Fred develops and executes a company-wide leasing strategy as First National Realty Partners’ Chief Revenue Officer.
For owners of retail commercial real estate, understanding the market dynamics that drive leasing demand is critical to success in acquiring and managing properties. Retail leasing demand is influenced by factors such as location, local market trends, broader economic conditions and consumer shopping preferences. Over the course of 2023, these factors have driven strong demand for leasable retail space, and as a result, retail landlords have continued signing leases on advantageous terms.
Consumer retail spending is healthy.
As Chief Revenue Officer and Head of Leasing at a realty firm, it’s become clear that consumer retail spending has held up better than many economists expected coming into the year. Many expected a recession to curtail spending activity in 2023, but the consumer has remained strong, and retail spending has grown consistently over the past several months.
According to a recent report by real estate brokerage JLL, month-over-month retail sales growth showed increases in April, May and June 2023. The Wall Street Journal reported that Commerce Department data showed that retail sales rose a seasonally adjusted 0.7% in July compared to June. A recent survey conducted by the Federal Reserve Bank of New York shows that expected median household spending growth increased from 5.2% in June to 5.4% in July.
Additionally, JLL’s recent Back-to-School Shopping Report shows that parents plan to spend 15.7% more on back-to-school shopping this year compared to last year. This is especially noteworthy because it shows spending outpacing inflation during a period of elevated price increases.
Retail vacancy rates are at all-time lows.
According to JLL, as of Q2 2023, there was less space available for lease in retail centers than at any time since the Great Recession of 2008. As a result, landlords are gaining leverage and signing new leases on advantageous terms, and retention rates have been very strong throughout the year. In a typical year, leases tend to be renewed at a 3% spread over the prior rental rate, but recently, renewals at 10% spreads have become commonplace.
This tilt in favor of the landlord appears to be here to stay. Retail construction has been muted since the Great Recession took many lenders and developers out of the market, and recent activity in the market has failed to jumpstart new development. JLL reports that since mid-2022, retail construction starts have been decreasing. 11.9 million square feet of retail projects started during the first quarter of 2023, which is the lowest level since 2005. Clearly, development activity has not caught up with demand, and the sector has digested any excess supply that lingered after 2008.
The market has shrugged off recent retail bankruptcies.
2023 has been marked by several notable bankruptcies in the retail sector. In February, retailer Tuesday Morning filed for bankruptcy protection for the second time since the pandemic began. Bed Bath and Beyond made headlines in April after filing for Chapter 11 bankruptcy protection. In the same month, David’s Bridal filed for bankruptcy just a few days after announcing a massive layoff.
Collectively, these bankruptcies have brought retail space back into the market, but this has not put a damper on the market for retail space. According to JLL, retailers have been snatching up vacated boxes and junior anchor footprints because they are generally in top-notch locations. Today, we are seeing bidding among retailers for prime locations, in many cases because retail executives have promised investors footprint growth and are under pressure to make good on it. Many landlords have benefited from gaining back space in the wake of a tenant bankruptcy because they have been able to unlock value by re-leasing it at a substantially higher rate with only modest spending required for capital improvements.
What is the impact of strong leasing demand on underwriting?
In my experience, periods of robust performance for owners of necessity-based retail are typically marked by a strong consumer, growth in the retail sector or limited availability of retail space. Currently, we are experiencing all these factors simultaneously, and I find it is having a major impact on acquisition underwriting.
When underwriting commercial real estate acquisitions, spreads or the amount that a lease can be renewed above the prior rate, are one of the most important factors in deciding whether to purchase a property and how much to pay. My team focuses on growing the firm’s commercial leasing business, and we are currently seeing some of the highest spreads in recent years. High-spread environments often allow sophisticated purchasers to underwrite deals with the expectation that rental rates will show strong increases in the coming months and years.
When retailers want to expand their footprint but face a tight market for leasable space, landlords gain leverage and can renew tenants at higher rates. In a tight market for retail space, investors can reasonably incorporate assumptions into their underwriting that reflect the expectation of sustained rent growth, longer lease terms and lower tenant turnover. In an environment like we currently have in 2023, investors often enjoy higher cash-on-cash and internal rates of return, two metrics that indicate the profitability of a commercial real estate investment.
Conclusion: Market signals point to sustained demand for retail space.
Commercial real estate private equity firms employ professional leasing teams to study economic indicators and market dynamics to gain insight into future demand for leasable space. As we head into 2024, many of these key indicators suggest that demand for leasable retail space will remain strong for the foreseeable future. A combination of robust consumer spending, low vacancy rates, subdued construction starts and aggressive growth targets among national retail chains is powering a rally in retail rent growth. As a result, I believe property owners stand to benefit from high tenant retention and strong cash flow growth, both of which tend to drive higher asset values.
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