Research Directors Discuss New Challenges

Winter 2013

National research directors from major commercial real estate brokerage and data provider firms gathered for their annual meeting at NAIOP headquarters this fall to share their views about what the future holds for commercial real estate. Participants heard several presentations and participated in lively discussions at the meeting, which was hosted by the NAIOP Research Foundation.

All agreed that the boom in e-commerce is creating new challenges — and new opportunities — for the industry. One of the biggest challenges will be determining where the opportunities lie, and how industrial and retail developers and operators can make the most of them. (For more about the e-commerce discussion, see below.) Participants also agreed that:

  • Most major central business district (CBD) office markets have recovered, while most secondary markets are still in recovery but improving;
  • While significant changes are taking place in the way various industries design and allocate office space, they are not seeing huge, across-the-board declines in square footage per employee;
  • Sustainability is becoming increasingly important; and
  • The future of suburban office, retail and multifamily housing markets remains unclear.

Thought-Provoking Presentations

Daniel J. Meckstroth, chief economist for the Manufacturers Alliance for Productivity and Innovation in Washington, D.C., kicked off the meeting, providing an overview of the factors that have stymied the U.S. manufacturing sector and identifying the changes that must be made to bring about a true resurgence. U.S. manufacturing, he stressed, is experiencing a cyclical recovery, not a renaissance. The element with the most potential to move the needle toward a renaissance is for sourcing managers to select domestic rather than foreign components. Meckstroth stated that the economy is moving in a direction that favors U.S. production of manufacturing components. Signs that point toward the increased feasibility of more domestic sourcing include slower-than-inflation growth in manufacturing unit labor costs (an annual increase of just 0.4 percent since 2001); a steady 3 percent annual increase in manufacturing growth since 2001; the declining value of the dollar (down 21 percent since 2002); very low natural gas prices in the U.S.; rising global transportation costs; disruptions to the supply chain caused by natural disasters; and customer demand for just-in-time delivery and collaboration.

table listing the participants in the 2013 NAIOP Research Directors meeting

Garrick Brown, national research director, retail for Cassidy Turley-Terranomics in Sacramento, Calif., spoke about the ways e-commerce is changing how people shop, how retailers manage inventory and how consumers obtain goods. “A lot of what’s going on in industrial,” he began, “is about retail.” Brown went on to describe the forces that are more closely aligning the retail, industrial and distribution industries at an extremely rapid pace.

The biggest and most visible player in this area is Amazon (now the fourth-largest retailer in the U.S.), “which has 50 million square feet of distribution centers (give or take), and wants to get to 90 million by 2016,” he said, adding that “this is all about same-day delivery — and doesn’t even include what they are doing on the grocery side of things.” Brown noted that mega e-commerce firms need mega bulk warehouses that can accommodate many more workers than a traditional warehouse/distribution center. That means “much more land for parking, much better HVAC systems, better power and more worker facilities on site.” And the inventory to meet that need simply doesn’t exist, meaning that there will be ample demand for new warehouse/fulfillment space that does meet the needs of e-commerce retailers.

“E-commerce is about convenience; shopping is about experience,” Brown stressed, noting that the fastest-growing brick-and-mortar retailers in the near future will be those that offer goods and services that can’t easily be purchased online, like restaurants, entertainment, nail and hair salons, and drugstores. Lifestyle and neighborhood shopping centers that offer appealing experiences such as free outdoor movies, yoga classes, concerts and wine tastings will perform better than traditional malls. Retailers and shopping center owners who figure out how to navigate the new world of omnichannel retailing (blending online and real-world presences), and retail venues located in walkable, mixed-use developments (both urban and suburban) also will succeed, he noted.

Changing Office Realities

The five-year leases signed at the trough of the recession are beginning to come up for renewal, Brown noted, and people looking to renew will see higher asking rents in many markets. Will some firms stay put and pay higher rents? Will others decamp to less expensive space or economize by shrinking their footprints? This round of renewals will be an interesting indicator of the health of companies and office markets.

“What we’re seeing on the investment side is people pricing through all of these significant rental risks,” said Frank Nitschske, principal, investment research with Prudential Real Estate Investors, adding that investors are accepting cap rates of 3 to 4 percent and underwriting their deals with the assumption that consistent rent gains will occur — about 10 percent over a three-year period in major markets.

Regarding those “shrinking footprints,” and whether office users really are reducing their utilization rates, Dean Violagis, CoStar’s vice president, research, said “I think it’s about the rent. If your rent is through the roof, you’re going to maximize efficiency. But if you’re in a suburban office market … with dirt cheap space,” it isn’t that important. Jeff Kottmeier, director, research & analysis for CBRE Global Research & Consulting, added that square footage/employee varies widely among different types of office users, and according to whether a company is remaining in its existing space or moving and doing a new buildout. “We are seeing both the public and the private sector moving toward smaller space,” he added, but not across-the-board shrinkage in office sizes or “benching” (where workers don’t have desks, but sit at a counter or table).

Sustainability is another factor influencing office tenants’ space needs. “If you’re trying to be efficient as a tenant, you’re not only looking at reducing your [physical] footprint,” added Maria Sicola, executive managing director and head of Americas research for Cushman & Wakefield, “but also at reducing your carbon footprint. And there’s a cost for that,” which will affect rental growth. Companies appear to be willing to pay that added cost. Rene Circ, director of research – industrial for PPR/CoStar added that PPR has forecast a 1 percent reduction per year over the next 10 years, which will result in shrinkage of only about two and a half feet per person per year.

The Big Unknowns

The group also explored many of the economic, industry, demographic and psychographic changes taking place that will have long-term effects on commercial real estate, including the following:

How quickly — and how much — will e-commerce grow? Brown, citing a Deloitte study that predicted that e-commerce will account for 30 percent of all retail sales by 2025, said that may happen even sooner, but doubts whether it will go higher. Others wondered if the millennial generation will buy even more online.

What is the outlook for struggling suburban office parks, as well as free-standing “zombie” office buildings in the suburbs? Will office space be converted to residential uses? Is redevelopment of office parks as medical or university campuses feasible? Brown noted that in California some large health care systems — attracted by low rents — have been transforming small to medium-sized office campuses into medical hubs.

How long will members of Gen Y be happy living and working in expensive CBDs? When they marry and have kids, will they start heading to the suburbs? If they do, will jobs and office development follow? While Brown and Nitschske agreed that there will be an eventual “return to the suburbs,” Nitschke predicted that it might not happen for another seven to 10 years, based on demographic trends.

What is driving the recent spurt of inland port development activity? Aaron Ahlburn, senior vice president and director of industrial research, Americas region, for Jones Lang LaSalle, suggested that it is the growth of intermodal transportation nodes. Ahlburn and Circ both commented on how interesting it would be to be able to track the amount of container traffic going through intermodal yards.

What can be done to rescue or develop the “just ok” suburban malls that Brown predicted will suffer the most in the next few years? He noted that some of these Class C malls have been exploring creative solutions like putting grocery, Wal-Mart, and Costco stores into former department stores. Community colleges and libraries also were mentioned as potential tenants at declining malls. And Brown noted that Kaiser-Permanente is looking for retail space in impoverished neighborhoods, where it can get two- or three-year leases to put in registration centers in anticipation of the implementation of the Affordable Care Act — and that its next step may be to look at putting clinics into some of those neighborhoods.

Will foreign investment be the savior of the nation’s secondary and tertiary markets? That depends in part on the long-term growing influence of attention-shy Chinese capital. “It’s not easy to track, and it’s being placed all over the world, not necessarily in the major CBDs,” noted Joe Mannina, chief operating officer for Real Capital Analytics. Foreign investors are “targeting areas that they never targeted before,” added Viologis, including places “like Austin, Texas, Seattle and Denver.” And what will the long-term impact of the EB-5 visa program, which allows foreign nationals to get a green card if they meet certain investment criteria, be on the real estate market? Will this “pay to play” program gain traction?

Emerging E-Commerce Concepts

E-commerce was one of the key topics discussed when national research directors from major commercial real estate brokerage and data provider firms met at NAIOP headquarters this fall. A few of their comments:

On Returns:

“One hidden e-commerce cost that no one ever talks about is reverse logistics — returns. There are a lot of variables there: what happens to goods when they come back to the store or the distribution center; they have to be checked in, inspected, restocked and so forth. A lot of labor goes into that.” — Aaron Ahlburn

“I used to think nobody would buy shoes online. But Zappos has turned out to be a huge success because their return policy is very liberal.” — Garrick Brown

On Owning and Investing in Fulfillment Centers:

“Amazon has about six developers, their primary vendors, who they go to [for bids to develop fulfillment centers]. Amazon will sign a 10- to 12-year lease. Some developers keep the buildings, some sell them. Amazon has very good credit, so those buildings are very attractive [to investors].” — Rene Circ

“From an investor perspective, the most important question, as I’m deciding if I want to own this building, is ‘what is the rate of change of the physical characteristics of these buildings? When that Amazon lease rolls in 2025 (or whenever), will they want to stay in that building? If not, will there be enough less sophisticated e-tailers to backfill this space, or am I going to be left with a building that’s just way too clumsy, that covers way too little land and is way too expensive to re-lease at a rate that makes sense?’ It’s specialized, like a refrigerated warehouse; you can never convert it back and not lose money on it, because your basis is so high and your rent will be so much lower. Who is the next tenant when Amazon leaves? That is the most important question, from the perspective of a forward-thinking investor.” — Circ 

On Paying for Buildout:

“It’s all about the investment, and the return on that investment, and the rents are not high enough to justify [the expense of putting in] all the racking, the robotics — that’s all Amazon. Anything that’s incremental to the market, that doesn’t really increase the value of the building — or that increases the value of the building only to that tenant — gets amortized. Typically, the longer the lease, the cheaper the rate, because you’re amortizing over a longer period of time at some discount rate.” — Circ