by Brandon Michaels & Chris Adnams
· Over the past market cycle, of the four major asset classes, (retail, office, multifamily, and industrial), retail has seen the least amount of new development
· Over the last 10 years, Los Angeles delivered nearly 10% of its existing multifamily inventory while only adding 3% of its retail inventory; In other higher growth markets, this disparity is substantially larger
· As a result of the lack of new retail inventory, aging retail is still poised to remain competitive, relative to other asset classes that have experienced significant new development
· Limited new retail inventory may help stability, but there are still other threats that may prove to be impactful
· Heightened and prolonged interest rates for businesses, escalating operating expenses, and a resilient August inflation report may leave businesses less interested in growth and consumers less inclined to continue spending
Over the past market cycle, multifamily has been commercial real estate development’s darling. The lack of available housing and the well-known investment mantra of “everyone needs a place to live” has continued to drive builders’ interest, fueled by historically low rates over the last decade.
With the onset of Covid-19, a heightened demand for e-commerce, and a greater need for last mile and logistics warehousing space, industrial development has also experienced significant new development. Conversely, retail has not shared this same development focus since before the Great Recession of 2008. While this does mean U.S. markets are left with an aging stock of retail properties, it also means less competition with new supply, potentially helping to stabilize rents and avoid oversupply.
No Love For Retail
Of the four major asset classes, retail, office, multifamily, and industrial, retail has experienced the least development. Comparing the square footage under construction as a percentage of existing inventory over the past ten years, retail construction has rarely exceeded 1% of its current inventory, per Costar Analytics. More specifically, Los Angeles retail under construction is 0.48% of its current inventory while multifamily sits at 6.48%, down from its peak in 2022 Q4 of 7.76%. In markets that have seen higher growth in the past few years, such as Miami, retail construction still only represents 1.8% of its current inventory while multifamily has soared to 17.75%.
The construction disparity is even more pronounced between the asset classes when looking at the total supply delivered over the past 10 years as a percentage of inventory. Los Angeles delivered nearly 10% of its multifamily inventory while only adding 3% of its retail inventory. In higher growth markets, this development gap becomes more significant. Miami saw explosive multifamily growth following the onset of COVID, delivering an astonishing 32% of its inventory while only contributing 10% of new retail space, a 22% difference. Atlanta saw a similar gap in development, delivering 22% of its multifamily units in the last 10 years compared to just 6% of its retail space, a 16% difference.
Now, with higher interest rates, the all-in costs to construct new product are even greater than before, stifling new development and leaving much of the available retail product valued “below replacement costs”. So, while other product types, most notably multifamily, now have a significant percentage of new, higher quality inventory attracting tenants away from older product, aging retail may be poised to be just as competitive as before and will likely stay that way into the future as the cost to construct new product remains unattractive to developers.
Only Half of the Story
While a limited inventory of retail inventory does help to stabilize rental rates, there are still other equally significant threats against the product type. High interest rates hurt both the retail tenants and their patrons and escalating operating expenses have continued to eat away at net profit. Higher borrowing rates mean higher costs to operate, leaving businesses less inclined to expand, and in some cases halting business expansion and growth all together. Apart from the shuttering of the more than 1,383 Bed, Bath, and Beyond and Tuesday Morning stores, Business Insider, the global business media publication, identifies that roughly 1,000 other stores from major brands like Walgreens, Gap, Banana Republic, and even Walmart and Best Buy, are set to close their doors in 2023.
Furthermore, the recent consumer outlook in the wake of August’s 3.7% annual inflation, higher than anticipated, may result in retailers pulling further back on existing and future retail space needs. In an August report from the Conference Board’s Consumer Confidence Survey, data showed a drop in consumer confidence “erasing back-to-back increases in June and July, reflecting less confidence about future business conditions, job availability, and incomes.” 16.8%, up from 14.5%, of respondents expect business conditions to get worse and 12.4% expect their income to drop, up from 9.9%. Bloomberg’s Market Live Pulse survey takes this a step further, stating more than half of their respondents “thought that their personal consumption would drop in 2024, the first quarterly decline since the start of the pandemic.” Consumers are starting to feel the effects of their recent heightened spending and an announcement from the Federal Reserve Bank of San Francisco showed the built-up personal savings from COVID will runout by the end of October 2023.
Owners of retail real estate have enjoyed, amongst others, two benefits of recent: a lack of new construction and in turn, a lack of competition, keeping an aging asset still relative in the market, and a strong consumer with significant pent-up demand and historically high levels of personal savings coming off the heels of a the COVID-19 economic shutdown. These combined factors have created strong underlying fundamentals and stable growth.
While it doesn’t appear that new retail development will be on the horizon anytime soon, there is still significant risk to the asset class. Consumer sentiment on, escalating operating costs, and the impact of a heighted interest rate environment, pose a significant threat to underlying fundamentals, even with limited new development.