Top Ten Issues Affecting Commercial Real Estate (from the CRE Counselors 2015-2016 Report)

This is a market update from the Winter 2015-2016 Real Estate Report, put out by the Counselors of Real Estate, a Chicago-based organization that publishes scholarly articles each trimester by national thought leaders. The goal is to provide expert opinion on the most important issues impacting the US real estate market, to facilitate better decision making for real estate investors, brokers and advisors. The perspective below was provided by Noah Slayze, a former commercial real estate appraiser and 2015 CRE chair and guest speaker on the August 6, 2015 Commercial Real Estate Show.

#10: The Changing Retail Model
Retail models have been changing for a few years, but this year it’s really beginning to matter to the retail market asset class. Experts poled by the CRE fed back that 10-15% of shopping centers in the US are now functionally obsolete. Business has shifted from retail as a pure consumer destination to a combination of convenience and information. Consumer expectations of retail have become much more demanding due to the wealth of information they can get online and an ability to receive goods purchased online within a day or two of ordering. Store visits are now much more of a logistical experience and consumers expect to be able to get information, have an easy return process, and easily find merchandise.

Successfully branded anchor stores (“surrounding rooftops”) are critical for a shopping center to operate at full capacity at this time, and those shopping centers that are thriving now have many successful anchors in one location. The successful retail stores are those that are embracing the concepts of online retail and bringing them into the in-store experience. Shopping centers with store footprints that are conventionally laid out are having trouble remaining competitive to modern retail tenants.

#9: Real Estate Technology and Crowdfunding
Crowdfunding has now emerged as an accepted tool for sophisticated investors with large pools of assets. We need to develop a good regulatory and legal framework for Crowdfunded investments and better established criteria for accredited investors and sufficient communication to ensure an honest transaction.

Slayze sees a huge opportunity to continue to disrupt current real estate information channels and an opportunity to standardize the due diligence process for investors through disruptive technologies.

#8: Infrastructure
The cost of infrastructure development and repair, and the cumulative effects of not keeping up with infrastructure maintenance is starting to impact many regional markets that larger corporations are shopping for expansion and/or relocation. Those tenants are heavily weighing the financial impacts of paying for needed infrastructure in certain municipalities and that is driving site selection.

#7: The Gap Between Rich and Poor
Sometimes the gap is good news because it can grow segments on both sides of the spectrum including micro apartments, and the growth of 24 hour cities in more urban markets. 40% of US wealth is now controlled by the top 1% of the population which Slayze sees as “eliminating the middle” out of a lot of markets. There’s growth serving both ends of the spectrum. Typical American models were designed to serve the middle, and the middle is shrinking, hence the disruption in the retail asset class, for example. There are retailers on the low end that have been extremely successful such as Costco and Walmart, and retailers on the high end that are thriving, but not the traditional middle class market.

At the top of the market there’s always concern whenever there’s market manipulation and changes that could impact returns such as a minimum wage increase. Some states that are doing better than others including Texas and the Carolinas have been more aggressive at making relationships with offshore companies to lure manufacturing back through economic incentive packages.

#6: Energy
Last year we were talking about boom times in the energy industry in the US which drove down significantly the cost of energy, this year we’re talking about big increases in overseas production and a shift away from some of the US markets that responded very fast to low extraction costs here in the US. As a result, we’re now starting to see a shake out of some of the smaller players, and always, of course the strong players always gain ground in down times. If they see an opportunity to consolidate their positions to be ready for another rise in energy costs, they will.

There’s a mix of factors in corporate location decisions with regard to energy, including whether there’s enough availability. The growing trend to doing everything in the cloud is driving demand for electricity to a level not seen before and a material percentage of all the energy used in the US is just to keep data centers alive currently. According to an August 2014 article in Computerworld, US data centers used 91 billion kilowatt-hours of electrical energy in 2013, which analysts predict will increase to 139 billion kilowatt-hours by 2020 — a 53% increase over 2013. Data centers are looking for locations with cheap electricity, good water, etc

#5: Urbanization
Urban growth has been outpacing suburban growth for a very long time. To create more housing in the CBDs and urban cores, adaptive reuse is happening in all major urban areas to repurpose older structures that were being used for office into housing for millenials and seniors to a lessor extent. Slayze is seeing a big shift in the kinds of housing footprints being developed in those areas which are favored by millenials (born between 1980 and 2000) and seniors to a lessor extent who enjoy living car-less and sharing resources (also a strategy for better living in a world with higher costs and lower wages).

#4: Global Instability and Currency Devaluation
Instability is going on everywhere, and as a result, the dollar – in spite of itself – is gaining serious ground, which means there is a LOT of capital flowing through the US right now. The effect is keeping cap rates low despite slow growth and hot spots of conflict are still coming up all the time. Currency devaluation is driving a lot of foreign investment. The US market looks very stable to the rest of the world though it’s not and especially as we come closer to election season. Currency devaluations can have an impact on the selection of tenants and it’s a simple matter to vet those companies more subject to currency fluctuations than others in order to find a stronger tenant. But the second factor has to do with the capital market and the yields and foreign investors are starting to move away from the gateway markets and larger cities in places like Hawaii (a market favored by Japanese investors for many decades) and are starting to look at secondary markets where they can find higher returns. The secondary markets appear to have been doing better but they are subject to a lack of information and visibility to the larger investors.

#3: Rising Interest Rates
Interest rates aren’t rising right now but this year, CRE members are starting to take the issue seriously because of the inevitable future rate increases, which will impact exit cap rates, the choice of funding products and the underlying tenant contractual relationships. Right now landlords are seeking to lock in longer leases to nail down performance in a debt landscape that will inevitably change.

Rising interest rates are predicted to have a positive impact to multi-family property owners because it will shift the decision from own to rent for certain individuals at the threshold of affordability. The effect of rising interest rates on commercial tenants could impact a companies margins and either cause the cost of goods to increase and inflation along with it, or put pressure on companies to better manage other operational costs and to create further efficiencies given the delicate balance in the economy needed to keep consumption levels up. Multi-family just has more inflation protection built in to the income stream as rising inflation forces rents up to keep pace.

#2: Excess Supply of Capital
There’s a lot of money out there, a lot of overseas money out there, but the big question is, how long will this last? Couple that with a need to reinvent several asset classes including retail to make it conform to modern consumption behavior and that could add up to a lot of real estate innovation and ultimately drive infrastructure development in most major markets. Slayze feels we’re a little “long in the tooth” on this boom in capital flow through the US, but expects it to continue so long as there is global instability. The bottom line is that it is getting harder and harder for foreign investors to find high return places to place their money which is driving innovation at the deal flow level and a move to secondary markets.

#1: Demographic Shifts
We’re seeing a few demographic cohorts driving things, including of course the millenials who are projected to comprise three out of four workers in the workplace by 2025 just 10 years from now. But another group that really matters a lot are the baby boomers including individuals born between 1946 and 1964, and what’s interesting is that they are not following typical retirement cycles from older generations. They matter of course because of their tremendous consumption power, but they continue to live in manners typical of non-retired people. The impact on the office market by millenials is that they demand a more modern workplace comprised of open spaces, resource sharing, telecommuting, and healthy, green workspaces. Landlords need to be in touch with those requirements to remain competitive.

Senior housing is lagging to some extent but that sector is also driving medical services and we’re seeing a lot of analysis being done by medical service providers to identify how best to deliver medical services. There is an enormous shift going on in the medical industry as a result of many more people having access to healthcare services as a result of Obamacare. There is also a lot of medical specialization driving the demand for medical office and medical office footprints are changing as a result.