencers. This podcast is brought to you by DLC Management.

Karly Iacono 0:24
Welcome everybody, to ‘What’s in Store,’ the show where we cover hot topics at the cross section of retail and real estate. I’m Karly Iacono, and I’m joined by my co-host, Chris Ressa. Welcome, Chris. How are you today?

Ressa 0:38
I’m doing great. How are you?

Iacono 0:40
Excellent. Happy fall. Happy Halloween. Any big plans for next week?

Ressa 0:46
Oh, boy. So I’m Leonardo from the Ninja Turtles. So yes.

Iacono 0:54
Did you see that coming?

Ressa 0:55
My kids, my son is a ninja turtle fan. He’s Michelangelo. So I’ll be a ninja turtle to go trick or treating.

Iacono 1:04
We must get pictures of the whole family together. Or at least you dressed up, as an integrity.

Ressa 1:10
Right, it came in the mail last Friday, okay. And I walked home. And I saw this thing from Spirit Halloween on my, in front of my garage. No one had gotten it. And it was a little rainy. And it was late on Friday. And so I got it. And I came in and like everyone was watching TV on the capsule. And no one heard of me come in. And I went to the bathroom. And I changed.

And they were so focused on the TV. And I just wanted to make sure this bit right. Like, I’m not, I’m not good. When the costumes are like three sizes. Hopefully this works out. So I went into the living room, kids didn’t even hear me coming. It was like I didn’t exist. I went and sat in this one chair on the other side of the room. And like, knowing it, but I was in the full costume.

Iacono 2:07
Oh my gosh, that’s amazing. Did your kids turn around and freak out?

Ressa 2:12
And then there was a major freakout when my daughter turned around and saw like, there’s a Ninja Turtle, freaked out.

Iacono 2:20
Wow, that is perfect execution. You won major dad points. They’re so great. Too bad nobody could get that on video, that had to be pretty fantastic. Nice. Well we look forward to pictures. You’re not getting away without sharing them. So I’ll say more if you want.

Ressa 2:39
If you want to post that in the show notes, I’ll send it.

Iacono 2:44
Please do. That sounds good. Can’t wait. All right. We appreciate everyone tuning in for our monthly series. Today we are talking about the fervor that is happening around retailers trying to open new stores. So what is causing this extreme competition for retail space, in the face of very restrictive monetary policies, a potential recession, all of the headlines on the other side, saying doom and gloom.

But retailers don’t seem to be listening. So today’s episode is taking a deeper dive into what is causing the competition that continues to intensify the retail space. Alright, let’s kick it off. Chris, we have so many good points on this. But why don’t we just start with this. Why are retailers focused on opening new stores in the first place? Why aren’t they sitting on the sidelines, like so many other people, waiting for this economic situation to unfold?

Ressa 3:49
Well, I think if you go back and talk to the last two periods of time, where retailers really put a pause on new store growth at scale, it was the great financial crisis. And it was spring of 2014. Right. And in the great financial crisis, right, we had this, we had really what I would call two major things. One was obviously the consumer stress from the great financial crisis. But then we had this question of viability in certain retail store formats, because of the cars.

And if you went into COVID, it was the same thing, which is we had this stress to the consumer, you know, people potentially getting laid off or furloughed, and then we had this question of the viability of the physical store and everyone’s going to move to shop online. And I think right now It’s been settled.

And the case is not only are we not getting rid of physical stores, we need physical stores to support whatever e-commerce growth happens. And e-commerce is still a small portion of total retail sales. And so I think that’s a major difference between now and those periods of time where we had add new stores.

Iacono 5:35
We can’t move on yet. So to support e-commerce, are you suggesting that it’s a branding requirement that they need the physical presence? Or is it more on the fulfillment side that they’re actually shipping from stores, and they need to host, or they need to store the merchandise in these locations, and they found that the retail stores are just as efficient or maybe less expensive than industrial, farther from the consumer, or both?

Ressa 6:00
At DLC, we have a line that says ‘you can’t make money in clicks without bricks.’ So yeah, exactly like that. And we’ve definitely used that everywhere. And I think it’s all a bit costly. I think one, I think that to scale, from an e-commerce perspective, is significantly costly. And there’s profitability, it’s still elusive of e-commerce alone, and then a four-wall, even up perspective of an individual four walls of a store. There are many, if not the majority of stores that are actually profitable on a four wall basis. And so the cost of entry is higher because you have to physically construct the store.

But it’s profitable. And you see some of this happen. You know, some of the proof of this through all the direct to consumer brands that have ended up opening physical stores. I think the next part is some of the traditional retailers have figured out the logistics end and are starting to fulfill from stores, we are seeing many and many retailers do fulfillment from the store.

And so that logistics challenge of fulfilling from store, that has been a problem since before the COVID-19 pandemic, it is starting to unwind and retailers are starting to figure out how to make that work. And then you obviously have the branding component, which is, you know, many retailers will say when they open a store in a given market, their e-commerce sense will rise and that market when it closes store and more completely commerce sales will fall.

Iacono 7:46
When they’re fulfilling from store, is there a minimum square footage requirements that you’re seeing to add a fulfillment piece to the store? Or is it just as simple as they’re using the same stockroom and just packing it in one side and pushing it out to the front of the store on the other side?

Ressa 8:05
I don’t think anybody, I don’t think everyone, you know, has a one size fits all. Everybody is doing it differently. And you know, when you look at some of the retailers who fulfill from store, whether it’s ULTA, Target, they’re all doing some things inside the store, but they haven’t seen massive size increases or massive size decreases, and then it gets more like individual, how they figure it out in the store.

But I don’t have a number to point to you, because I don’t think it’s one size fits all because everyone’s supply chain network is completely different. Everyone’s digital capabilities are completely different. So it’s different everywhere.

Iacono 8:55
It makes sense. So we’ve established that the retailers need the stores, they want the stores. But why now? Why do you think there is such competition? Is it fear of missing out? Is it future planning? Is it just tremendous sales, and they are capitalizing on that? What’s your feeling about timing and why we’re seeing such pressure right now?

Ressa 9:20
Well, a couple of things. So one, I think that if you have a proven model, especially in the change store model, whether it’s food and beverage fitness trackers, I think the easiest way to grow top line sales is more stores in spaces, you know, whitespace in geographies where you don’t have stores or filling in markets where you have holes, right, you have a proven model that can be, that’s profitable. It’s a very, you know, replaceable thing to do and open new stores.

So if you take the dollar stores, they have a pretty good formula in the type of market, in the type of demographics where they’re successful. And if there are white spaces where there are no new score cameras to the top and bottom line. And so it’s actually helped, it could be helpful in a downturn. Because if you do have some store sales that potentially calm down, this could be helpful in opening new stores in markets where you have just net new customers net new whitespace. And so that that’s one reason.

Iacono 10:40
It’s so, that’s so counterintuitive, but true, right? If same store, sales are softening, how do you boost the top line while you add more stores? Right, to increase sales? But that’s certainly one way to expand. So interesting. Okay.

Ressa 10:56
Yeah, I think the other, I think the other thing is like, if you believe in your business, and you’ve got a strong track record, there’s still very little vacancy to speak of. And I wouldn’t call it, finally access to a market has come to light, and you want to take advantage of the opportunity. Maybe some softening has caused that specific space in that specific market or that specific real estate to become available. And you have to be nimble enough to take advantage of those market opportunities. And retailers are doing that today.

Iacono 11:41
Now, what’s the characteristics of the retailers that you’re talking to that are clamoring for space in your centers? Are you seeing the household names, the Nationals, be the most active? Or is there a new surge from small business? Who’s calling you and trying to be down the door?

Ressa 12:00
So I think all the national retailers are, you know, I said, many of the national retailers are who are doing well and have come out of the COVID doing well, we’re doing well before COVID, I think all those groups are still adding store count. I think franchising has become so big, that there’s all these new franchise concepts that have come to light.

And then I think all these, over the last 20 years, all these new uses coming together that rate in a retail format now are adding to that, whether it’s service base uses, the health and beauty service areas, just, you know, this is still expanding, whether that’s a med spa, a Salon Suite concept, whether that’s, you know, the old news of the world and cosmetics, so you have the health service, and you have health care, which is the medical, you have the fitness and you also have all this food and beverage, your entertainment.

So like people are talking about, like, all these, you know, who are the retailers, and I think they’re, you know, there’s a lot different ones that have come on the scene and starting to really all come together, you know, in the last 20 years. And then, you know, the one that I thought was going to slow down significantly, was the small business and franchise work because you know, access to capital at modest pricing is super important.

But if you look at like some small business formation stats, and this is not just retail, this isn’t anything. It’s higher than pre pandemic levels. It’s not at its peak, which I think was in like 20, late 2020 2021. But it’s like it’s higher than pre pandemic levels. And it’s growing, small business formation is growing, which I wouldn’t have thought of, but And we’re seeing that down to the retail level for entrepreneurs wanting to open up new stores.

Iacono 14:22
I think that stats that we pulled out, August is up 1.3% compared September is up 1.3% compared to August, even after being adjusted for seasonality. And then I think that the timeframe you were referencing was the three year period 2020 through the end of 22 was up at 9% from the 10 years prior.

And so we were coming off just record growth in small businesses, but we’re still seeing growth on top of that recently. So that’s amazing. And those are just census numbers. I mean, you really can’t argue with them. That’s just straight data.

Ressa 15:00
Fascinating that all the small business formation that’s happening. I’m very curious at the capitalization of all those small businesses. But it is fascinating.

And so, you know, clearly all of that’s not in retail. But you know, there’s some tech involved in that there’s healthcare, there’s a bunch of things, but I think it just speaks to like, the, you know, a little counter to the narrative that everything’s slowing down, which, you know, small businesses are looking at and said, You know, I need to figure out how to open my business and get access to some market share in whatever industry they’re in. Right.

Iacono 15:43
Good news, good news, for sure. Let’s shift gears a little bit and talk about the supply side. Obviously, development is something that, that I study carefully because it affects our day to day business. What are you seeing on the retail development side, I’ll just share, you know, from our perspective, it’s been very difficult to make deals, pencil cap rates are expanding, construction costs are still really high.

And frankly, rents are not keeping up, although they are still rising. It’s not the same pace to outpace the other expenses associated with the deal. So it’s tough. I think new retail development is really tough. Are you seeing things a different way? Or is that been the case? In your business as well?

Ressa 16:26
Yeah, I think it’s very challenging. The lack of new development is causing a boon to people who own existing real estate today, that’s been, you know, that’s been a narrative that’s gone on for a while, which is, retail space has had muted new construction.

And therefore, if you own existing real estate that, you know, retailers are forced to look in existing real estate versus new construction, because there is no new construction to speak of, I think, when people were talking about that they were talking about traditional shopping centers, I think what’s changed is that, you know, right now, it’s challenging even to do what was the creme de la creme of like freestanding Net Lease developments, those of slowing those who are very hard to pencil.

And it’s because if you just think about in the late teens, early 2020s, you know, these were financial market driven deals, right? Like the renting, even in the face of construction costs rising, the rent didn’t have to rise as much because the capex kept falling and interest rates kept falling, and you could financially engineer the development deal. And today, it’s back to the fundamentals, it’s back to the brand, and what is it cost.

And those fundamentals are a bit out of whack today, which is forcing people to look at existing products, and slowing down some development deals, you don’t have to go far. If you go on, you know, Twitter or X right now. And you look at some of the things on new store net nice development, there is a lot of a lot of discussions to be had both positive and negatively. It is pretty fascinating what’s going on on accessibility. It’s too hot topic. But it’s a challenge.

And, you know, everyone’s like, well, construction costs have to go down. I don’t know anything. Construction costs are a bit like college education, like, the steel might go down, but the lumber goes up, and then lumber might come down. But labor goes up. And it feels like it’s a bit like college education where just always rises.

Right. And I think that, you know, in order, there’s going to have to be some slow down, and you’re going to end up in a place where, over time the rents rise before we get back to, you know, meaningful construction, I think on the on the new shopping center.

And this is already happening. There’s virtually very few new shopping centers being built, did this work itself out in the you know, the admittedly 2000 teams and everything still penciled on the net nice development side? And now, you know, that part of the business is going to have to work itself out and it’s, it’s in the early innings there.

Iacono 19:30
That is for sure. We look at these every day for developers projects in the works, projects coming online things that are nearing completion, and what is the exit look like? And how do they maximize proceeds because that’s our core business and the market changes every week. It’s amazing.

So very, very time sensitive business and very sensitive to market conditions, but important. Now we know the retailers want to expand developers want I’m to do projects because that’s their business. So how does the model change? We’ve been talking a bit about fee development. What’s your experience with that? And where do you see that shaking out,

Ressa 20:11
I think the development is gonna rise, generally speaking. And speaking to some retailers, I won’t mention names, in the market looking to do free development deals, which is, and they’re not going to tie up the capital to do their whole expansion in this, but they’re looking at ways to make sure they can continue to open stores and not miss out on a three to sales in those markets. And to do that, that means they need stores.

So one of the ways maybe to do that is to do, you know, pay a developer to do all the work, but not actually buy the property, and they would buy it, and the developer would do the work. But the tenant would spend the construction, and they would finance the deal versus the developer doing it. Now, most retailers don’t want to be the real estate, business and own real estate.

But you’re gonna see that’s, and I think it’s a little tough to me, it’s been telling, which is they that that’s the strategy, I’ve heard some of these retailers said they want to partner with developers to do it a fee basis versus like, just contribute more capital to the cost to maybe buy to rent for pay more rent at first, where they’re going to is they’re going to see how much of the they can, you know, cut into their total new store by doing feet development. So I think this is

super interesting. Like, again, demand is the demand versus supplies and saying there’s so much more demand and there is supply. I did people are attacking problems access supply, is potentially has the opportunity to not be as traditional as in years past when that cannot be what has happened,

Iacono 21:59
How do the numbers break down on this, I would love to see the side, maybe you’ve done this a side by side comparison of a free development versus a traditional development, how much is the retailer really saving? By taking on what in my opinion is a risk of owning the real estate when they you know that the exit might be variable, and it might take more time than they think we know they don’t don’t want to own the real estate. So they’re factoring and exit in, which can change so they’re taking on more risk? At what cost savings? Is there a percentage or is it not enough data yet?

Ressa 22:35
I mean, developments, not new. So there’s certain they all have data, because they’ve all they did some of it last year and the year before they’re just right, you’re gonna see it increased? I think, historically speaking, you would see, you know, they would, you know, there’s some retailers who self development is, you know, has always been a big part of their I talked to retailers, you know, before where we were today.

And they wouldn’t be a self developer, unless they couldn’t figure out how to access the real estate and the piece of real estate you had you were able to tie up, and they’re like, Okay, fine, we’ll let you be the developer, you could own it, you could be out of the airport, because that’s it. But there’s always been self development.

And, you know, in the past few years, they’ve been looking for a spread, but the spread needs to be the math is very different on how they’re figuring it out. If they could get to net neutral, you know, build it to a six and sell it at six that, you know, for some retails ever performance different, but it’s some retailers that could work for them. That’s all they need. Right? Right, because they’re at that point, they only so you can model cash flows for 3040 years. Right?

Right, from the actual retail operation, because you’re not beholden to only a 10 year term with maybe two five year options, you now have the ability to like, whatever your model says you can, since you control your own real estate, you have a little bit different. It’s a different map.

And I learned this a long time ago, but one of the ways it was reinforced when I went to the bet that bankruptcy you know, my team and I are like doing some math and couldn’t believe some, you know, you know how some of the retailers got to their app is related to what they’re willing to pay for the lease, because we were looking at our selection can’t make this work. Because they’re using the they’re using the real estate, they have a different pro forma, that’s just not real estate. There’s other things.

Iacono 24:45
So anyway, I would love to see those side by side. So you’re gonna make some good friends with the retailer so I can see how they’re looking at these different analysis because it is interesting. So we’ve covered a lot the last thing we want to touch on It is why retailers are so bullish on their business. And one thing I think that obviously is timely, where we are given the time of year is holiday sales.

And what’s interesting when you and I were speaking about this is the difference in the headlines. holiday sales are expected to be much weaker, holiday sales are expected to be up 5%. Some of the data is saying, what do you think’s real? What’s driving holiday sales? And what are your expectations? Chris?

Ressa 25:33
All right. I think at the end of the day, the train left the building, and people are spending, and I don’t think I think sales will be whatever your expected, whatever expectation is, I think they’re gonna be slightly above expectation. I say that when expectation is clearly mixed. And I would say, generally speaking, there’s this cautious optimism, which is just a pun, really, but that’s when everyone’s really cautiously optimistic.

I think one of the things that I point to historically, that I’ve seen, is the trains left the building, it’s rare for us to go back to school, and have a poor holiday. That’s rare. And since we had a positive back to school, I would assume we had a positive holiday, it would add positive is, you know, it’s like beauty is in the eye of the beholder. Like what is positive mean, right? If you’re expecting double digit sales comps, that’s not going to happen.

But if you know, if we were up 3%, is that is that bad? In the USA? Who would say because of inflation? Or you would have some saying? Well, you know, it’s good, because how good the last few years, but I think generally speaking, one of the things that I like to look at when I think of this is, I look at some of the average store sales on a score wall basis of retailers, what is the average unit, and in many are significantly higher than they were peak COVID.

And then I think about like, okay, there’s a cost increase proportionately and I wouldn’t say on a many cases they did not, right, obviously, labor’s up, right, but they’ve been able to squeeze profit at, you know, a creative profit, incremental sales, because a lot of these retailers have scale.

And when you scale, you’re able to, you’re able to, you’re able to really, you know, squeeze profit into places where or other to be able to so, you know, if the average store sales to retailers came down significantly, I raised my eyebrows, but that’s not the direction, you know, at least over a five year period, that’s happened.

Iacono 28:02
And that’s really the difference between top line sales, and NOI, right? All of those things that happen in between the lines, the expense savings, the scaling, the efficiency of operations. But I think that’s just a lot harder to report on, that detail is much easier to just throw out sales numbers and compare them.

But the fact that sales are still good, maybe you could attribute it to a fleet inflation, maybe there’s more to the story. But really how that shakes down to net operating income, I think is more important. And it sounds like you’re saying at least that you think that trend is positive as well, because of other cost savings along the way,

Ressa 28:41
Depending on the retailer. In some instances, some inflation is good for retailers, and they don’t give it all back. So they are able to retain some of that, you know, when raising prices isn’t always a function of costs, rising signs, raising prices is a function of demand warrants. And people are willing to pay for more for my product.

And we mix these two things, which is the price has gone up because the underlying cost to make that product and distribute that product has risen. There’s also the price has gone up because there’s limited supply, or there’s outsized demand for that product, and businesses are able to raise price without because it’s more valuable to that end consumer to that.

Iacono 29:46
Great point. And that’s just an overall win for the retailer.

Ressa 29:50
When that happens, and I think we don’t talk about it, well, the price is going up.

Iacono 29:56
Right? It may be the product warrants it instead of that, but inflation is driving it, huge difference. It’s true.

Ressa 30:03
Like, you know, there’s some products that if you breathed it 10%, people still paid with no reason for it other than you just think you can charge more.

Iacono 30:15
Right. Exactly. Yeah. I wonder how often that happens? I would imagine quite a lot. Actually. Yes.

Ressa 30:23
It’s the opposite of, you know, sending out coupons to get everyone in the store so that you can sell more, but you got them in because of the lower price, right?

Iacono 30:35
Yeah, I can think of a few retailers that I feel that way, like Lululemon, every time you go, the leggings are another $15 more and it’s like, okay, here, we are still gonna buy them for the kids. Okay. So I think some retailers definitely get away with it for sure. Yeah,

Ressa 30:53
It’s people, you know, you know, there’s a lot of brand equity in that concept. And there’s others as well.

Iacono 31:00
So, exactly. Well, we covered a lot of different warehouse sales going on here.

Ressa 31:05
Yeah.

Iacono 31:07
I think the consumer mindset is that they, you know, we’re accustomed to certain lifestyle spending, has been up for so many years now, post COVID, that I do think it’s going to continue. I’m a little concerned about consumers taking on more debt because of how high interest rates are. So I think credit card debt rising is a concern. And we’re kind of bumping up against a threshold where that becomes a material change to people’s lives, where interest really starts to impact them. I don’t know that we’re quite there yet.

But I think people are unwilling to give up the the purchasing that they’ve enjoyed for so many years. So that’s going to keep driving it whether that’s a good thing or bad thing for the consumer, is another story, but I think the sales will remain strong this season. And to your point, back to school was only a few months ago. So although economic factors are shifting, you know, pretty quickly, I don’t think we’re gonna see a whole reversal in a few months. So we just had strong sales, I think that’s going to carry through.

Cool. So we covered a lot of different factors from holiday sales, where retailers are finding their profitability to challenges with development, limited supply, and why retailers are still focused on stores. So all of these factors holistically lead us back to our topic, which is why we expect the intense competition and fervor if you will, for the demand for retail space to continue definitely through the end of the year and probably into next year, as well.

For everyone listening, we’re so glad you could join us for this month’s episode of ‘What’s in Store,’ as always reach out to Chris or I anytime with further thoughts, questions or ideas on retail real estate. Thanks for tuning in everyone and we’ll see you again very soon. Thanks everyone.

Ressa 33:15
Thank you for listening to Retail Retold. If you want to share a story about a retail real estate deal that you were a part of on our show, please reach out to us at retailretold@dlcmgmt.com This show highlights the stories behind the deals from all perspectives. So it doesn’t matter if you are a retailer, broker, entrepreneur, architect or an attorney Also don’t forget to subscribe to Retail Retold so you don’t miss out on next Thursday’s episode.