Tuesday, June 7, 2022

Post 29: Trends Part 8 - The New Normal in Commercial Development

 I try to have the title of my posts be a good indicator of the content, but in this case I’m afraid it is a little misleading.  Yes, it is about the changing world of commercial development, but the title implies that I know what the “new normal” will be which is at best an exaggeration and at worst an outright fabrication.  Commercial development over the next five to ten years is going to be buffeted by forces that are still taking shape and I doubt that anyone has a firm handle on what the future holds.


Part of the problem is that there is a great deal of experimentation going on as the owners and developers of commercial property try to figure out what will really be marketable over the long haul.  There are a lot of short-term distractions – pandemic recovery, runaway inflation, war in Ukraine, supply chain disruptions, labor shortages, etc. – that make it difficult to identify the long-term trends that will be fundamental to success.  Businesses are trying all sorts of things simply to survive.


What I think is most likely is that there will be a lot of churn in the market as various experiments are tried and evaluated.  Some of these new commercial formats will fail quickly, others will seem promising at first but fail after a few years, while some will prove successful enough to last.  The end result will be a commercial environment that is more diverse and specialized than in the past.


My goal with this post is to identify the forces that will be most influential in shaping future commercial demand, and then take my best stab at predicting the physical form that demand will take.  Finally, I will make several suggestions about the steps that cities should take to adapt to the changing commercial environment.  As always, it is important to keep in mind that cities change slowly and commercial property is often renovated several times before it becomes so obsolete that it is torn down.


Industrial


If I were a real estate investor, I would probably focus on industrial property.  This sector has been relatively strong in recent years, driven by major expansions in warehousing space needed for the boom in online shopping.  Warehousing will continue to expand for the foreseeable future, but I also think that more traditional manufacturing space will make a comeback as well.


This positive outlook is fueled by two major forces that I think will shape industrial development for the next ten years (and perhaps more).  The first of these is a growing geopolitical struggle to unseat the U.S. as the world’s undisputed economic and military top dog.  China and Russia are both flexing their military muscles, and those two plus a wide variety of European, Asian and Latin American countries are emphasizing economic nationalism instead of the focus on globalization that has dominated the world economy in recent decades.  The COVID pandemic, and the supply chain disruptions that followed, underscored the dangers of relying too heavily on a single foreign producer for key medical and technological products.  The same can be said for the “just-in-time” manufacturing systems that rely on uninterrupted transportation networks and far-flung sources for raw materials and cheap labor.  The fact that China has shown little interest in resolving the long-standing economic complaints lodged by the U.S. (and others) is another reason that many companies are rethinking the role that China plays in manufacturing.

BNSF Intermodal Facility Near Kansas City
Source: HDR

The second force is the absolute explosion in industrial innovations, particularly in the fields of bio-science, material science, robotics and genetic engineering.  These innovations are likely to fuel a wealth of new products that will create new demand and may necessitate new manufacturing facilities and processes.  I could bore you with dozens of examples, but the key point is that the scope of innovations coming out of the “idea economy” is staggering.  And since many of these innovations will help companies address the ESG concerns of their shareholders, I expect the adoption rate of the new products to be relatively rapid.


The end result is that I expect demand for industrial space – both manufacturing and warehousing – to be relatively robust for the foreseeable future.  Companies are going to diversify their supply chain so that no single country can disrupt their manufacturing processes.  Some companies will actually bring factories back to the U.S. after decades of “off-shoring” in search of low labor costs.  Other companies are altering their business plans to include strategic stockpiling, which means increased demand for warehouse space.  For example, in just the past two years, the 10 largest national retailers have acquired more industrial space than in the preceding eight years combined. [1]


This increased demand, however, does not mean a revitalization of the rust-belt factory towns of the early- and mid-20th century.  Expect both manufacturing and warehousing facilities to be highly automated, driven by the need to both reduce labor costs and minimize problems with labor shortages.  The warehouse automation market, for example, is expected to grow by 50 percent by 2025 to $37.6 billion.  What employment there is will likely be much more technical in nature than the traditional blue collar factory worker of decades past.  Geographically, I think the bulk of new construction will be clustered in the South where unionization rates are relatively low and around multi-modal transportation hubs in order to simplify logistical issues.


Office


Not surprisingly, office occupancy rates got hammered during the pandemic.  Occupancy rates have generally been positive for the most recent quarters, but building owners are going to have to dig themselves out of a deep hole.  The National Association of Realtors says that as of February, 390 of the metro areas they track are experiencing an increase in occupancy.  But they estimate that there is about 110 million square feet of office space that has been left vacant since the pandemic started and that it may take until the end of 2024 for that backlog to be reabsorbed. [2]


The currently vacant 1400KC
office building
High-tech metros (Boston, San Jose, San Diego, San Francisco and Seattle) and metros in the south and west (Austin, Dallas, Atlanta, Houston) are bouncing back fastest, while some of the largest metro areas (New York, Chicago, Washington DC, Los Angeles) are still struggling.  Office asking rents are also trending up, although at modest rates.

These numbers obscure an interesting phenomenon – buildings may be technically occupied (ie. leased) but the number of workers actually in the office is much smaller than before the pandemic.  In some metro areas, that percentage is still below 50% which has had a huge impact on the service and retail businesses that used to cater to those workers.  Many restaurants, bars, salons and boutique shops in office-heavy districts have gone out of business and are not being replaced.  It also means that many companies currently have more office square footage than they really need.  The return-to-work push has been somewhat more successful in the midwest than on the coasts, but no place is anywhere near 100% which means that more changes to the office environment are likely in the future.


The slow pace of workers returning to the office is problematic for office building owners and developers for two reasons.  First, there is a record amount of office space with leases set to expire in 2022 – 243 million square feet nationwide.  This is up roughly a third from pre-pandemic levels. [3]  Second, there is a glut of subleasing space available as firms downsize their office footprint.  Office sublease availability increased to over 150 million square feet in Q1 2022 – up from roughly 90 million square feet in Q1 2020. [4]  These two factors explain the sluggish rebound of the office market and suggest that new office building construction is likely to be modest (and in some places nonexistent) for the next several years.


Companies are facing a conundrum.  On the one hand, they want employees back in the office because they are easier to manage, it is easier to build corporate culture, and it is easier to promote collaboration and creativity.  On the other hand, employees are pushing back against full-time, in-office work.  A recent report from Microsoft concluded that:


The experience of the past two years has reshaped our priorities, identities and worldview, drawing a bright line between what’s important – health, family, time, purpose – and what’s not.  As a result, employees’ “worth it” equation – what people want from work and what they are willing to give in return – has changed. [5]


In the end, companies have two priorities that they cannot ignore:  (1) they must retain their experienced employees in the face of the “great resignation” that has roiled labor markets across the country; and (2) they must attract talented new workers coming out of college if they expect to grow in the future.  There are, of course, several different strategies that companies could try but I suspect that many firms will end up settling on hybrid work schedules as at least part of their strategy.  Hybrid schedules give GenZ workers the flexibility they crave and it gives older workers the ability to rebalance their work/life priorities.


The next question, of course, is what will hybrid work and the rebalancing of personal priorities mean for office design and office space utilization.  I think the most progressive companies will significantly reconfigure their office space and perhaps even relocate to find space that is more suitable for their perceived needs.  For some firms, this may result in a significant reduction in floor space, but I don’t think that is necessarily true for all firms.  Even if only 50 or 60 percent of workers are in the office at any given time, the days of packing workers into row upon row of cubicles is a thing of the past.  


It may also result in a ‘flight to quality,’ as companies trade floor area for higher rents in buildings with aesthetic appeal, better technology or better amenities.  Inviting lobbies, comfortable common areas, and concierge-like services may be seen as essential techniques for making employees want to return to the office.


Keep in mind that new office layouts are essentially competing with “home” as a place to do work, but with an emphasis on collaborative activities that are hard to accomplish through Zoom meetings.  If an employee is expected to simply keep their head down and grind away, they might as well do that from their home.  Hybrid work is going to put the focus of in-office time on collaboration, creative brainstorming, and team building activities.  This means that office designs should accommodate a wide range of group activities with an equally wide range of spaces for both formal and informal gatherings.  In addition, employee concerns about personal wellness may push companies to make their offices more spacious.


Finally, advances in technology will play a larger role in office design than ever before.  Ventilation systems will push far more fresh air into work spaces and that air will be filtered with far more sophisticated HVAC systems.  Office buildings will be loaded with sensors that automatically adjust lighting and room temperature as people enter or leave rooms, or as the amount of sunlight changes throughout the day.  Facial recognition software will improve security systems and make buildings more “touchless” and “smarter.”  Think of an elevator, for example, that recognizes your face and takes you to the correct floor without any action or instruction on your part.  The end result will be an environment that makes employees want to come into work – at least part of the time.


The problem is that I have no idea how many companies will actually make significant changes to their office layouts, how many will make a few cosmetic changes and then pretend that they have done something significant, and how many will do nothing and simply insist that their employees return to the office.  The companies that make major changes may be the exception that gets all the media attention, but those that do nothing may be the norm.  Only time will tell.


Retail


In my mind, the commercial sector with the murkiest future is retail.  The pandemic hit the brick-and-mortar portion of this sector hard with a record 12,200 store closures in 2020, resulting in vacant storefronts in shopping centers across the country. [6]  However, 2021 was a bit of a bounce back year as openings exceeded closings, with retailers taking advantage of rent reductions and consumer wallets full of federal stimulus money.  Consumers who had switched to online shopping in 2020 reverted back to in-person shopping in 2021, at least in part, as pandemic restrictions eased.  Stores such as Dick’s Sporting Goods, Best Buy and Macy’s reported online revenue falling while sales at brick-and-mortar locations grew. [7] 


Unfortunately, there are still storm clouds on the retail horizon.  The euphoria of pandemic spending is winding down and the reality of high inflation is settling in.  A variety of major retailers have reported disappointing revenue results in the first quarter of 2022 and retail stock prices have generally been weak.  Analysts at UBS are predicting 40,000 to 50,000 store closings over the next 5 years, which is better than what was expected a couple of years ago, but still not great. [8]  In short, I think there will be a lot of adjustments and experimentation over the next few years as retailers search for ways to survive – and perhaps even thrive.


One possible adaptation would be for stores to increase the amount of inventory they carry in stock.  This might be particularly crucial in light of current supply chain issues which are not likely to abate any time soon.  It would also allow local stores to provide fulfillment services for online ordering instead of relying exclusively on warehouses and distribution centers.  Buying online for in-store pick up is also proving to be popular.  This “omnichannel” approach to retailing has been one of the most successful ways that brick-and-mortar stores have fought back against the online giants such as Amazon.


A second adaptation is to ditch inventory almost entirely and become a showroom for orders that are shipped directly at a later date.  Indochino is doing this successfully with men’s suits and Yardbird is doing it with outdoor furniture, to name just a couple of examples.  The result is a much smaller store footprint and an ability to be much more responsive to changes in customer tastes.  This approach may even end up reshaping the way that new cars are sold.  Ford now reports that a third of their sales are vehicles that have been custom ordered, with the customer waiting for the factory to build and ship the vehicle several weeks later.  The CEO of GM, Mary Barra, has stated that inventory levels will never return to previous levels. [9]  Think of what this means for car dealerships that recently relocated to an 8- or 10-acre site (assuming the need for acres of inventory) when 3 or 4 acres might be sufficient in the future.


The headwinds facing the retail sector are going to be brutal in weeding out poor performers and poor commercial locations or layouts.  Here are the factors that I think are particularly important:


1. Labor shortages.  Retailers across the spectrum, but especially food service and hospitality businesses, are struggling to find enough workers.  These jobs were already perceived as being generally unrewarding, but in light of the pandemic they are now perceived as unsafe and underpaid.  Consequently, progressive retailers are automating as rapidly as possible.  Self check-out lanes are being installed nearly everywhere, and some stores are experimenting with facial recognition, RFID tags and cameras powered with artificial intelligence to track the items you pick up in real time so that there is no check out process at all – your credit card is simply charged for whatever you walk out with.  Expect to see AI-powered robots in the next few years assisting customers looking for advice or performing repetitive tasks such as cooking french fries.


2. Inflation.  At the moment, inflation and high interest rates are consuming all (or at least most) of the wage gains for the average worker.  This means that consumers are going to be
very price conscious, and the free spending of 2021 is likely to be a thing of the past.  The rising cost of housing, food and gas are going to crowd out spending on discretionary items. such as clothing, furniture or housewares.  Mom-and-pop stores and small chains are particularly likely to have a hard time being profitable enough to stay current with technology trends and product selection.

3. Online shopping.  Although the rush to online shopping that resulted from the pandemic has abated somewhat, the pressure on brick-and-mortar stores is not going to let up in the long run.  Some retailers are finding creative ways to go online themselves, but that takes IT talent and resources that many retailers simply don’t have.  In addition, Amazon, WalMart and other online giants with deep pockets are going to continue to simplify the buying process and expand same-day and next-day delivery.  Brick-and-mortar stores selling commodity products from worn out facilities in secondary markets might as well start their “going out of business” sale now.


The bottom line is that some stores will thrive, but many others will struggle and a fair number will fail.  This means that even high quality shopping centers will be continuously filling vacancies.  Class B and C locations may not be able to stay anywhere near full or will need to resort to lower quality retailers or non-retail users paying lower rents.  This will be the beginning of a slow, death spiral that most shopping center owners refuse to recognize until it is painfully obvious and the blighting impact on the surrounding neighborhood is well underway.


Impact on Cities


Cities are in the unenviable situation of knowing that the nature of commercial development is going to change, but not knowing exactly when, where or to what degree.  This is particularly true for midwestern cities where the tendency to hang on to the status quo is particularly strong.  I will be making some predictions about what this “new normal” might look like, but as I noted at the beginning of this post I’m not confident that my predictions will be very accurate.


Perhaps the best place to start is to identify those areas where failure is most likely.  To begin with, there are several retailers that were struggling to stay current with changing retail trends and consumer preferences before the pandemic (e.g. Sears, KMart, Nine West, Mattress Firm, The Gap, etc.).  The pandemic made things worse which means that they are likely to close many of their stores, and a few may cease to exist entirely.


Vacant Big-Box Retail Store
Where things will really get bad is where struggling stores are paired with retail formats – such as enclosed malls, department stores or stand alone big box stores – that are falling into obsolescence.  These combinations are not only likely to fail, they are likely to be difficult to redevelop without a great deal of creativity.  Department store owner Hudson’s Bay Company (Saks Fifth Avenue, Hudson’s Bay, Lord & Taylor) plans to convert many of its empty stores into co-working office space run by its Convene subsidiary. [10]   I’m skeptical of how successful that will be, but it is better than doing nothing.  For cities, the conversion of a department store or an enclosed shopping center into office space, a medical services mall or an Amazon fulfillment center means a hit to sales tax revenue but it is better than the blight and property tax default that can result from extended vacancies.


Another potential trouble spot will be districts that are almost exclusively office buildings, particularly where many of those buildings are 30+ years old.  This could be either a traditional downtown area or an aging suburban office park.  I recently spent some time in Cleveland and I was impressed with the number of major office buildings in their downtown, along with nice public open spaces, large hotels, three major stadiums, and several civic attractions.  But the area was weirdly devoid of people.  As companies fight to get employees back to the office, mixed use areas containing residences, retail shops, bars and restaurants, and activity spaces that attract people at least 18 hours a day will be a far more compelling location for office workers.

Cleveland seemed to be coming up short on the residential part of the equation, but at least it had most of the other pieces in place.  Many other cities have downtowns or office parks that have almost no other uses and I fear that they will have a hard time keeping their buildings leased.  Large older buildings, in particular, may need to be converted to other uses as the demand for office space is reset over the next few years and companies take advantage of soft rents to move to higher quality buildings or to buy a smaller building that they can fully control.  The problem with converting office space to something else is that it is expensive – which means the value of the building must fall substantially to make it financially feasible.


I mentioned earlier that industrial space is likely to be a bright spot in commercial real estate.  Unfortunately, not every city will benefit and those with old factory districts hoping for a rebound may be disappointed.  Older factories and warehouses are unlikely to meet modern needs which will emphasize automation, a high-tech workforce, and access to inter-modal transportation options.  Another growth area that cities need to be prepared for are warehouses near population centers.  The rise of same-day delivery will mean that companies will try to shorten the distance between fulfillment centers and the consumer.


Exactly how all of this will play out is anyone’s guess.  Cities will need to be especially vigilant for obsolete commercial properties that are falling into blight and encourage those owners to consider redevelopment into something else rather than hoping for a tenant that never materializes.  In addition, cities need to be extremely cautious about using public money to subsidize commercial projects.  An uncertain market combined with the typical hyperbole of real estate developers is a recipe for projects that fall far short of expectations.  At the same time, cities should be open to unconventional projects that may require development approvals that are outside the norm.  Several smaller projects that result in creative places may lead to more long-term value than one mega-project that depends on a lot of public money.




Thoughts?  As always, share your thoughts and ideas by leaving a comment below or sending me an email at doug@midwesturbanism.com.  Want to be notified whenever I add a new posting?  Send me an email with your name and email address.



Notes:


Special thanks to Hank Simpson of AREA Real Estate Advisors in Kansas City for sharing his insights and wisdom.


  1.  “The Future of Industrial Real Estate:  Trends for 2022 and Beyond;” Newmark; https://www.nmrk.com/insights/thought-leadership/the-future-of-industrial-real-estate-trends-for-2022-and-beyond.

  2. Scholastica Cororaton; “Commercial Weekly:  Office Occupancy Rose in 84% of Metro Areas as of 2022 Q1;” National Association of Realtors; February 2022; https://www.nar.realtor/blogs/economists-outlook/commercial-weekly-office-occupancy-rose-in-84-of-metro-areas-as-of-2022-q1

  3. Konrad Putzier and Peter Grant; “Office-Lease Expirations Pose Risk to Landlords”; April 13, 2022; The Wall Street Journal.

  4. “Leasing of Sublease Space Gains Momentum, but Availability Grows in Q1 2022”; May 3, 2022; CBRE; https://www.cbre.com/en/insights/briefs/leasing-of-sublease-space-gains-momentum-but-availability-grows-in-q1-2022#:~:text=However%2C%20sublease%20availability%20increased%203.6,in%20the%20past%20six%20years

  5. “Great Expectations:  Making Hybrid Work Work”; Microsoft Corporation; March 2022; https://www.microsoft.com/en-us/worklab/work-trend-index/great-expectations-making-hybrid-work-work?wt.mc_id=AID_M365Worklab_Corp_HQ_CustomContent%20

  6. Phil Wahba; “A Record 12,200 U.S. Stores Closed in 2020 as E-Commerce, Pandemic Changed Retail Forever”; January 2021; Fortune; https://fortune.com/2021/01/07/record-store-closings-bankruptcy-2020/

  7. Peter Rudegeair, Charity Scott, Sebastian Herrera; “More Online Shoppers Are Taking It Offline”; April 16, 2022; The Wall Street Journal.

  8. Lauren Thomas; “UBS expects 50,000 store closures in the U.S. over the next 5 years after pandemic pause”; April 13, 2022; CNBC; https://www.cnbc.com/2022/04/13/ubs-50000-retail-store-closures-in-us-by-2026-after-pandemic-pause.html

  9. Paul Eisenstein; “With Dealer Lots Bare, Car Shoppers Turn to Build-to-Order”; February 2022; Forbes; https://www.forbes.com/wheels/news/build-to-order/

  10. Konrad Putzier; “Saks Owner HBC Bets Flex Space is Future of Work”; April 13, 2022; The Wall Street Journal


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