YH Portfolio Properties

Traditional Brick And Mortar Retail Is Dying (If Not Dead!)

Amazon has been decimating traditional retailing for some time now. Other online retailers have low to zero real estate rent and drastically lower payrolls than standard retailers with a physical location. Online concerns can offer the same goods at drastically lower pricing than the traditional retailer saddled with real estate rent + property taxes, insurance, and maintenance (aka NNN). Nothing new there-

Existing (not brand-new construction) neighborhood retail centers and grocery anchored shopping center deal structures usually have smaller cash outlays from the landlord perspective for build out construction and therefore shorter break evens BUT typically shift the brunt of the build out costs to the tenant. Most landlords offer some free rent to allow the tenant to recoup a small portion of the build out. It is very common for the local to regional credit (versus national) retailers to open operations in a precarious financial position with revised (i.e. usually unrealistic) projections requiring profitability from month 1 to succeed. The culprit here is the significant construction costs (and naturally cost overruns) the tenant must fund on the front end- write a check or put on a credit card. Scared yet? Defaults are a big problem in retail and the stats prove out that 50% of retail operations close up inside of 5 years. Why do you think landlords don’t fund build out directly? They are anticipating (even expecting) a tenant default… Not where you want to be as an investor.

Retail landlords will attempt to plug holes with non-traditional retailers; this is the beginning of the end of your retail investment. When the retail center rent roll starts listing churches, schools, day care/rehab tenancy, the retail owner is trying to cover basic operating expenses and will typically have a mass exodus when the traditional retailer leases come up for renewal.

Freestanding, Single-Tenant Retail – No Management, Sit And Forget? Not So Fast…

Single-tenant retail (“ST”) is where a tenant occupies the entire property; sometimes a developer builds the property to tenant specifications (aka a build to suit) and funds 100% of the extensive cash outlay (buying the land, engineering, legal, construction costs and yes- brokerage fees). The ST signs a long term (12-20 year) lease in consideration for the property being custom built and contractually takes care of everything related to the property- janitorial, air conditioning repairs, parking lot/lawn maintenance, etc. These ST investments are pitched as no management headaches and just sit back collect/cash rent checks. Mike oversaw a large disposition portfolio of ST freestanding retail across Texas for many years for a publicly traded company. This company vacated the ST freestanding sites before lease expiration and kept paying rent looking to sublease the site (hence disposition property) to another tenant for the remainder of the lease term.

Here is the inside scoop on supposed “headache-free” ST/NNN investments-

• The initial rent structure to the ST are NOT market rents; they are a product of the total cash outlay to build the property and a return to the developer. The ST rents routinely exceed market rent rates by a significant margin. If you invest in a ST deal, most investors think the ST will renew and same or higher elevated rent due to stated renewal options in the ST base lease agreement. The only time this happens is on superior locations and these “gems” are typically 10% or LESS of the retailers’ total locations. Investors need to brace for a huge rent reduction at lease renewal or a vacant, hard to lease “investment”!
• A superior credit tenant as your sole tenant is not as safe as you think. Mike has seen high credit tenants vacate a ST property, pay rent for a short time looking for a subtenant, and then propose a buyout (usual offer is 40%- 50% of the base rent remaining or less) to the landlord/investor (you). The landlord counters for higher buyout and the ST stops communication, stops/slow pays direct deposits to the landlords account and the investor is left to sue an enormous corporation or take their low buyout offer.
• The “sit and forget” strategy fallacy. Mike contacted one ST property owner with a buyout offer from his client that vacated the freestanding retail property. This “sit and forget” out of state property owner was shocked; not at just the low buyout offer but that the property had been vacant for over 6 months.
• Assume you invest in a ST property and they vacate as illustrated above. You will be faced with a marked reduction in rent IF you find a single tenant needing exactly that size building. Mike had 2 vacated ST freestanding properties in one submarket asking 50% of the rent the ST was paying that sat vacant for over 7 years. Your next move upon a vacating ST may be to split up the ST property and convert to multi-tenant. The premises will require (out of YOUR pocket) a costly full demising wall to the roof/deck, split and add more electrical, an ADA compliant restroom(s), AND new air conditioning unit(s). This is before tenant build out and puts the investor in a negative position for years, if not forever, on this investment.
• Also look in the news for defaulting retailers; ST and multi-tenant. Sears (mostly mall locations but appliance retail sites), Blockbuster Video (an investor “darling” build to suit in the late 1980’s and 90’s), travel agencies, Toys R Us, Nine West, numerous bridal retailers, Payless Shoes, Claire’s, the list goes on. The “watch list” of potential bankruptcies in the near future is chock-full of household names.

Office Buildings? Technology Employee Demands Are Sinking This Ship…

These can be multi-tenant or single tenant properties. Mike represented office building landlords in this arena between 1988 and 2002 with over 600 office leases consummated. “Cash outlay” is the money the landlord has to pay on the front end like legal, broker commissions, build out (remodeling costs of the premises), and any other cash incentives to secure the office tenant. Build out costs for a standard 5-year lease can easily run $10-$15 per square foot and broker commissions are 4-6% of the gross rentals. We have seen “break evens” to the office landlord/investor run to 3-3.5 years and longer. That means that the 1st 3 years of a 5-year lease the landlord is trying to recoup the front-end cash outlay just to break even and hopes the tenant fulfills the lease to realize a profit.

We saw a 52,000 square foot, three (3) floor tenant (in a 10-story office building) relocate from out of state, sign a 10-year lease, and default on the last stage of move in (only moved into 2 of 3 full floors leased), and then bought out of the lease at the 5-year mark.

Changes in the office market to the detriment of the landlord/investor-

• One trend is allowing employees to work from home- companies are cutting their rent budgets to allow workers to work remotely from home. This obviously translates to companies needing less square footage in the overall office market.
• Co-working spaces- Tenants acting as sublandlords are leasing large blocks of office buildings (sometimes in quasi-retail projects as well) and subleasing to companies on short term basis. Again, a move to “in the field” where employers can rent a few offices and the co-working conference room on an “as needed” basis. Also from the investor/landlord perspective, these build outs are enormous and can run $50 per square foot or higher (again plus a 4-6% of gross rentals to the brokers as a commission and other cash outlays). These leases have break evens well past the 5th year of the lease.
• Technology and millennials- Video conferencing, file sharing, email collaboration, and other technologies allow business to be conducted remotely; not from a fixed office space. Interactions over the internet are reducing the need for each employee to be tethered to an office. Millennials are largest growing segment of the work force and mostly refuse to be tethered to an office desk. Companies are accommodating this by open, collaborative areas requiring substantially less office square footage to run operations.

Overall take away for the office market- High cash outlays, long break evens (and risk of tenant failure during the breakeven), and technology with worker demand for flexible work environments tends to work against the office market. Remember YOU as an investor ARE a landlord and should share these downward trending concerns in the office market.