What’s In Store? with Karly & Chris (Trending Topics)
Guest: Karly Iacono
Topics: Eminent domain, retail real estate, retail trends
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 0:18
Good morning. Welcome everybody to ‘What’s In Store?’, the show where we discuss hot topics at the cross section of retail and real estate. I’m Karly Iacono, Senior Vice President at CBRE, and I am joined by Chris Ressa, the COO of DLC. Chris, great to see you again. How are you doing?
Ressa 0:36
Well, how’s your summer going?
Iacono 0:37
Amazing. I will tell you quickly before we jump into all of the fascinating things we have to talk about, I bought a folding kayak that was just delivered early this morning before I left for work, and I am so excited about it.
Ressa 0:48
Interesting. How does it fold up? Like how much?
Iacono 0:52
Like a suitcase, like two feet by three feet. And it’s a two person 10 foot kayak that does not require to be inflated.
Ressa 1:00
And paddles.
Iacono 1:06
Well, I already had those, yes, but not fold up. No. But they come apart in different pieces. So I’m covered. I have it in the back of the convertible and my summer was just upgraded pretty extensively when you go kayaking, everywhere, lakes, rivers, wherever I wherever I am. Oh, very cool. So how about you?
Ressa 1:22
So I’m just good. In the beginning the kids were sick, but now healthy and getting ready for school. So it is good. I will say this. You know, this is the summer for people on vacation. Getting things done has definitely been a challenge.
Iacono 1:41
I agree. Yeah. I feel like every deal. It’s, you know, three different countries and four states that everyone’s calling in from so yeah, thank goodness for zoom. Oh, great. So we have to everyone listening, some really interesting things to talk about.
And today’s show is about everything retail real estate related, that people are not talking about, okay, everything might be a stretch, three things, three big things that people are not talking about related to retail, commercial real estate, and we really think they should be.
So we’re here to bring them to your attention and share our thoughts today. The first one, let’s jump in, is the tremendous infrastructure bill that was just passed by Congress, and how that will impact eminent domain and what that means for retail real estate. So Chris, why don’t you kick us off on what you think this bill means to commercial real estate investors, tenants. So what impact this will have?
Ressa 2:46
Yeah, I think that it’s interesting, right? This is like massive infrastructure bill. And states have been on the sidelines for projects for a long time. And the federal government is about to give them money for their projects. And the states are going to spend the money on projects. The if you think about retail real estate, retail real estate, is typically the real estate that’s closest to roads, access points, bridges, things like this that are going to be needed by governments to complete their projects.
And I have to imagine that it’s going to lead to more pickup in eminent domain. And I don’t know how many cases of eminent domain there are across the country. I don’t know if that’s even kept because it’s different by state, by state, municipality by municipality. But, you know, I recently had on the podcast, someone who’s retail retold someone who specializes in eminent domain, and he believes over the next like three to five years, you’re gonna have a pick up of like 30% in eminent domain cases.
And it’s just his number, but it feels significant. And if we’re going to do all this infrastructure would seem to be that some of the eminent domain might just be like, a sliver of land. Right. Right. Normally, it’s not like they’re taking the whole building or something like that. But I do think it’s something we should be talking about as an industry, because I think there’s going to be an increase in eminent domain cases.
Iacono 4:34
So with that, we will likely see an increase in 1031 exchanges. So 1031 exchanges we talked about all the time. It’s a huge part of my business. Definitely a fantastic mechanism everyone’s already familiar with 1033 is less talked about, for those of you listening who aren’t familiar, it’s an exchange when your property is taken by condemnation or eminent domain. The rules are completely different, much more flexible, you have two to three years, depending on how the property is classified to replace the property, instead of this tight 45 day Id period, no intermediaries required no ID period.
So the time pressure that we see with 1031 exchanges isn’t there. But it’s still an exchange mechanism. So we might have this new group of investors that we really it’s it’s such a small portion right now of exchanges, but that I think, could tick up with this 30% increase in eminent domain that you just mentioned, and we have this whole new subset of buyers that have to buy, but they don’t have to buy for two to three years. And what does that mean for the market? Philosophy, pricing, etc? Yeah, totally agree.
Ressa 5:43
And that 30%, that’s not 30% of properties will be subject to eminent domain. And that’s right, whatever the number is, of eminent domain cases, could increase up to 30%. Based on where the, what the government’s think they need to take on these projects, and the process is, you know, could be really quick, or could be cumbersome, because you could be working with, you know, the their engineers and to try to get them off of your property.
And, you know, you can do a lot of research on eminent domain, it’s different by locale, to locale, but it seems to reason that there’s going to be an increase them to make cases.
Iacono 6:27
Last thing and maybe you know, the answer, I don’t on this, how do they value the properties? When you’re approached? Is it independent appraisers?
Ressa 6:36
Do you have an appraiser? And so they have an appraiser come, but I mean, it doesn’t take into it typically doesn’t take into damages. Okay, right. So, you know, if you, you have to respond quickly, if you respond quickly and get into court, you can, you can start to really talk about price. It’s definitely hard to stop taking, but you can definitely challenge pricing.
Iacono 7:09
Okay, sounds like this could be a another windfall for the the legal industry as well, I’m sure it’s not an easy process. Alright, so eminent domain may be still a small portion of property trades, probably still a small portion, but an uptick of 30%. Around there certainly could be impactful.
So very interesting. All right. Number two, retail real estate is becoming more durable. Now, this is, of course, in direct conflict with most headlines that are always for some reason, extremely negative on retail on necessarily so in my opinion, I think yours as well. So what do we mean by that? Why do you think retail real estate is becoming more durable?
Ressa 7:57
I mean, there, there are ton of reasons, I think the first thing that I think about is the supply and demand. And the supply of retail real estate has changed. So one, there’s been repurposing of spaces. We see department stores turning into multifamily units, we see malls getting knocked down and turned into industrial, we see self storage.
And so if we were once over stored in America, the market has been changing, I think to the because of the challenge and construction costs, not much new development is being built. So as you’re actually removing supply off the market, you’re not having new supply by via new construction come online.
And then, you know, there’s been a significant uptick in occupancy at retail centers because you can, it’s easier to profit in a store physically then at scale then at scale online. And so I think the one piece and I think some of this has been talked about but I think what we’re not talking about enough is like to say, Honey, we shrunk the space. So if you think about what this new occupancy has become, you take a Kmart box. Kmart was, I don’t know 100,000 square feet.
Today if you look at that former Kmart pucks, what is it it’s a TJ Maxx Five Below Burlington and in Alta that’s an example could be many different things. So what that means is when one Kmart When Kmart filed bankruptcy, or any single one tenant in each space, when they closed it put 100,000 square feet on the market per location. Well, in today’s environment, you would have to have four different credit worthy entities file to equal that one vacancy.
So when one of them files, maybe it’s only 10,000 square feet of vacancy put on the market at once, versus yesteryear when it used to be 100,000 square feet. So, you know, over the last couple of years, I had three Kmart boxes, one went to one tenant, the other two were split up into four different tenants. So those, you know, we shrunk the size of the space, making it a much more durable, and the credit risk spread out through multiple credit worthy entities. And this has happened at scale across America of different boxes, you know, we had a sports box broken up into two.
And so as the space gets smaller, and you add more doors, You’ve spread the risk through more creditworthy entities. And one big event doesn’t add a significant amount of supply to the market all at once, which is what I would say the biggest disrupter to leasing velocity are multiple mass closures all at once, because it just puts a significant supply to the marketplace all at once. Well, now those mash closures are going to add less and less supply to the market every time.
Iacono 11:42
And I can’t think of very many handful of retailers that still occupy very large for format stores that are on bankruptcy watch lists, there’s a few. But it’s less than less to your point. So there’s two fold right, we have more store openings and closures we have less vacancy in the market overall. And then on top of that we have the smaller store footprint coming in and backfilling the vacancy so we’re protected against any future risk.
And I think exactly what you said, that’s the piece that people aren’t talking about. There’s a lot of stats, I’ll share a few with you actually. Because, you know, we put at CBRE a lot of these out but just store closures and openings. So first six months of 2022, there were 4328 announced store openings very specific. And 1912 announced closures, according to that was actually CoreSite stat.
And then we have 1.9% more openings, and 58% fewer closures compared to this time last year. So the market is really tightening, we don’t have as much space in terms of vacancy and availability. And then when we do have bankruptcies, it’s just a lot easier to manage. Because it’s not the same square footage. So completely agree. I think all those factors come together and just create a much more stable retail landscape. And we certainly do not hear that presented that way.
Ressa 13:08
No, not at all. I think you just think about where you know, anyone out there lives and think about a repositioning of a of a box. Most times it got repurposed to multiple users.
Iacono 13:25
Right? Most I’m sure there’s pretty significant on the front end there. So it’s it may be a bit painful at the beginning. But then the long term value creation with higher rents, with better credit with less risk over time. It’s absolutely worth it, if you can pull that off. So
Ressa 13:43
Yeah, the in the last like five or six years, our we’ve repositioned over 100 boxes that are north of 15,000 feet. So if you think about and it’s not 100 different spaces, it’s 100 different new tenants that went into those spaces. So it could have been one that we turned into four, but it’s significant.
And I think you know, and what’s really interesting is, you know, the lack of vacancy is so real. We have a center and a market in Texas where there is literally zero existing product over 15,000 square feet of arable zero is a major market zero. And if you’re a national retailer looking to expand and like some of these markets, there’s literally zero space available.
Iacono 14:42
Wow. Yeah, this chart doesn’t hold everywhere in the country. But yeah, it’s definitely pretty widespread. Yeah, great news. Alright, so the third thing we’re going to touch on today are retail rents. Now we have talked about rents and Previous what’s in stores, there’s data out there about rents.
But I think the the point here that’s being missed is that retail rents are rising. And this is really impactful for how deals pencil out, they’re already rising, and they’re gonna have to continue to rise, if we’re gonna have development deals make sense? So there’s a lot of factors that are pushing rents up, but why don’t you kick us off on this point, Chris, with your thoughts on how it relates to construction and development?
Ressa 15:30
Yeah, I think, I think something else, too, which is, if they don’t continue, it’s one it’s not just new development, it’s an existing improved space because the cost to put a retailer you know, a former Toys R Us and reposition that and take that and put in a new credit worthy entity has a significant cost to the landlord. And to make the deal pencil given construction costs, the rents either rise or the deal doesn’t get done.
And given the supply and demand in the, you know, so heavily weighted in the landlord’s favor in today’s environment, rents are rising, and they’re going to continue to rise. And they need to rise even more. On the new development front, right. And this applies to the existing as well as you have construction costs rising, and cap rates potentially creeping up. Which I think in the pandemic, in the heart of maybe not the pandemic in the heart of people staying at home.
For the amount of time they did, I think, you know, what we saw as people were making the money on the cap rate compression, as construction costs rose, more so than on the rents rising. And if cap rates are going the other way, and construction costs are like college tuition and aren’t coming down, then rents will rise or deals won’t happen.
Iacono 17:15
We’re already seeing that we have developers on very tight margins on some of these smaller single tenant Net Lease deals, fast foods and love and things like that. And they’re going back to the tenants and saying, We need X amount more because of the cost of this project. And our projected exit cap rate has changed significantly. So there’s a lot of conversations happening right now, some deals are moving forward with higher rent, some aren’t. But to your point, it has to happen.
Ressa 17:44
What I do think the counter to rents rising. What I do think you may start to see in some instances is retailers contributing more to the capex of the project. See what I think has happened over the last few years. I think what has happened over the last 15 years, is, you know, the burden of the cost to install a tenant, the bird stores opened on the backs of landlords spending the money to get the stores open.
What I think you and I’m seeing already is some retailers with significant cash position built up over 21. In order to you talked about the developer that went to the tenant said, Hey, in order to make this numbers work, I need more rent. You know, we have had retailer say, Well, what if i less than that cost burden?
Iacono 18:47
Right? Right, it’s all fine.
Ressa 18:50
So that could be the mitigate. But that hasn’t transpired just yet. But I do believe that, given that stores are profitable, given that at scale, given that retailers have a lot of cash on their books, and they spent so much money deploying into tech over the last 10 years, and they still need to do that a little bit. Some would argue a lot of it, but they there was a huge pendulum, right dollars used to go into stores like this and tech was here.
There was a flip as that starts to even out retailers deploying capital into the physical plant of their locations is a pretty good investment. And they already start to get a taste of this right. There’s a ton of remodels that have happened and are continuing. The next step is how much more of that goes into their expansion. And if capex gets diverted to that, that could be the mitigant for retailers. But without that rents are rising.
Iacono 19:55
How much of this do you think is pressure from the landlords and how much of it is just general All inflation. So if we see inflation ease, do you think we’re gonna see rent growth ease? Or are they just not going in tandem?
Ressa 20:08
Inflation in what? Right? Because if if inflation eases but construction costs don’t ease, right? You know, and I said construction costs are like college tuition, right? Like because steel goes up. Okay, so lumber goes down, let’s just say lumber goes down, but then labor goes up, labor goes up. It’s like, it’s, it’s finds its way in.
So to me, it’s it’s less inflationary, it’s more the cost of doing business today. And if if the construction costs plummet, sure, but it’s hard, if you have a $1.85 trillion infrastructure bill, that’s going to, you know, need a lot of construction. It’s hard to see construction costs, compressing.
Iacono 21:09
Now, how do you think all this fits together with potentially depress profitability from retailers due to inflation or less consumer spending? I mean, this is all tenant by tenant. But if we have sales reports coming out that aren’t as strong, do you think we’re going to see more pushback on landlords demanding more rent or tenants gonna say, we just don’t have it in the budget? Or is that just such a different area for them? That, that it’s
Ressa 21:38
okay, I think you’re always in. Everyone’s got budgetary constraints. I think, you know, this goes into another a whole other piece, which is how much margin can a retailer drive into a sale? Right? I think that’s what it comes to. And we saw it in in, you know, 2020 and 2021, when there was inventory shortages, the retailers were able to create significant margin because of supply shortage into the product.
And the challenge today is there’s an excess amount of products. So you’re gonna start to see discounting. But I think that comes down to that that cascades into a whole other discussion about inventory control, and pricing power.
Iacono 22:33
Now, look at the moment.
Ressa 22:35
At the moment, there’s another retailer willingness step up and take it. Right, so they might lose out on that deal.
Iacono 22:46
Exactly. So I have a few stats to back that up. So retail completions were a record quarterly low of 3.6 million square feet in Q2 according to CBRE. So this is a 56% drop from the year before. So when we’re talking about availability and options for retailers, if they want to expand, it’s getting really tough.
So the increase in rent might be something that they’re going to have to swallow. I think my concern is more forward looking. If their margins are being compressed, did they start looking at their fixed costs, like real estate and say, maybe we just don’t expand? Maybe we just don’t take that other location? We’re not seeing that now. But I’m wondering, you know, in a year, if these factors continue, economically, if that might be something we see more of,
Ressa 23:34
I think the macro forces of the challenges with last mile, and with the lack of profitability in e-commerce at scale, are so large, that expansion isn’t going to slow.
Iacono 23:49
Great. I like it. Yeah, I think we should just end there. Perfect. Thank you so much. For great insights, we covered eminent domain, we covered the real estate becoming more durable, because the store size is shrinking, which I love. And then we just covered the increase in retail rents.
Ressa 24:08
Yeah, and I don’t know why people aren’t talking about this enough. But I think like, to me, this is a precursor to the ‘What’s In Store predictions for 2023. With that we do at the end of the year, because, you know, I think at some point this is going to start to be hot conversation. It can’t sit under the radar for too long,
Iacono 24:31
Completely agree. We’re starting the conversation right here right now. Chris, this was great. Wonderful to see you. To everyone listening, thank you for tuning in to ‘What’s In Store’. We look forward to seeing you again next month. Have a great day everyone.
Ressa 24:45
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