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April 28, 2016

Analysis: Should Retailers Rent or Bye?

Analysis: Should Retailers Rent or Bye?
APRIL 22, 2016
BY JONATHAN LAPAT

While generally steady post-recessionary economic performance has led to an extended period of retail growth, retailers and retail real estate professionals around the country have begun openly wondering about just how high rental rates can continue to climb. In the last few years, occupancy costs are up significantly virtually across the board; most dramatically in dense urban locations in larger markets. While growth has leveled off or become more modest in many suburban markets and secondary locations, the ongoing urban trends have some retailers wondering whether certain markets might be reaching the threshold where occupancy costs can no longer be justified or supported by existing or anticipated sales.

New York City is an easy example of just such a phenomenon in action. There are a multitude of vacancies along some prime retail corridors like Broadway in Soho. In Boston, rental rates are also going up faster than sales. Boston’s New York high street equivalent is Newbury Street in the Back Bay and while the vacancy rate is fairly low still, rental rates are reaching new highs and new asking prices are coming in 15%-20% higher than observers might have expected a year ago. While sales numbers are generally very strong along Newbury and nearby Boylston Street, many retailers are in awe of just how high the rents in the area have climbed and are taking more time to determine whether unhealthy occupancy costs are worth the return on investment.

This rental momentum has a ripple effect, as well, with newer developments in the market asking higher rents. The key consideration here is how the developers are approaching pricing to realize the full potential of the property while remaining a viable option for retailers. For example, ground-floor retail is often positioned as an amenity to upper level office and residential. When this is the case, developers can price accordingly, not to mention be more selective about the type of retail in the project.

While rental pressures are an issue for all retailers, some are more willing and more likely to pay the higher price tag. Retailers may be willing to pay a premium for flagship store visibility, or to protect market share. Grocery stores and movie theaters fall into that category, while smaller footprint retailers are typically going to be more concerned about margins and less willing/able to pay the highest rents.

The Northeast is far from the only part of the country where occupancy costs are influencing retailer decisions and starting to change the shape of the retail landscape. In Florida, The Rotella Group’s Steve Miller says that occupancy costs have started to become a significant barrier to entry for some new retailers. Florida’s additional sales tax on rent isn’t helping matters. Steve points out that not only are they not seeing any indication of costs declining in South Florida, but prime areas in South Beach are reaching eye-popping numbers north of $300/foot.

According to Steve, “Downtown Miami and South Beach is starting to resemble New York with respect to urban density and increasingly active and engaging live-work-play environments.” He explains that “smaller footprint high-end luxury retailers and specialty boutiques are taking up more and more market share and precious square footage in these urban areas,” fueled at least in part by a booming tourist industry and wealthy international clientele (hotel occupancy numbers remain in the 90s in South Beach).

Over on the West Coast out in Los Angeles, X Team International Treasurer Bob Haas, a partner with L.A.’s Cypress Retail Group, notes that rents are climbing there, as well. As with the East Coast markets, this is being driven primarily by skyrocketing prices for premier properties within tier one trade areas – with growth in secondary trade areas modest or even flat. In L.A. there is a true supply shortage, with very little new development other than a handful of vertical mixed-use (which isn’t as conducive to retailers outside of smaller storefronts and restaurants).

The high cost of construction in the region isn’t helping rental rates become any more affordable, but Bob continues to see that the bigger driver is sales and what they think they can afford to pay in rent:

“We are starting to see retailers take a more cautious approach to their real estate decision-making, but the best product (because there is so little of it) will continue to support higher rent structures. The best locations and trade areas will continue to be in demand as long as the overall market remains generally positive.”

Overall occupancy costs – including things like taxes, common area maintenance fees, and other extras – are escalating, and there is some concern in the brokerage community about how that impacts what tenants can afford to pay on the base rate. “In L.A. proper we haven’t yet hit the market limit–but I think we may be close, especially for some retail categories,” says Bob. He thinks a little room for growth remains in prime urban areas, largely because of the strength and size of the L.A. market, with its population density and largely favorable income/demographics numbers.

Ultimately, developers who don’t want their spaces turning over every few years would be wise to make sure their occupancy costs are competitive, reasonable and sustainable–ideally in the neighborhood of 8%-12% relative to sales. When retailers’ occupancy costs start getting north of 15%, alarm bells start to ring, and north of 20% it’s often time to wave the white flag. With rare exceptions for special circumstances, most retailers will be unable to sustain such elevated occupancy rates – and nobody profits from empty storefronts.

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