IllinoisCRE Six commercial real estate myths debunked Matt Baker July 2, 2018 Share on Facebook Share on Twitter Share on LinkedIn Share via email Commercial real estate is a complex industry, but there are still some basic rules and trends that guide how it operates. But what if those presumptions are incorrect or exaggerated—built on kernels of truth but with enough anomalies as to throw these “rules” into doubt? In a recent white paper, Evaluating Popular Misconceptions in Commercial Real Estate, Newmark Knight Frank (NKF) explored some common myths about CRE. The paper probed every asset class, looking into the broadly accepted ideas about real estate that are often (mistakenly) taken as gospel. Many of these ideas do not accurately reflect today’s commercial real estate market, the NKF thought leaders argue. The report reduces the market’s misperceptions down to six pervasive myths, and offers realities that contradict those myths. Myth 1: Brick-and-mortar retail is being replaced by e-commerce In reality, brick-and-mortar retail remains vital, though a transformation toward experiential retail is accelerating. While in-person sales still constitute a whopping 91 percent of the American retail market, consumers are often looking for a shopping experience that differs from the transactional format of the past. Chicago’s Magnificent Mile, for example, exemplifies the transition toward experiential retailing. Home to upscale shops, luxury brands and tony restaurants, the city’s premier commercial district will welcome the world’s largest Starbucks Roastery in 2019. Starbucks’ plan calls for an interactive, four-level flagship location where customers can see rare, small-batch beans roasted, brewed and packaged. Formerly a Crate & Barrel store, the 43,000-square-foot space will also feature tours, multiple brewing methods and specialty reserve drinks and food. Though growth in retail real estate has skewed toward discount stores—which require a different footprint than many available vacant spaces provide—this new format Starbucks is indicative of consumers’ desire for stores that are capable of offering a “sensory experience.” The ability of consumers to touch and explore new gadgets or receive personalized assistance to determine fit for clothing or shoes is a value that can’t be found online. Myth 2: Office design is primarily about efficiency and cost control There’s no denying tenants’ focus on the bottom line, but today’s new office designs create productive workspaces while working to attract/retain talent. The key to understanding this apparent contradiction lies with the Great Recession. In 2007-2009, companies looking to stay afloat sought ways to cut costs, and with occupancy second only to payroll as companies’ largest expense, space reduction was a logical next step. The need to trim budgets—coupled with technological advances during this timeframe that allowed more and more employees to work virtually—led to a general trend of fewer square feet occupied per employee. Post-recession, companies were understandably still cost-conscious but they also took part in a flight-to-quality with reduced footprints and upgraded locations. This drift toward smaller spaces sparked a revolution in office design aimed at efficiency and improving the office experience for employees, as attracting and retaining talent has become vital in a tighter employment market. With the U.S. unemployment rate at 3.8 percent as of May 2018—the lowest it has been in 18 years—the pressure to attract and retain talent is incredible. So even though a company will usually take less space when signing a new lease, they are conscious of employee desires, leading to a balance between open-space concepts and collaborative areas with individual and shared spaces that are tailored to focused work, away from disruptions. Myth 3: Foreign Investors have soured on U.S. commercial real estate While foreign investors have become more cautious, they are still investing significantly in U.S. commercial real estate. Investor capital is still out there, but opportunities are less abundant since much of the inventory has already traded during this cycle. Many of the available properties are value-add opportunities or located in secondary or tertiary submarkets that are less comfortable and predictable for foreign investors. In addition, capital controls imposed on Chinese companies by their government to curb spending on U.S. assets has altered the profile of the typical investor. For example, Dalian Wanda Group sought to divest itself from the formerly named Wanda Vista Tower under construction along the Chicago River, putting the combination residential/hotel tower on the market in January. The move was a direct result of increased scrutiny that the company faced from the Chinese government into its business practices. While Chinese real estate investment in the U.S. fell 64 percent between 2016 and 2017 to $6 billion, this change in global investment dynamics allowed for other countries to increase their investment activity. The Netherlands’ year-over-year activity was up 916 percent to $3.2 billion and Singapore’s U.S. investment activity increased 189 percent to $9.6 billion. Canada’s $21.0 billion in investments last year (a 51 percent year-over-year increase) re-established itself as a dominant foreign investor in the U.S. Myth 4: Older, close-in industrial product is often vacant and obsolete Yes, e-commerce is driving up demand for large fulfilment centers in exurban, highway-accessible locations. But industrial properties close to major cities remain highly desirable for last-mile distribution facilities. In a market where consumers expect merchandise nearly on-demand, companies looking to decrease the distance between products and customers are often willing to accept the functional challenges of older buildings. What’s more, creative delivery options, including third-party logistics providers, may expand the need for close-in fulfillment centers even for smaller retailers. Because of the age and smaller size of most urban industrial properties, there is a pervasive notion in the market that they are unfit for modern tenants. In fact, industrial locations close to major cities are highly desirable for last-mile distribution facilities since they minimize shipping costs and quicken delivery times to the end-user. Both of those factors can be competitive differentiators. The perception of Chicago’s close-in industrial buildings has gone from obsolete to highly attractive as last-mile fulfillment centers. In 2015, Amazon leased 150,000 square feet at 2801 S. Western Avenue, a 277,000-square-foot warehouse built in 1979. While it does not offer state-of-the-art features like some newer product, the warehouse is just a six-mile drive from Chicago’s CBD, and it boasts more than 1.5 million people living within a five-mile radius. In west suburban Forest Park, Partners Fulfillment occupies a Class B warehouse that was built in 1975. What the building lacks in high-end features, it makes up for in location, as it is just 10 miles from Chicago, 16 miles from O’Hare Airport and 15 miles from the Chicago UPS hub. Myth 5: Suburban office locations are no longer desirable Depending on the tenant type, suburban office space is still highly desirable. Part of the appeal is that suburban building owners and operators are putting in amenities usually found in urban centers to attract and retain tenants. Returning again to the nation’s economic recovery from the recession, modest demand levels resulted in a slow comeback for office space, particularly in the suburbs. The expansiveness, serenity and security that tenants sought in 1980s-style suburban office campuses gave way to new desires, such as walkability and activated environments. However, those suburban buildings that offer a prime location accessible to transit or easy highway access still have much to offer tenants. Mixed-use, suburban environments that can replicate the ease of access and mobility of urban offices can remain popular with today’s office tenants. Prime suburban submarkets—particularly those near existing or future transit stations—have had an influx of new construction and renovation of the existing competitive stock. In addition, suburban market conditions have tightened faster than CBD conditions during that same five-year period. Since the first quarter of 2013, in the 56 major markets tracked by NKF, U.S. CBDs experienced office absorption of 31.5 million square feet, or 2.1 percent of inventory as of 2018. Meanwhile, suburban office markets experienced absorption of 186.6 million square feet during the same period, or 5.7 percent of its 2018 inventory. While the U.S. suburbs maintain a higher vacancy rate at 14.5 percent, versus the CBD rate of 11.5 percent, suburban vacancy has declined 240 basis points during the past five years. CBD vacancy has only declined 160 basis points over the same period. Myth 6: Millennials are the future of multihousing demand With student debt and changing lifestyle preference delaying home purchases, millennials have indeed been a major catalyst for apartment demand over the past decade and younger tenants still constitute the largest percentage of renters for multifamily units. Over that same period, however, baby boomers have increasingly been drawn to walkable, mixed-use communities as a welcome alternative to the expensive and physically taxing hassles of maintaining a home. According to U.S. Census Bureau data, renter households increased among all age groups in the last decade, with the largest gains (44.7 percent) among those 65 years and older. Compare this to renter households headed by those under the age of 34 which have seen a more modest 12.3 percent increase over the same period. Growth in the older adult population in coming years will only stimulate this interest, as more seniors look for vibrant neighborhoods with nearby amenities. The National Multihousing Council projects that the cohort of those 65 and older will grow 50.5 percent by 2030 and consequently will continue to be a key driver of rental unit demand in the coming years.