Investors in cannabis real estate may be able to buy failed facilities at distressed prices.
Similar to what happened in Colorado, California’s cannabis industry might experience some growing pains, industry experts predict. State and local government requirements and an oversupply of product expected to flood the market in coming years are likely narrow the supplier field and cause some operators to shut down. That, in turn, might provide cannabis real estate investors with opportunities to acquire facilities of failed operators at distressed pricing, according to Jim Fitzpatrick, principal at Costa Mesa, Calif.-based Solutioneers, a consulting firm that assists cannabis businesses in securing licensing and helps real estate investors identify cannabis compliant properties and obtain financing.
Currently, there is a limited supply of legal cannabis product in the marketplace, according to Fitzpatrick, but he notes that might soon change because the state of California did not limit the number of grower licenses available. As a result, the market might eventually become flooded with growers and an oversupply of cannabis flower and oils that will cause prices to drop significantly.
Today, California still has a robust cannabis black market, notes Matthew Karnes, founder of New York-based Greenwave Advisors, a cannabis research and advisory firm. However, he expects a shift to legal production as the state may begin to crack down on illegal growers when it fails to achieve projected revenue from the cannabis industry.
In addition, Fitzpatrick notes that many cannabis manufacturers may find it challenging to obtain required state licensing in January 2019 due to non-compliance with the state’s health and safety standards. Many cannabis manufacturers purchased Chinese processing equipment that does not comply with the new California Chapter 38 Fire Code and/or will not achieve the state’s safety standards, he says.
With no grace period to work out safety issues, many manufacturers might be forced to shut down, Fitzpatrick says. “Most operators aren’t capitalized to withstand a six-month shutdown to achieve compliance,” he notes, adding that this will provide investors an opportunity to acquire distressed assets for pennies on the dollar.
Fitzpatrick predicts that the biggest shift in California’s cannabis market will take place in the course of 2020 general election, as the state’s cannabis industry matures and expands into new markets. He says that over the next two years strategic ballot initiatives throughout the state will seek to remove current local government bans on cannabis operations. According to Sacramento-based cannabis real estate developer Tim McGraw, approximately two-thirds of the state’s local governments currently ban cannabis cultivation and manufacturing operations.
Some investors are already snapping up assets in non-cannabis-approved markets zoned for commercial real estate at opportunistic pricing, Fitzpatrick notes, and will fund campaigns aimed at passing ballot measures to allow cannabis operations in these areas.
But the legalization momentum is not limited to California. Karnes notes that investors are also entering New York, New Jersey and Michigan, which are expected to legalize recreational cannabis within the next 12 months.
Additionally, he says that investors attempting to get ahead of the cannabis legalization market are investing in commercial real estate assets in states where it has been legalized for medical use, as they expect it is only a matter of time before recreational use will become legal too.
Meanwhile, real estate and financial experts are launching new services to help growers and operators become profitable and investors to fund cannabis real estate assets.
McGraw, for example, is developing cannabis business parks that provide a “WeWork-type” collaborative campus environment that offers producers and manufacturers efficiencies and synergies while cutting their costs.
Expected to be operational by year-end, his first project, which is nearly fully leased, repositioned an existing cantaloupe storage facility located on 32 acres in Mendota, Calif. to provide 107,000 sq. ft. of laboratory and cold storage space for cannabis operations, as part of a total of 800,000 sq. ft. of space licensed for all types of cannabis operations, except outdoor growing. McGraw has also started work on an 80-acre, 1.2-million-sq.-ft. project in Williams, Calif., and has two Southern California projects in the works near Los Angeles and San Diego.
There is a high level of demand for space in these projects because they provide a turn-key solution for cannabis operators that cuts through the red tape and saves money, McGraw says. This is because McGraw pre-negotiates with local governments to impose a flat permit fee on tenants rather than tax their revenues.
The state of California taxes cannabis revenue at 15 percent and allows local governments to impose an additional revenue tax, which usually varies between 7.9 and 25 percent, but is a whooping 43 percent in Los Angeles, he notes. “The key to success in this industry is margins,” McGraw says, adding that paying high taxes puts producers at a severe disadvantage, making it difficult for them to compete with businesses in neighboring jurisdictions with lower tax rates.
Funding cannabis real estate is another big hurdle for the industry, as federally-insured banks withdrew financial support for the cannabis industry after U.S. Attorney General Jeff Sessions rescinded the Obama Administration’s Cole memorandum earlier this year, which had protected cannabis-related businesses in states that had legalized pot in some form.
As a result, cannabis operations and real estate are being funded with private money, Karnes notes, including family offices, high-net-worth individuals and public and private cannabis REITs.
New financial organizations, however, are launching innovative funding ecosystems for cannabis real estate and business operations. Costa Mesa, Calif.-based AllGreen Funding, for example, is a financial brokerage established specifically to fund cannabis real estate and entrepreneurs. AllGreen Funding Founder and CEO Brian Eaton says his firm is working with all types of private cannabis lending resources, including family offices, real estate debt funds and private equity investors. The firm is in the process of raising a capital fund to finance cannabis assets as well.
Eaton notes that private investors “won’t stick out their necks” without ample compensation,” so interest rates for cannabis real estate are high at 10-15 percent, compared to other types of secured loans. He predicts, however, that as the industry progresses further with more credit unions and eventually financial institutions getting on-board, rates will come down.
Moody’s has pegged initial property losses from the hurricane at between $16 billion and $20 billion.
As the recovery efforts following Hurricane Florence continue, the commercial real estate industry is beginning the long and complex process of damage assessment and remediation.
While estimates of the total damage caused by the storm may not be complete for some time, the industry is already bracing for a pronounced impact.
“Clearly the size and the scope of Florence is quite significant. … The sheer magnitude of the damage will not be known for multiple days,” says Clark Schweers, principal and head of the forensic insurance and recovery practice at BDO USA LLP, an assurance, tax and financial advisory firm.
Florence, which began as a Category 4 storm in the Atlantic Ocean, made landfall as a Category 1 hurricane on Friday in North Carolina. It brought a record amount of rainfall—more than 33 inches—in Swansboro, N.C., and powerful winds, causing significant flooding. The storm has killed 37 people as of Tuesday’s count, The Associated Press reported.
When it comes to property damage, ratings firm Moody’s has initially pegged property losses from the storm between $16 billion and $20 billion. This is likely a conservative estimate, the firm stated. A new report from Morningstar Credit Ratings issued Thursday morning identified $1.49 billion in securitized commercial mortgages that are at an elevated risk because of major damage. The firm found 189 properties backing 187 securitized loans in 16 of the 18 North Carolina counties that have been declared as disaster areas by the Federal Emergency Management Agency, though assessment is still ongoing.
Morningstar said it doesn’t expect a surge of loan defaults; business-interruption insurance should help for most properties. But flood damage could hinder refinancing some existing loans and paying off any maturing loans over the year.
After Hurricanes Harvey, Irma and Maria, few CMBS loans fell delinquent, Moody’s reports. “It’s a known factor for certain locations, so when the deals [are] rated initially, we definitely take that into account,” says EJ Park, a senior credit officer at Moody’s. Prior to the storm, Moody’s anticipated CMBS loan exposure in the Carolinas at 2.7 percent and commercial real estate CLO exposure at 0.9 percent of the universe it rates. The firm found 345 loans backed by properties likely to be hit by the storm, for a combined 1,479 properties in North Carolina and South Carolina that hold a loan balance of $10.7 billion.
The storm appears to have missed larger cities in the area, such as Charleston, S.C., but hit hard in less-dense areas. Some of the commercial assets likely to be most impacted include single-tenant retail, garden-style apartments, single-family rentals, vacation properties and light industrial buildings, says Ross Litkenhous, vice president of strategic development at Altus Group, a commercial real estate software provider and advisory firm.
Commercial real estate professionals in the region face concerns not just about the extent of damage from flooding and wind, but also the sheer amount of wind-driven rain seeping through properties, Schweers says. Even minor water intrusions can have big impacts on commercial properties where people live and work. And with extreme flooding blocking access to properties and infrastructure, quick remediation appears unlikely. “Mold can be quite devastating and extremely costly for owners to deal with if it’s not able to be dealt with in the beginning,” he notes.
Further challenging remediation efforts, surging floodwaters in the region have triggered other environmental contamination concerns from coal ash and pig waste, The New York Times reports.
And while there is never a good time to have a natural disaster, the timing of Florence is particularly bad. Construction materials and labor costs are soaring, and they could increase further with tit-for-tat tariffs, Litkenhous says.
Meanwhile, the storm’s impact on the residential side is likely to create more demand in the local apartment sector, already somewhat constrained. “Clearly with the sheer amount of residential damage that has occurred, there is going to be significant demand for temporary housing and for apartment rentals,” Schweers says.
In the region’s smaller cities that were impacted, the multifamily occupancy rate was running around 94 percent before the storm, says Greg Willett, chief economist at RealPage Inc., a provider of property management software and services. That means few apartments may be free for temporary housing.
For example, there are about 22,000 apartments in Wilmington, N.C., with an occupancy rate between 93 percent and 94 percent. That translates to only about 1,500 vacant units. “That’s not a lot of stock if a bunch of single-family homes have been damaged,” Willett says.
While the recovery efforts appear to be challenging, the industry may be more prepared to bounce back than it was a few years ago. Following the wildfires on the West Coast and last year’s trio of harrowing hurricanes—Harvey, Irma and Maria—natural disaster resiliency has been top of mind for commercial property executives. However, natural disasters might always be a challenge “because it’s something that’s difficult to plan around,” Litkenhous says.
In the second quarter the world’s largest retailer saw a surge in digital sales alongside its fastest same-store sales growth in more than a decade.
While Walmart is increasingly cognizant about competing with Amazon and other online retailers in growing its e-commerce volume, the retail behemoth hasn’t lost a step at its stores. It’s omnichannel strategy includes beefing up its online sales, improving its mobile and same-day delivery capabilities and broadening its appeal to shoppers. The result: In the second quarter the world’s largest retailer saw a surge in digital sales alongside its fastest same-store sales growth in more than a decade.
Walmart’s U.S. e-commerce sales climbed 40 percent—a big jump from previous quarters—and company officials said their online sales are on track to rise about 40 percent for the full year. This is an indication that the company’s grocery delivery options and redesigned website are reaping results. Meanwhile, store traffic was up more than 2 percent and U.S. same-store sales increased 4.5 percent.
Revenue increased 3.8 percent to $128 billion, topping analysts’ estimates of $125.97 million. Walmart’s shares increased 9 percent after releasing its strong quarterly earnings report.
Walmart officials acknowledged that the strong economy, low unemployment and seasonable weather also helped boost sales.
“We benefited from a favorable economic environment and weather,” said Doug McMillon, Walmart’s president and CEO, in its second quarter earnings call with investors. “Customers tell us that they feel better about the current health of the U.S. economy as well as their personal finances. They’re more confident about their employment opportunities.”
“The consumer is the healthiest they’ve been in 25 years,” says Jan Kniffen, a retail consultant and founder of J. Rogers Kniffen Worldwide Enterprises. “But that still means that they bought it from Walmart instead of Amazon. So they’re doing the right thing. The stores are now the best they’ve ever looked. Doug McMillon has completely rebuilt this whole inside of the store to make it just as good as it ever was for the consumer.”
Walmart is cutting back on new stores, focusing on e-commerce, remodels
Walmart has slowed down in one regard, however. It’s cut back on its pace of expansion.
“There’s sort of a new point of view coming from Walmart where they’re building on the traditional foundation of their stores, but they’re not adding many new stores,” says Laura Kennedy, vice president at Boston-based Kantar Consulting, a retail and shopper research and consulting firm. “They’re to add fewer than 15 new Supercenters this year and fewer than 10 new Neighborhood Markets. And there were years where they were adding a couple hundred Neighborhood Markets a year.”
Kennedy says the company started this move toward many fewer openings in 2017. Walmart added about 35 new Supercenters in 2017. In the past, they were adding some 200 Supercenters annually. Now Walmart is focusing on remodels of about 500 stores per year.
“Walmart has figured out they pretty well blanketed the country, so they continue to open stores, close stores and relocate stores—the things they’ve always done—but now they’re focused on the big store and the little store and nothing in between,” Kniffen says. “They basically walked away from the stores in the middle.”
Spending big bucks on e-commerce
Walmart has invested billions in its e-commerce business to compete with Amazon.com. The retailer is also pursuing a more affluent online shopper. Walmart paid $3.3 billion to acquire Jet.com in 2016 in an effort to reach higher-income, urban millennial shoppers.
Last week, Wal-Mart relaunched the Jet.com website to become the “shopping destination for city consumers.” The new website focuses on “localization, personalization and smarter recommendations” and new partnerships including with Nike and Apple. The relaunch started in New York but will also roll out to other major cities.
Since its Jet.com acquisition, Walmart has purchased niche brands like ShoeBuy, Bonobos and ModCloth and partnered with Lord & Taylor, which will bring new products to Walmart.com.
Walmart is also battling Amazon internationally, agreeing to pay $16 billion to buy 77 percent stake in Flipkart, India’s largest e-commerce retailer, which will give it a major presence in one of the world’s biggest markets. It’s a deal that Amazon also bid on.
Leveraging current stores
Walmart is taking advantage of its existing network of 4,700 stores to get products to shoppers quicker.
“They can leverage their store base to be much more competitive with Amazon,” Kniffen says.
For example, Walmart’s online grocery delivery option will be available to more than 40 percent of U.S. households by year-end, meaning deliveries from about 800 stores. And grocery pickup service for online shoppers is now available at more than 1,800 locations with more to come. That’s also part of the remodel strategy.
“Any of the stores that have the space to do so, they’re blowing out the one side and putting in the drive-thru acceleration lanes,” Kniffen says. “That gives them the ability to be more much attractive to the consumer, and it gives them something at the moment Amazon can’t do. They’re looking at different ways to leverage that store base to be more competitive with Amazon, and they’re doing a pretty darn good job.”
Grocery makes up more than 50 percent of Walmart’s revenue. Walmart is one of the biggest U.S. grocers and is way ahead of Amazon in that sector. However, Amazon has been increasing efforts after acquiring Whole Foods in 2017. However, that’s only 400 stores.
“It’s nothing in the total game in grocery,” Kniffen points out “When you look at what Walmart has done, they’ve made themselves a much better competitor to Amazon and they basically said, ‘If you’re going to win in grocery, you’ve got to win against us. And if you can’t win in grocery, your growth rate is going to slow down,’ because that’s where Amazon’s new focus is. They’ve taken over books. They’ve taken over electronics. They’re taking over apparel as we speak. But now they’re moving into grocery and that’s the real battleground and Walmart is way ahead.”
Dolllar store competition
While Walmart continues to expand its appeal to compete with Amazon, it also wants to gain back share from the dollar-store sector.
“A lot of their focus is now on Amazon rather than dollar stores,” Kennedy says. “That’s not to say that they don’t still compete with the dollar stores and they don’t still see them as a competitor, but the bigger target is on Amazon.”
When Dollar Tree acquired Family Dollar in 2015, it took market share from Walmart, predominantly from the lower-income shoppers seeking rock-bottom prices. The other significant player is Dollar General. Both chains have between 13,000 and 15,000 locations.
The huge number of dollar stores, their price strategy and range of merchandise make them a direct competitor with Walmart.
“I think Walmart would probably say they’re definitely still a major competitor—a competitor to shoppers who want to be confident they’re paying the everyday low price for products,” Kennedy says.
“Clearly, Walmart’s growth would have been better had Dollar Tree, Dollar General and Family Dollar never existed,” Kniffen adds. “None of us ever believed that there was a bottom below Walmart, but those guys proved there was. They managed to do it with small package sizes, convenient locations and small footprints.”
Kniffen says about five years ago, Walmart said they were going to “quit giving share in this space, and they brought in smaller package sizes and marketed against them and did all kinds of work with consumer products guys to make sure that they were competitive on price and size – not just price.
“I can’t really tell if they’re gaining share back,” Kniffen says. “It’s hard to measure that, but it certainly put a lot of pressure on that space, and they’re certainly trying not to lose share any longer in that space.”
There’s a lot to like about the West Coast, which has both natural advantages in terms of its ports and its geography, and man-made strengths in the form of a top-tier education system and the presence of multiple, rapidly growing technology firms.
It’s telling that roughly one-third of commercial real estate lending by U.S. Bank occurs on the West Coast, including substantial exposure to California.
There are multiple factors behind this focus on the region, including population growth, job creation, exposure to the rapidly growing Asia markets and an unusually high level of economic diversity, with California alone having added nearly three million jobs since 2010. Together, these elements combine to create an extraordinarily dynamic and robust labor market that, in turn, supports demand across multiple property types, including multifamily, office and industrial.
Washington and Oregon
Starting furthest north up the coast, Seattle has been another major beneficiary of the tech boom and significant immigration, which has resulted in 18.7 percent population growth since 2010, which makes Seattle the fastest-growing of the 50 largest U.S. cities. In addition, it has recently joined forces with nearby Tacoma, Wash. to create a joint port, which on a combined basis makes it the fourth largest in the country. From a technology perspective, four of the five companies with the largest market caps are based in the Seattle MSA, with Amazon and Microsoft having headquarter offices and Google and Facebook expanding regional offices in the area. This growth has spurred a variety of investment in assets ranging from single-family homes to multi-family to office and hotels.
U.S. Bank is serving as the administrative agent on two major construction projects underway in the downtown South Lake Union neighborhood. They include a 600,000-sq.-ft. mixed-use development comprised of multifamily units, ground floor retail and an office component that’s 100 percent leased to Google. The second project is a nearly 200,000-sq.-ft. office project that’s 100 percent leased to Facebook. Both are expected to house a significant number of new jobs.
Portland, Ore., on the other hand, is an example of a mid-sized city benefiting both from regional growth and the national trend towards re-urbanization among millennials looking for higher paying jobs and an attractive lifestyle. By comparison, it remains reasonably priced in both office and residential sectors, versus the Bay Area and Seattle.
Looking ahead, we expect demand for office and multifamily to remain strong across the region, followed by industrial, though growth is likely to slow as new inventory comes on-line. Retail, which has been relatively quiet, has trailed out West as well, something we expect to continue.
In the past, the California economy rested mostly upon the three pillars of aerospace, entertainment and agriculture. These industries are still critical, but media and tech companies are gaining in importance. Meanwhile, the port of Los Angeles ranks as the busiest in the country, followed by the port of Long Beach and then Seattle, which collectively serve as the entry point for the country’s trade with Asia and contribute to a robust industrial sector. Within California, there are multiple major sub-markets, each with its own economic drivers.
In San Francisco and the Bay Area, tech, of course, is the prominent driver of growth and job seekers continue to pour into the area, despite the well-publicized issues with housing. The population has increased more than 20 percent since 2010, and now exceeds four million. For a number of reasons, new construction is challenging in both residential and office sectors and, partly as a result, the prices paid for existing stock are skyrocketing with class-A office properties now changing hands for as much as $800 per sq. ft., up from $400 per sq. ft. just eight years ago. Employment is driven by the name-brand tech companies—Google, Facebook and Apple, to name a few,—as well as by the vibrant start-up culture.
Presently, there is a lot of new office construction between the peninsula, the East Bay and the city itself, and it tends to lease up very quickly. We recently closed on a 440,000-sq.-ft. mixed-use development in Silicon Valley that is 100 percent leased to one of the top social networking companies. Other projects include a 44-unit eight-story luxury condominium development in Nob Hill and a mixed-use seven-story class-A life science office/lab across the Bay in Emeryville.
As is to be expected, some of this growth is starting to broaden out as the pricing for both housing and office becomes prohibitive. Sacramento is one potential beneficiary, with some tech companies starting to gravitate there and bringing their employees—and the demand for housing—with them.
In addition to the international significance of its ports (nearly 40 percent of overseas goods flow through the ports of Los Angeles and Long Beach), the big growth story in Los Angeles is taking place downtown, where $26 billion has been invested to improve the live/work environment, and to attract people back to the city center. As a result, the downtown residential community has continued to expand, from fewer than 20,000 people a decade ago to more than 70,000 today. U.S. Bank recently led a $190 million financing of a two-phase 600-plus unit luxury multifamily project located in downtown Los Angeles’ fashion district. Additionally, located in the rapidly renewing Los Angeles Arts District, we financed the acquisition and renovation of an original Ford Model-T factory, which is 100 percent leased to a major media tenant.
Orange County is home to a broad range of diverse tech companies, which support one of the strongest office markets in the nation. Its strong education system feeds a highly educated local workforce, while the robust job creation is adding demand for multifamily housing in what has historically been a supply-constrained market. One result: the county is home to the top-selling master-planned community in the country. Among the projects supported by U.S. Bank is a master-planned community for 2,000 homes approved in Lake Forest, one of south Orange County’s most desirable markets. The project is one of Southern California’s premier master-planned communities, being developed in partnership by two of the nation’s leading builders of luxury homes.
San Diego is a major tourist destination with one of the top life Science/biotech markets in the country, if not the world. It’s also the principal home base of the U.S. Pacific Fleet and the Marine Corps, as well as a spate of related defense industries. Recent projects in which we’ve participated include funding the first speculative office development downtown since the recession, a 400-key hotel, also downtown, as well as a research lab which is already 100 percent leased. On the multifamily side of the market, the city has been experiencing significant annual rent increases and extremely low vacancies. As a result, we have a very active pipeline of apartment transactions, including acquisition, renovation and new construction.
There’s a lot to like about the West Coast, which has both natural advantages in terms of its ports and its geography, and man-made strengths in the form of a top-tier education system and the presence of multiple, rapidly growing technology firms. There are challenges too, in particular, a lack of affordable housing. (Although, for U.S. Bank, over the past three-four years, two-thirds of new construction loan requests have been for multifamily and mixed-use projects.) Competition for skilled labor and for land is pushing up prices as well. No region exists fully outside the economic cycle, but there are plenty of reasons to be optimistic that the next downturn, when it comes, will be moderate. Something else to like about the West.
Wayne Brander serves as executive vice president and West region manager with U.S. Bank | Commercial Real Estate.
With core assets delivering thin returns, institutional investors are looking at value-add and redevelopment opportunities.
Whether it’s in a more favored sector like multifamily, a less attractive sector like retail or a somewhat in-between sector like office, the best paths for institutional investors to drive value these days are the ones less traveled.
That’s the assessment of Jacques Gordon, global head of research and strategy at real estate investment management firm LaSalle Investment Management. And other experts in the sector echo those sentiments.
Gordon says purchasing and then improving an undermanaged apartment complex or value-add office building stands to deliver a better payoff, in many cases, than snapping up a stabilized property. He also notes that pursuing retail assets that feature experiential components or that could be remerchandised also provide opportunities to seek value in a sector that’s been largely out of favor among institutional investors in recent years.
Byron Carlock, leader of the U.S. real estate practice at professional services firm PricewaterhouseCoopers (PwC), says that while “a lot of dry powder” is sitting in the private markets, there’s still significant transaction volume. In the second quarter of this year, overall deal volume was relatively flat compared with the same period in 2017, according to a PwC report.
Moving forward, Carlock expects value-add and redevelopment to be two of the most active acquisition categories. Furthermore, Carlock believes a new federal law promoting redevelopment in distressed “opportunity zones” around the U.S. could extend the current real estate cycle.
A recent report from Gordon and his team at LaSalle Investment Management, a JLL subsidiary, peels back the layers on some real estate sectors and redevelopment strategies that could greatly benefit institutional investors.
“The way the real estate investing game is being played by investment managers today is to first try to find a good idea, like repositioning apartment buildings, and then executing it as quickly and quietly until the idea gets fully priced in the capital markets,” Gordon says.
In the multifamily sector, Gordon and his colleagues say in the report that they’re still attracted to suburban apartments “but are turning some attention back to urban locations.”
The report notes that some urban markets initially affected by the latest rise in supply are now seeing supply levels decrease. Therefore, some urban markets might be investment targets in the next year. Meanwhile, levels of new supply in suburban markets remain mixed, the report adds.
Gordon says revamping an apartment complex that’s, say, 20 years old so that it appeals to the core 25- to 35-year-old renter could yield “very good” results. Not every apartment renovation will succeed, he says, but it’s got a better chance of performing well if sufficient “value engineering” is done for apartments and common areas to ensure the reward is greater than the risk.
“Real estate has got to be an actively managed asset class,” Gordon points out. “You no longer can just buy a building, kick back and collect the rent checks, and expect everything to go great.”
Gordon says institutional investors also can find value in the battered retail sector, which has been buffeted by concerns over the impact of e-commerce. A “smart investor,” he says, isn’t dissuaded by the uncertainty rattling the retail business.
In fact, despite all the gloom and doom that has beset the retail sector, a new report from Cushman & Wakefield predicts that overall vacancy rates for retail will barely budge during the next couple of years—from 6.6 percent in 2018 to 6.8 percent in 2020.
“A smart investor can realize that if everyone’s fleeing a sector as big and broad in America as shopping centers that there may be better value there, and that is the case,” Gordon says. “There’s much less money chasing shopping centers today than there is multifamily or logistics.”
Several hundred class-B or class-C malls in the U.S. are candidates for adding assets like apartments or hotels to empty pad sites and turning the existing property “inside out,” Carlock says. As result, he adds, a mall “becomes a relevant piece of real estate again when it may have fallen into irrelevance.”
To be especially smart about buying a retail asset, an investor must carefully consider the trade area as well as the strategy for attracting more shoppers and boosting rental rates, Gordon says. For instance, he goes on to say, if the aim is to make a retail center more “experiential,” an investor must look at what that will entail. Does it go beyond stepped-up food and beverage offerings? Where will the experiential components go?
“The brick-and-mortar store is not irrelevant. It just needs to be, in many cases, redeveloped to become more relevant,” Carlock says.
As for the office sector, LaSalle’s Gordon once again turns to the notion of rejuvenating an existing property rather than buying a new one. In doing so, though, an investor must weigh the mix of:
- In-house and nearby amenities, such as restaurants and coffee shops.
- Services provided by both landlords and tenants, including health and wellness classes.
- Community-building aspects along the lines of those you’d find at coworking spaces.
Gordon says the office sector is undergoing a “real sea change” in terms of how tenants and landlords must collaborate to create “durable, lasting and attractive” work environments for occupants, from baby boomers to millennials and beyond.
The LaSalle report notes that “cracks are beginning to show” in the pricing of office properties that don’t offer amenities either inside or outside a building.
According to Carlock, about 80 percent of U.S. office stock was built before the 1990s, and some of it “needs to be redone to satisfy current demands.” However, he adds, “office space is not always out of date as we move to the office of the future.”
Repurposing an existing office building to beef up amenities and other features could be a particularly attractive investment tactic now, given that the Cushman & Wakefield report highlights a “strong wave” of office development in 2018 that’ll put downward pressure on effective rents in some markets.
Well-defined agreements, good communication, and fairness can help assure a successful project, start to finish.
Whether you’re a developer, owner or contractor, cost overruns can undermine the viability of any construction project. That’s why clearly defined contracts are essential—for all parties involved In our work assisting project sponsors and builders across all kinds of projects and issues, we’ve identified these five common ways to mitigate future risk through careful use of contract language. We’ve also found that these same principles, among other best-practices approaches, can provide guideposts and starting points for project participants who find themselves in disputes whether mid-stream or post-completion. Well-defined agreements, good communication and fairness can help assure a successful project, start to finish.
Here are five of the best ways to mitigate the risk through careful use of contract language.
1. Include Competitive Bid Procedures
If you’re an owner or developer, it’s important to articulate the need to obtain comparative bids on all subcontracted work to ensure competitive pricing. This is especially important if a contractor self-performs work. Without such a clause, there’s no way to know how competitive pricing actually is. Requiring three bids is a good starting point, because it offers an effective comparison between bidders to ensure cost competitiveness without being overly burdensome for either the contractor, owner, or developer.
For contractors, this clause is an effective way to validate subcontractor cost competitiveness in the event of an audit—which will likely be required by most contracts anyway.
2. Clarify Allowable and Unallowable Labor
One of the most effective ways to manage the cost of a project is to clearly define allowable and unallowable labor rates along with the associated burden.
This generally includes determining if labor charges are based on actual wages or predetermined rates, as well as defining on-site versus off-site requirements—so it’s understood by all parties what costs are directly associated with and billed to the project and what rates are compliant with the contract. Adding an owner or developer approval requirement for non-approved labor types further protects each party from unanticipated costs or audit exposures.
Without this clarification, it’s easy to get into gray areas that can quickly turn into disputes or overruns.
3. Set Rates and Caps on Contractor-Owned Equipment
If equipment costs aren’t controlled by the contract from the outset of a project, rates can easily become excessive.
By establishing set equipment rates, allowable equipment charges and charge caps, developers and owners are protected from unexpected overruns. This may include defining whether rates are charged hourly, daily, weekly or monthly and typically includes adding an owner or developer approval requirement for non-approved equipment types.
This clause also shields contractors from potentially being exposed during a contract audit, especially if minimum reporting standards are written into the contract, because all of the necessary documentation is understood to be required from the outset of the project.
4. Define Change-Order Reporting Requirements
Change orders aren’t uncommon, so they should be anticipated and managed accordingly through the project contract. This can be achieved by defining a mutually approved price, agreed upon unit pricing, or requiring itemized backup for change orders with actual cost.
If change orders aren’t billed based on actual costs incurred, then the quotes or estimates provided by the contractor could be more than the actual cost of the scope change. Requiring validation to back up the change order helps to verify the cost of those changes aren’t artificially inflated, and it also protects contractors from potential exposure during a contract audit.
5. Add a Right-to-Audit and Accounting Records Section
Incorporating a clause stating that project costs are auditable establishes the expectation that all costs sent to the owner or developer can be reviewed, audited and validated for contract compliance.
Without this wording, contractors may not be contractually obligated to provide developers or owners this information, even if it’s requested. And if contractors aren’t aware that this level of documentation is an expectation from the outset of a project, then they may not have it available.
Stephen Bacchetti, CPA, CIA, CCA is a manager at Moss Adams specializing in construction and performance audits for construction and capital improvement projects. He works closely with developers, tribes, universities, K–12 school bond programs, and hospitals on construction and capital improvement projects ranging from millions to billions of dollars. He can be reached at email@example.com.
Assurance, tax, and consulting offered through Moss Adams LLP. Investment advisory services offered through Moss Adams Wealth Advisors LLC. Investment banking offered through Moss Adams Capital LLC.
Strong demand from renters has kept up with a high pace of new construction, allaying fears of overbuilding in the market.
New renters are filling thousands of gleaming, new apartments in downtown Chicago. That’s been a pleasant surprise in a market that experts had worried would be buried in a flood of empty, new units due to a wave of overbuilding.
“There has been a lot of confidence restored to the market… we can handle this new supply,” says Brandon Svec, a market economist in the Chicago office of CoStar Group. Last year, “we were all telling a story of oversupply.”
For example, the Streeterville and River North neighborhoods of Chicago, just outside of the Chicago Loop, developers opened 2,927 new apartments over the year that ended in the second quarter 2018, according to Marcus & Millichap. Developers also have 3,360 new apartments under construction in these neighborhoods.
Yet strong demand from renters has filled those vacancies this spring and summer, and that has reassured investors. Despite the huge number of apartments developers still have planned for the metropolitan area—and particularly the neighborhoods downtown—rents continue to grow.
Rents are expected to rise 5.32 percent for class-A apartments in Downtown Chicago in 2018 compared to last year, according to JLL. Rents are expected to rise more slowly for other types of apartments in 2018: 2.78 percent for class-B and class-C apartments downtown; 1.16 percent for class-A in the suburbs and 2.17 percent for suburban class-B and class-C apartments.
Overall the percentage of apartments that are vacant in the Chicago area is a relatively healthy 5.5 percent, as of early September, according to CoStar. The percentage of apartments that are vacant in Downtown Chicago fell to 6.8 percent in early September. That’s down from 10.2 percent the year before, according to CoStar.
As a result, investors, backed by readily available financing, are still paying high prices and accepting low investment yields for apartment properties.
“Apartment buildings, if priced correctly, are selling very quickly,” says Ryan Engle, senior vice president investments and senior director of the National Multi Housing Group for Marcus & Millichap.
Prices still high for Chicago apartments
“Cap rates have remained very stable since 2016,” says Svec. Cap rates represent the income for a property as a percentage of the selling price. Investors paid cap rates averaging in the low 5 percent range over the 12 months that ended in early September. “Cap rates likely have bottomed out for this cycle.”
The cap rates in Chicago are a few percentage points higher than in the top markets on the East and West Coasts like New York City or San Francisco. “Investors chasing yield still find Chicago’s central business district multifamily to be a relatively safe play,” says Chuck Johanns, executive vice president for JLL. “Suburban cap rates have not compressed as fast, and we continue to see healthy transaction activity in suburban areas.”
Apartment experts now hope that demand from renters can fill what had seemed like a tsunami of new apartments scheduled to open. “If we can get eight or ten more quarters out of the real estate cycle, then we can get these new apartment absorbed,” says Svec.
Developers still have 18,416 new apartments in some stage of the construction process in Chicago—a number equal to about 4 percent of the existing inventory of apartments in the city, according to CoStar. That’s about the same level as last year, though developers seemed to be taking out fewer building permits to add to the number of apartments under construction.
“We are starting to see construction fall off a little,” says Svec. “It’s getting harder and harder to make deals work as the cost of land and construction goes up.”
Although more consumers are shopping online and many retailers are spending big bucks to beef up their e-commerce strategies, off-price retailers are aggressively expanding and proving to be resilient.
While department stores have faced intense pressures from Amazon and the growth of online sales more generally, consumers continue to head to brick-and-mortar, off-price chains in healthy numbers, keeping the performance of that sector stable.
Off-price retailers sell racks of second-hand merchandise, closeouts, last season’s products, overruns and returns from other apparel companies at rock-bottom prices. The rapidly shifting inventory and “treasure hunt” experience help draw shoppers in. Furthermore, while apparel sales account for the bulk of sales at off-price chains like TJ Maxx, Ross Dress for Less and others, many companies are looking for ways to increase their product mix, with the home products category gaining popularity.
“These stores are winning on their value equation,” says David Weiss, a partner at Chicago-based consulting firm McMillan Doolittle. “Consumers at almost all income levels appreciate what these companies can provide—first, a low price. Everything these retailers do is built to offer the lowest possible prices. Stores are bare bones. There is limited marketing spend. It is important to realize that the bare-bones experience is what makes these low prices possible.”
Second, Weiss says, is the treasure hunt “really comes to life” in these stores. “You’re not sure what you will find, but you are excited when you find a deal. You can’t find that replicated well on the Web yet,” he says.
Customers like off-price stores because they’re “off-mall” and conveniently-located, stores are shoppable, agrees Christina Boni, vice president and senior analyst at Moody’s Investors Service.
“Those things are driving the customers to these stores, and they also attract a younger customer than maybe some of the alternative retailers, like a department store,” Boni says. “They offer millennials the experience that appears to be resonating with them.”
Boni says the off-price retail sector has been able to grow through its brick-and-mortar channel, and these retailers are “still getting a very strong return on capital in terms of adding new stores.”
Some off-price chains, in fact, don’t even put products for purchase online because inventory changes too frequently.
The big three are adding hundreds of new locations
The three largest off-price chains–TJX Cos. (parent company of TJ Maxx, Marshalls and HomeGoods), Burlington and Ross Stores—are reporting solid sales and aggressively expanding physical footprints.
Framingham, Mass.-based TJX is opening 238 stores this year, and the company believes there’s the potential for 6,100 stores globally. Same-store sales have grown 2 percent in fiscal year 2018 and 5 percent in fiscal years 2017 and 2016.
Dublin, Calif.-based Ross Stores recently added 30 stores as part of its 2018 expansion plan (22 Ross Dress for Less locations and eight dd’s Discounts stores). This is part of the company’s plan to add about 100 stores in 2018. Together, Ross and dd’s currently operate 1,680 apparel and home-fashion stores.
The company said in its second-quarter earnings report that Ross Dress for Less can grow to about 2,400 locations nationally, up from its prior target of 2,000, and dd’s Discounts can ultimately become a chain of approximately 600 stores, an increase from its previous projection of 500. Ross’ second-quarter same-store sales were up 5 percent over the same period in 2017.
Lastly, Burlington, based in Burlington, N.J., is opening 39 new stores this fall. Same-store sales increased 2.9 percent in the second quarter. Burlington Chairman and CEO Tom Kingsbury said it was the company’s 22nd consecutive quarter of positive comp sales growth during Burlington’s latest earnings call.
They’re beating other retailers
Off-price retailers will remain among the top performers in the U.S. retail industry over the next 12 to 18 months while department stores will continue struggling, predicted Moody’s Investors Service in a report released last October.
Boni says these predictions still remain on point. Moody’s projected that operating income in the U.S. off-price sector would grow 6.9 percent in 2017 and 5.4 percent in 2018, compared to 9.6 percent in 2016. (This rate of slower growth is primarily due to new store openings, the report says).
Moody’s credits off-price retailers’ significant scale, flexible business model, adaptable real estate strategies and strong vendor relationships for their success. Also, their fast-moving inventory limits their exposure to fashion risk as styles change.
However, department stores face challenges
Meanwhile, Moody’s predicted that department stores would see operating income fall 9.3 percent in 2017 and 2.7 percent in 2018.
Department stores will continue to struggle as they seek to “level the playing field with both off-price and online vendors,” the report says.
While off-price retailers aren’t weighed down by the high costs of e-commerce, department stores must invest in e-commerce strategies to lure shoppers and stay competitive. Moody’s analysts predict that continued partnerships will form between online and offline players. (Kohl’s, for example, offers Amazon products and accepts Amazon returns at some of its stores).
Also, department stores are trying to take advantage of the successful off-price sector with Macy’s Backstage concept and Nordstrom Rack, for example.
Will momentum continue?
Some industry experts say there may be future pressure on off-price retailers to sell merchandise online.
Also, Weiss says future threats could include increasing competition driven by store expansion as well as some online channels.
“The risk at some point is just oversaturation,” Weiss says. “And the stores that were open 20 years ago; are they still in locations that make sense? Competition is certainly continuing to expand. At what point does that become oversaturated?” He says that’s difficult to predict right now.
But Weiss adds that the bottom line is consumers like value, and that’s what off-price retailers offer.
“I think the only thing that will slow them down is will opening more stores cannibalize existing stores?” adds Jen Helm, managing director at commercial real estate advisory firm Newmark Knight Frank’s Minneapolis office. Helm specializes in retail and hotel properties. “I think the concepts are still strong and will continue to expand in areas where they can capture market share. They have won over shoppers because bricks and mortar still works. People want to touch and feel and try things on.”