Your Top Retail CRE Questions Answered
Guest: Karly Iacono
Topics: Leasing, e-commerce, CRE
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 unpack hot topics at the cross section of retail and real estate. I’m Karly Iacono, Senior Vice President at CBRE, and I’m joined by my co host Chris Ressa, the COO of DLC. Welcome, Chris.
Great to see you. How’s life? Great to see you. I just got back from the Florida Keys. Have you been?
Oh I have been to the Florida Keys last year I had the pleasure and Isla Murata. I hit the keys twice last year but it’s been a while what was your trip? It was good. I forgot we went to the Florida Keys. Business trip together a big group of us. We were in stock and start best practices but my wife and I went to marathon Florida. We did this swimming with dolphins thing. Dolphins Research Center. Unexpected how much I enjoyed swimming with dolphins.
It was the coolest my one, my one friend I told him he’s like how was how was marathon I said it was great. I told him about this swim with dolphins and that and he and he broke back in a text message to me he goes the way your bill port dolphin. And so he had to carry you around through that whole thing you got to use it it was it was so fun for you. And for you.
You opened the door or just walking through. Love it. We went skiing just got back from Breckenridge with the kids and I feel like are you went skiing we went when we go we go. We rocked it was amazing. Getting back not so fun. But we made it we’re here. So alright, let’s jump in. We have a really interesting episode. I feel like I say that every month because they are different and interesting. But this month is a little bit different.
So for everyone listening, what we’re going to cover today are the top three questions both Chris and I get asked, and our respective line of work. So we’re gonna start with Chris’s top three questions he gets asked most which are by nature of his business, of course, mostly leasing and tenant related. And then my top three questions are interest rate and capital markets related, which we’ll cover in the second half of the show.
So let’s jump in what is Chris, one of the top three things that you get asked every day? Yeah. So the first one is how at least has changed since COVID. And I get asked this, you could be at a dinner party, right? And I think no matter what industry you’re in, people are like, so how’s your business changed since COVID? Like and they don’t know about our industry? They’re not like, that’s a common one. But a little bit more granular is how the leases have changed.
So I answered generally, by and large, there, it’s not drastic, there hasn’t been drastic changes, I think there was headline news and media around that the nature of leases are going to totally change, they’re going to be these flexible documents on a go forward. And I would say just the quite opposite happened. And I mentioned this before, but I think the most flexible thing that people were talking about was the term of the leases.
And people were thinking that leases were going to be more shorter term, more flexible. And it’s not the case, there’s a lot of longer term leases, in fact, longer term driven by retailers and tenants often, I have not had more. You know what we call blending extend requests in my tenure in this industry than over the last few months. I think construction costs are so high. And people don’t want to relocate stores, there’s no new build.
They don’t want to relocate, there’s no new build. And so they’re staying in place. So they’re trying to lock up long term at the best rate they possibly can so they can get their footprint in that market. So by and large, there are a couple of things we can talk about a couple of provisions that I see that have been changed, but by and large, there’s been very little and I think the one that people are thinking in the back of their head when they ask the question on the flexibility in term has the opposite has happened.
Do you think that’s because, well, we thought at one point least is we’re gonna be all CPI driven. So the rent increases were going to be tied to CPI. I haven’t seen that become the case and most leases Have you are used to seeing mostly fixed rent increases and leases are used.
So, I think and I think the biggest burden with the CPI piece in a lease is neither party wants to administer it. And like have to calculate what is the rent now? Right, it’s no different than the fair market value in options that come up in leases, it’s, it’s now you have to have this administrative burden, there’s a cost to both parties to just figure out what the rent is in the lease.
And so I think that’s always on both parties, it typically goes away, I think people on the landlord side want to get as large of increases as possible, try to match or beat inflation and, and tenants want to try inherently to make sure their increases are as low as possible. But I didn’t see a lot of CPI. And I think the major reason for the CPI piece, is it it’s too hard to administer.
And I think that could be why we’re seeing longer term leases, because tenants are more comfortable with the predictability of the fixed rates, especially given our inflationary environment. So if CPI increases were not instituted widely, and we have what everybody agrees are reasonable annual increases are every five years, then that’s actually more beneficial to the tenant, because they don’t have to face a complete rent reset in five years, maybe they’re doing a 10 year base term, and two, five year options.
So they’re controlling it at a fixed level, for a longer period of time. So I can see where they would want that security, where three years ago, we thought it was going to be all about flexibility. And now given inflation, it’s we want long term predictability without these massive rent resets.
Certainly. And I think you hit on a point that’s interesting, which is one of the things I was saying in the middle of COVID, when people were talking about that was like, Wait a second, if you’re in a growing business, and your business is doing well, what you want to do is lock in as long term as possible at as low as cost as possible. You don’t want to have it flexible and give the upside to somebody else of your business.
And that’s why the mature grow and growing companies have always wanted to control real estate and lock it up as long as possible. And they would give up that flexibility because they don’t want to give up the upside in their sales to somebody else. I do think the inflation is apart.
I do think definitely construction cost. I do think there’s no, there’s very limited new product coming out of the ground. And given the occupancy rates in our industry, there’s nowhere to move to. So the fear of closing a store and losing that market is strong, and they want to put up a real strong foothold on that market.
Right. Right. So leases have changed, but not in the ways we thought they were going to at the start of the pandemic. Yes. Good discussion point. All right. Number two, what is the second most common thing that you get asked?
You know, is the pool of tenants decreasing? And the answer is pool of tenants is increasing. People try to every time there’s headline news around a store closure, they think, you know, there might be or a retailer in trouble, a retailer in trouble you I think goes into people’s heads like, you know, the tenant pool might be decreasing. But the new business formation that we saw in the pandemic, and obviously, it’s not as high anymore.
But the lack of physical product coupled with the business formation, coupled with just innovation and all these new concepts, and taboo, coupled with the online stores, opening physical stores. The tenants are different. Some of the uses are different. We have more service and medical. Then we had previously more entertainment more experienced driven, but there are a myriad of new uses in the tenant pool is increasing and not decreasing.
And I think you touched on something really important that I just want to highlight. It’s the expansion of the definition of retail. So medical entertainment, all these things that had you know, different very different footprints 10 years ago So now we’re coming into retail centers and retail spaces. So it’s not just that our core retail tenants are expanding, which they are, they can find space, but also that the overall definition is expanding. So we have a much broader tenant pool overall. Yeah,
The explosion of restaurant fitness. I mean, there’s a, there’s restaurant fitness, medical feels like it’s in almost every center in America, right? Like, the expansion of this. And those are just three categories.
Alright, let’s move on to number three. This is a headline buster.
Yeah, I get this all time. I’ve gotten this for a while, you know, and they go, people will be like, so how’s ecommerce been hurting your business? What a pointed question. And the, the reality is, in our SEO automation said, this is turned out the way it’s played out is the physical store has been the solution to e commerce, not the victim. And, and so and that’s the bottom line with, you know, the closest real estate to the consumers retail real estate.
And all these ecommerce businesses want to get closer to the consumer. And they’re using physical presence retail real estate, to do that, and that’s going to continue to grow. Especially as you know, the cost of last mile delivery just doesn’t seem to want to come down, it only goes up. So the reality is, there’s been disruption. No doubt. This disruption started a while ago.
And it’s been evolving. And we’re now at a tipping point where physical retail has been a solution for E commerce, whether that’s by digitally native brands, opening stores, whether that’s by mature physical retailers, who have ecommerce businesses fulfilling from store, whether that is, you know, the small micro fulfillment centers that come in to retail properties every now and then whatever it may be, physical retail has been a solution, right.
And you could come up with that solution a myriad of ways, right? If you’re walking down the street, you go online to order your Starbucks. So you can walk right in and pick up your Starbucks at the at the physical counter without that physical counter, you don’t have a cup of coffee from there. So physical retail has been the solution, not the victim to ecommerce.
I think that’s the quote, of 23, maybe 22. That’s, that’s just such a great line. And I think really sums up all the changes we’re seeing in distribution. And you know how the actual endpoint is crucial. That’s where it all comes together. Like you just said, for your Starbucks, you’re still walking up and picking up that cup of coffee, rarely have it delivered to you. So
Yeah, and I mean, that we’re always going to have delivery, right. And I think delivery is a good solution. But what we’re starting to see, especially by the pressure put on Wall Street onto brands to be profitable. Convenience is going to have a cost. And we’re starting to see that cost.
And I say this all the time, just get a get a whether it’s whatever brand you want to use to deliver the coffee, whatever delivery program, deliver a cup of coffee to your house, it’s like $24, $25 to do that like, and it might be a little different in your neighborhood pending out close, you live to the store. But that’s a lot of money for anybody to pay for a cup of coffee, that doesn’t make economic sense.
And the cost of gas. And the time to go pick that up is significantly less than having it delivered. So there’s a cost of convenience, and we’re starting to see the consumer have to pay the burden of that. And that’s only going to accelerate not going to decelerate.
And I would say even if they are willing to pay for this cost of convenience, as you call it, a lot of these deliveries are being done by third parties that are going to the physical locations to pick up the goods right even if you’re getting it delivered you’re still you’re not going to back warehouse if you know DoorDash is picking up your Starbucks they’re gonna go to Starbucks, pick it up and deliver it to you.
So I think either way, right either way physical retail wins. Yes. Love it. All right. Glad to hear everything is good and your your tenant retail world. Let’s move on to the questions I’m getting asked on capital markets. So this is slightly more challenging, although not all negative. Let’s start with the number one question I get asked which is will cap rates go back to where they were in 2021 peak levels p cap rate compression.
I’m gonna say no, just pretty simply. Alright, let’s move on to question two. No, I’m kidding. So cap rates were overall retail cap rates were 5%. Now, this is a lot of variation in different deals, of course, right? A 20 year investment grade Singleton, a deal is going to trade different than a local strip center with no national tenants. So as with any data source, you kind of have to dive in a little bit deeper.
But overall, retail cap rates were 5%, in 2021, that went to 5.85 at the end of 22. And we’re now predicting it to go up to 644 by the end of the second quarter of 23. So we’ve already had over 100 basis points of expansion, and we’re expecting more now. Do we think that they might come back a little bit?
Yes. But unless we see a 10 year treasury, that’s point nine or 1%, like we had in 2021, I don’t think we get back to some of these crazy sub four cap low four cap cap rates that we had, I just don’t think that the market gets there again, in this cycle. So do we think we’re gonna get back to where we were? I think it would be extremely difficult unless there was a major turnaround with the the monetary policy. Any comments on cap rates?
I think it depends on time horizon that we’re talking about, like, if you were talking about the next 50 years, I probably odds are they’ll come back down at some point, right? We’re talking about in a much tighter time window, called the next three years, I think it’s probably fair to say that cup cap rates are, you know, it’s gonna be hard to get back to that level. Right. So I think the time period matters.
I think certain, you know, I think certain product types in that sub sector overall, I think you’re I think certain product types in the sub sector probably hold for a little bit, because they’re just so strong of a tenant or a brand. Right, you know, is McDonald’s cap rates up? Maybe, but like, they’re still going to be lower than other competitors, probably because of their, you know, their credit worthiness.
So, but overall, I think, you know, unless we see something in the short term that happens with monetary policy, it’s hard to envision that cap rates compressed to that, will they come back? So I think, to me, what they should be asking you is, will they come down? Will they get back to 2021? I don’t know. But will they come down?
I think there’s an argument to be made at some point that they’ll be that you might be less than they are today. You know, could you see them be less than they are today, in a year is that? Could you see that?
I think it depends on how high the 10 year Treasury goes. Because we’re we will touch on this in a minute. But we’re reaching an inflection point with financing that it just kind of grinding everything to a halt. So there has to be a little more expansion to make more deals financeable before they can come back down. So do I think they’ll come? Do I think they’re gonna go up a little more? Yes. And then potentially come back down at the end of 23? Absolutely, hopefully.
But how much farther down? Do we get to 21 levels? I don’t think so. Do we get to where we are right now? And maybe even a little better? Probably. Right. So come down is such a relative thing. So it’s from what data points. So we’re going to expand a little more and then come back in. And to your other point, I think it’s important to look at that McDonald’s cap rate to McDonald’s cap rate. Can you find a you know, four and a half cap deal? That still is worth it? Right for the tenant?
The lease term? Yeah, I can think of a few. But would that deal have been a four or 375? A year ago? Possibly. Right? So it’s relative to your type of investment? How has the cap rate expanded? Not relative to anything in the market? Yeah, certainly expanded. So the second question, which kind of dovetails off the first is how is interest rates impacted the market? And I think something really important to look at here is the spread between the 10 year treasury and cap rates.
So we’re at 215 basis points roughly right now and 2022. Above the 10 year treasury, that is the tightest spread we’ve seen since 2008. So how and what that tells you is how much farther can connect condense, right? If you’re only 215 basis points from the average retail cap rate above the 10 year treasury, where do you go from here? So that spread was well over 400 basis points just a few years ago, so very material difference.
So what this is causing is really an illiquidity event in the market. We don’t have a lot of lenders who are active the ones that are bringing in their loan to values. We just have a sort of a time in the market where it’s very difficult to finance deals, a lot of the lower price point deals are still being bought by all cash buyers. buyer demand is sort of unwavering. But how do you get the deal financed is the challenge right now.
So interest rates are impacting the market because they’re, they’re slowing down transaction velocity because of negative leverage, meaning you you’re actually coming out of pocket in some cases to finance a deal instead of it adding to your overall return instead of the financing being a creative.
So I think we’re going to continue to see that unless we see cap rate expansion that exceeds the increase in the interest rates, we’re gonna continue to have a very tight market from a financing perspective. And I think we’re gonna see that for the next few quarters, then hopefully, things will stabilize a bit. Are you being impacted by by interest rates at all, Chris and your business?
I think everyone is, I think, for sure, what comes to mind is, you know, it’s a good time to have really strong relationships with your lenders who want to continue to make sure they do business with you, for sure. It’s it’s like you said, the buyer appetites, you said unwavering, it’s like insatiable, but the modeling the deal, the pencil is really challenging. And there’s a there’s a myriad of ways that that can happen.
And I think one of the ways you’re probably right that you hit on that you’re going to see, and what’s going to have to loosen, given that we don’t expect monetary policy to go back to the old way anytime soon, is that the pricing on the deals and the cap rates are going to have to move you would think
And we are seeing a lot of creative solutions. At least people are trying right seller financing, sort of a mid mez piece of debt, like anything buyers can do to get deals that they really want. But it’s very difficult to get those kinds of deals over the finish line. So buyer demand reads remain strong. I am confident in investors creativity and ability to get things done when they want but it’s certainly more challenging from a traditional lending standpoint right now.
You know, we’re obviously seeing headline news, what’s what’s the Carly take on transaction volume between now and 12 months from now?
I think we’re I mean, we’re certainly down in terms of velocity across capital markets broadly, retail is no exception. all asset classes are down in terms of overall velocity. But because the buyer demand is so strong, and retail fundamentals are so strong, which is my third thing I get asked all the time, I think we’re gonna see that loosen second half of the year right now everyone’s just sort of the sellers don’t want to sell unless they have to the buyers are kind of waiting. We’re still in that like, Give and Take there’s lot of bifurcation between seller and buyer expectations right now.
But people still want to move things forward. So when we have a motivated seller, meaning they’re willing to work with the market, work with the buyer get creative on financing, those deals are absolutely trading and we’re seeing more and more sellers like that, when we have to straight cap rate buyer’s or seller’s those deals are very sluggish right now. So if you build something and your exit cap is four and a half in your mind, and that’s what you need to get.
Those deals are tough to get done right now. If you have a buyer that is maybe in a considering a sale leaseback or structuring something a little bit different, absolutely. Tons of demand. And those deals are moving forward efficiently. So I think it depends on what type of deal we’re talking about. And again, that the timeframe for a sale,
I’m gonna ask you, I’m going to add to your three questions, I’m going to be like your top five. So that was that was your fourth transaction by by transaction time how long it takes to get the deal done. What are you seeing there right now.
So it depends if it’s financed or not be all cash deals are standard Net Lease timeframes, 30 days, due diligence, 15 or 21 days to close, like, best case scenario, right? If there’s any sort of environmental concern, or if the deal is being financed, that due diligence is getting pushed out, not on the front end, but by way of optional extension. So maybe 45 days due diligence and 30 days to close.
Or maybe you keep it really tight at the beginning and then you do an optional extension that both sides have to agree to if you can show the progress is being made. So I think it’s honestly less of an elongated timeframe. That was more of a COVID situation because you couldn’t get surveys done. You couldn’t townships weren’t open for approvals for development, things like that.
So I’m not seeing that be the main concern right now. It’s more the lenders. So if it is being financed, they need a little more time or maybe the buy has to go to more lenders to get terms that actually work for the deal. It’s less straightforward. But in terms of third parties that’s actually improved in the last two years.
Are you? So are you not seeing a ton of like, you know, extension options being parked?
I’m seeing him be requested by buyers. And I think that’s really the key right now is collaborative buyers and sellers are getting things done. So if a seller says I am willing to sell at XYZ price, the virus is great. And then there’s a hiccup. Whereas a year and a half ago, that seller might have said, Honestly, that I’m not giving you another two weeks in your due diligence, I’m not giving you any, any more time, I’m not changing anything about the deal.
Now, that seller hopefully will say, Okay, how do we work through this, you still want the deal, I still want to sell it to you, let’s be a little more collaborative and see if we can figure it out. So the mindset has shifted. And those are the deals that are getting done. It’s not a hard line, I’m sticking to XYZ timeframe, it’s whatever comes up, whether it be financing related, tenant related, whatever it is, if we’re willing to focus work on it together, then there, hopefully, typically is a path forward.
Got it? And then the last question, actually, my third one, which I kind of I kind of glossed over, but I just it’s so positive, I’d want to touch on it. Is it a good time to buy retail? So all of this aside, right, the financing piece is challenging. We’ve hammered this and hammered it. It’s true, is what it is that the key here though, our retail fundamentals remain the strongest they have been many, many years. And we’ve touched on this in previous episodes.
But I think it really bears ending on this point, because it’s so important. Rents are growing occupancy is at historically low levels, we have very, very limited new completions because of the high cost of construction. So there’s limited product on the market, limited availability of quality product, and the actual fundamentals for the sites, you know, the retail sites, even single tenant two that are existing or have never been stronger.
So we’re seeing a lot of people, especially given the volatility of the stock market look at retail and say, Hmm, this checks a lot of the boxes for what I’m looking for, it’s going to be a little rocky for the financing piece for the next you know, few years, potentially, hopefully not quite that long. But this is a solid asset, and it’s an asset class that continues to improve.
And I think that’s really the gold star here. Right? That’s what we are focused on getting the deals done is tough. But owning the assets is a very positive thing.
Yeah. For sure, I think the fundamentals of retail have never been stronger. And we’ve touched on this and you said it perfectly, I think and when you bring on the the negative retail, if you think about some struggling retailers, you know, there’s been a lot of noise around like Bed Bath and Beyond right now, right, we keep hearing about Bed, Bath and Beyond.
And I think people were surprised at their ability to can, you know, to extend out and get another opportunity to try to reinvent themselves with the new financing they got. And it it reminds me and I haven’t heard this lot. It reminds me a bit of Circe interesting, who was, you know, left for you know, you know, everyone kind of put them, you know, in their rearview mirror for so long yet, and everyone’s like, Ah, they’re not gonna make it, they’re gonna go away.
And then like 30 years later here, they still were.
And they held on, it takes a lot to take down a retailer. And there’s a lot of reasons why. But it’s really hard to really for like such a successful that for a brand that was successful for a long time. And as all the access that they’ve had and cash flow that continues to come in through the door.
It’s hard to take down a retailer and I think, you know, bed bath is proving this with their resilience here and no matter what, you know, headline news, you know, the a lot of the street for a while hasn’t been happy with them. And there’s been you know, a lot of negative news about them. But that what I said to myself when I saw they got this new financing and they didn’t end up like, you know, filing or something like that yet it was like, I’m surprised I am surprised.
I’m surprised I’m surprised because I know how hard it is to take down a retailer. And you know, it’s reminding me of Sears like, when is this going to happen? When is this gonna happen? When is this gonna happen? Next you wake up. It’s like five years later still hasn’t happened yet. Right? And Like, I don’t know that that’s gonna be bed bath.
But man, it’s hard to take down a retailer. Hard to bet against it. That’s a great data point. Great story. Yeah. So. All right. I think that’s a wrap for today. We covered a lot of good stuff for everyone listening. That was what’s in store. We’re so glad you could join us and we look forward to seeing you again next month. Thanks so much, Chris. Thanks, Carly. Thanks, everyone.
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