Q2 2019 Edition
© 2019 TRANSWESTERN transwestern.com
In a mature business cycle, commercial real estate owners, investors, developers, managers and tenants alike feel a sense of dual responsibilities. One is to capitalize on the opportunities that continue to be created in a growing economy. The second is to ensure their house is in order, with preparations made to weather market corrections or flattening economic growth, should those changes occur.
In this issue of Insights, we offer perspectives to help you achieve both objectives. Our cover story offers perspectives on office renovations and amenities. We sample the current menu of building features and services, and discuss the reason many tenants not only desire, but require, amenity-rich workplaces to support their business strategies.
"We hope these perspectives inspire or confirm your own real estate strategy."
Our article on leasing to government entities underscores the excellent credit many departments and agencies can bring to the properties they occupy. We also offer suggestions to prepare landlords, as well as tenants who may be considering taking space alongside public-sector users, for special considerations such as security protocols and a potentially more rigorous procurement process.
We hope these perspectives inspire or confirm your own real estate strategy, and look forward to serving you on your path.
Megafirms like Amazon and Google kicked off an amenities race more than a decade ago, using on-site cafés, outdoor terraces, gyms, nap pods and other workplace add-ons to attract and retain skilled labor. Coupled with the popularity of co-working venues offering similar enticements, elements of those trendsetting tech spaces have filtered into all types of industries.
"Without a renovation and/or addition of amenities, few landlords can significantly increase occupancy or raise rent."
Now most landlords are convinced that many of these once-optional offerings are essential to achieving the highest occupancy and rents in their markets.
Years of experience have shown that renovation and repositioning are keys to boosting occupancy and rents at office properties. When two buildings offer similar space and rental rates, and then one property undergoes a well-planned and executed renovation, the upgraded property typically garners more user attention, boosts occupancy and commands higher rents.
A recent survey of Transwestern clients bears this out, showing that office landlords achieved higher occupancy rates and increased asking rents at their buildings after renovating or adding structural amenities. That means that even for budget-conscious tenants, the driving force behind leasing today is not rental rates alone. Without a renovation and/or addition of amenities, few landlords can significantly increase occupancy or raise rent.
Taking it a step further, the evidence suggests that achieving the lowest rental rate is less important to many users than obtaining distinctive, amenity-rich space. Given today’s fierce competition for labor, a few dollars more per square foot is a welcome tradeoff for a workplace that helps reduce the ongoing costs of recruiting, hiring and training new employees to replace those lured away by other firms.
A sense of place
Office tenant preferences have shifted away from walls, fixtures and finishes to instead focus on the employee experience. Companies want to create a culture that will attract and retain employees, and interactions within the physical space go a long way in reinforcing their brand. How, selection teams ask, will this space make their workplace cooler than other workplaces competing for the same labor?
For the past year, Sleep Number® has operated its headquarters from a newly renovated office building in downtown Minneapolis. As part of the lease agreement, landlord DCI Technology Holdings completed a multimillion-dollar enhancement that added a fitness center, a cafeteria on the fifth floor and other common-area improvements.
The bed maker occupies 238,415 square feet or roughly half of the five-story building, which serves as its administrative offices, its research and development laboratory and a call center. That activity stands in stark contrast to the building’s use for three years before the renovation and Select Comfort’s arrival, when the building housed a single datacenter and was otherwise vacant.
Sleep Number’s move from the suburbs to its downtown location gives employees access to not only a renovated workplace, but also a consolidated headquarters experience that communicates the breadth of the organization. Additionally, employees can access retail, restaurant and residential offerings in the surrounding area. The property itself plays an important role in what the organization can offer its employees, reinforcing the workplace’s role in recruiting and retention.
A survey of select Transwestern client landlords suggests that property owners have heard the call and are making investments to provide the increased amenities and upgrades tenants want. The most common renovation components are upgrades to lobbies and common areas, both of which were included in almost four out of five projects.
Yesterday’s large (and largely unused) lobbies provide ideal opportunities to create gathering areas, coffee bars and alternative workspaces for tenants. As a gateway to the building’s leased spaces, the entry can convey vibrancy that sets a positive tone for tenants, visitors and even those passing by outside.
Significantly, almost half, or 44%, of improvements in the survey involved fitness centers, equal to the percentage for mechanical systems and heating, ventilation and air conditioning upgrades. In a sense, an amenity that many landlords would have considered extravagant or unprofitable 10 years ago because it had nothing to do with “work” is now on par with essential office building mechanicals on many renovation checklists.
And at around 40%, tenant lounges, speculative or turnkey office suites and conference centers aren’t far behind, underscoring their importance to today’s tenants and the landlords catering to their needs.
These findings provide food for thought in planning renovations and upgrades, understanding that some amenities won’t work for some properties. Owners should choose those that will accentuate existing strengths and combine into a compelling offering, taking into account the larger environment around each building.
In fact, a few, distinctive onsite amenities that complement attractive elements of the surrounding neighborhood may be all a property needs to achieve a competitive advantage.
"Property owners have heard the call and are making investments to provide the increased amenities and upgrades tenants want."
A branded building typically enjoys greater appeal than generic competitors, enabling tenants to say, “We’re in the building with the golf simulator,” or, “I’m at that place with the terrace and coffee bar.”
To inform these types of decisions, Transwestern performs building diagnostics through The Lab, a team of specialists from across the United States who analyze a property from multiple perspectives, then collaborate to suggest a data-driven leasing and marketing program. A building amenities expert is part of the team, which helps to ensure building owners are investing in amenities that attract tenants and ultimately improve the value of a property.
The Lab is seeing landlords achieve the best results when they execute a holistic renovation and repositioning, rather than add amenities piecemeal. Amenities should support and reflect a cohesive leasing strategy that considers market forces, competing space and idiosyncrasies of the subject property.
Repositioning and renovating holistically helps to shape the user experience, orchestrated from the streetscape through the entry, lobby, elevators, corridors, fitness center, lounge, event center and other areas. Such a renovation leads to the fastest lease-up and the highest rental rates.
Few private-sector firms can rival federal agencies for credit quality. The same could be said for most state agencies and municipal governments in communities where the public sector makes up part of the tenant base.
Particularly in periods of economic uncertainty, landlords can appreciate the relative assurance that a government tenant will fulfill its contractual obligations through the end of a lease term. Government default risk, at least at the federal level, is minimal, even in the event of a radical economic shift such as a recession.
That exemplary credit can come at a price, however, chiefly in the form of bureaucratic processes and other forms of red tape. Here are key points landlords should weigh in deciding whether to market their properties for lease to government entities.
Public administrations and agencies bear a responsibility to spend tax dollars wisely, and are unlikely to pay rent that exceeds the local market rate. In most cases, an agency will select the space offering the lowest cost of occupancy among properties that meet its stated criteria. Related to that point, governments following a regimented process to select an office property may require more time and landlord interaction than a typical private-sector user to evaluate options and make a final decision.
"As growth slows and headwinds buffet the economy, landlords are wise to consider government tenants for their resiliency in a weaker economic climate."
What’s more, some governments use their own lease terminology and impose special conditions. Many of these points derive from legal requirements for transparency or to guard against the agency overpaying for goods or services at taxpayers’ expense. Before beginning a lease conversation with a government organization, landlords should educate themselves about the process they will be expected to follow and decide if they are prepared for the undertaking.
For example, the General Services Administration (GSA), which provides workplaces for the federal government, uses detailed procurement processes to acquire everything from office supplies to office leases. In accordance with its standard procurement practices, the GSA pays rent in arears at the end of each month, rather than in advance at the beginning of the month, as most landlords require of private-sector tenants.
To avoid confusion, landlords should inquire about any tenant expectations or requirements that differ from industry norms. An example is the scope and responsibility for tenant improvements.
In a conventional lease, a landlord may lease unfinished space, then provide a set amount per square foot of tenant improvement dollars to help the new occupant build out usable offices. Some state agencies and the GSA, by contrast, demand that landlords provide a “warm, lit shell,” which means the property owner provides all mechanical, electrical and HVAC systems in the space at the owner’s expense. For those government entities, the term “tenant improvement” refers to only the finishes from the ceiling down. A landlord facing those expectations should determine the additional cost to provide a warm, lit shell and incorporate that amount into the offered lease rate.
Soft and hard terms
At the end of any lease term, the GSA is required to conduct a competitive analysis to determine whether the agency will remain at its current building or relocate. This procurement can delay lease negotiations, which prompted the GSA in 2015 to create some flexibility at the end of lease terms, called “soft term” or “non-firm term.”
The GSA can give the landlord a move-out notice at any point during the soft term, usually with 120 days’ notice. For example, the GSA could sign a 10-year lease with the first five years firm and the remaining six to 10 years as soft term. The tenant would then be fully committed for the first five years, as with any other lease. During the soft term, however, the GSA may occupy the space for any amount of years six through 10. In a conventional lease agreement, at the end of the initial five years the tenant would have to either vacate or commit to the full remaining term.
When the GSA initially began using soft term, it was typically in a 10-year lease with five years of firm term. To achieve better rates, the GSA evolved its structure to provide landlords with more predicable terms. It now typically executes 10-year leases with eight years of firm term or 15-year leases with 13 years of firm term. This approach has been appealing to landlords and still provides the GSA the flexibility it needs at the end of its lease term.
A government agency leasing 30,000 or 40,000 square feet in a multitenant building will likely confine any special security measures to its space. The larger the headcount at a government installation, however, the greater the required security screening before individuals are permitted to enter. This is an important consideration for multitenant properties, because screening can begin at—or even outside—the building entrance and affect all occupants. Properties with large numbers of government employees may be locked down as tight as an airport, requiring anyone entering the premises to pass through a metal detector and have their bags searched, scanned or x-rayed.
"The full faith and credit of government can add tremendous value to a commercial building."
Security requirements are one of the reasons that government agencies often co-locate with other agencies, although they may not be required to do so. The current federal emphasis on efficiency and right-sizing may lead a GSA tenant to reduce its footprint in a lease renewal, returning to the landlord space that may be difficult to market to non-government users due to stringent in-place security. On the other hand, federal agencies with significantly changing size requirements have shown increased willingness to relocate to new properties in recent years, creating opportunities for landlords seeking to add government tenants.
Weighing the balance
As growth slows and headwinds buffet the economy, landlords concerned about stable rental income through a potential downturn are wise to consider government tenants for their resiliency in a weaker economic climate. State and local practices vary, as do the real estate requirements of organizations in the public sector, so landlords and their leasing representatives should learn how government leases are structured and perform at the local level.
As recent experience proved, while rent may not be processed and paid in the rare event of a government shutdown, the GSA settled all rent payments once the government returned to full operation. Tenants that enjoy the full faith and credit of their government can add tremendous value to a commercial building despite any unique considerations.
Investment decisions can trigger varying degrees of emotion in an investor depending on context. Acquiring a single-tenant, net-leased real estate asset to provide personal retirement income can touch nerves rooted in our primary needs for food and shelter.
"Investors can often resolve their dilemma by adopting a practical evaluation strategy."
Consequently, even a seasoned investor may find themselves ratcheting up their usual criteria when setting out to hunt one, ideal property that will carry them through their golden years. While a number of available properties may meet the overall performance objective, the investor’s implied requirements are often more onerous and may be impractical or impossible to address with a single asset.
Whether the challenge seems to be a lack of suitable options or difficulty choosing the best opportunity from among an overwhelming number of possibilities, individual investors can often resolve their dilemma by adopting a practical evaluation strategy. A key to the process is to separate essential criteria from non-essential expectations that would rule out otherwise promising assets. The method should also aid the selection process by enabling the investor to rank and compare properties offering the greatest benefits.
Investment options in single-tenant retail can be wide-ranging, including standalone properties leased to pharmacies, banking centers, restaurants and other operations. Because investors preparing for retirement are focused on creating stable income, however, they may tack on a laundry list of additional requirements. This list usually includes some form of the following demands:
Triangulate the options
Investors and real estate professionals who have arranged transactions in the low-interest-rate environment of the past decade recognize the preceding description as a very tall order. Yet there is a practical approach, based on the five points, that will help narrow the list of potential acquisitions and identify the property most likely to satisfy the investor’s overall goal.
"More often than not, yield is the overarching driver – especially for an investor who may be depending on the cash flow for retirement income."
Instead of trying to achieve all the criteria listed, investors should consider the “triangle approach.” The premise is simple: If a property meets three of the five requirements – say, lease term, attractive rent hikes and creditworthiness – it’s a deal worth considering. If an opportunity doesn’t fit at least three of the requirements, investors should pass and move on to the next potential property. The triangle approach often works well for investors who view each of the requirements as relatively equal.
When profit is paramount
The preceding approach breaks down when one of the requirements is paramount to the buyer and becomes a deal dictator, lording over the rest of the triangle. More often than not, yield is the overarching driver – especially for an investor who may be depending on the cash flow for retirement income.
This scenario happens frequently enough that it warrants deeper discussion. For investors who demand above-market yield from a single-tenant, net-leased retail asset, there is a single metric that they should consider above all others.
By extension, investors should examine the rent’s relationship to that profitability. How much rent does the tenant pay relative to the profit made at the location? If the tenant’s sales drop 20%, will the store remain profitable? What about a 50% slump?
"The asset’s profitability to the tenant company is key, with all other criteria being equal."
There are, of course, many factors that contribute to the success and profitability of a particular store, such as location, the reputation of the company and even economic trends. A pharmacy with a solid national reputation could face losses if policymakers regulate the cost of medicine. Similarly, a restaurant chain known for comfort food may not fare well in a health-conscious market.
The best profitability indicator is usually a profit-and-loss statement specific to the subject location. If the investor is unable to obtain this report, they can’t truly measure the site’s importance to the tenant.
This is especially true in retail. Given the booming ecommerce industry and recent mergers and acquisitions among chains, many retailers have had to close stores and evaluate supply chains. In this environment, it’s crucial that investors choose stores with high profitability to ensure their investment’s longevity.
The new year hasn’t brought radical economic changes, but the pace of growth has slowed.
Labor market slowdown
The national economy’s solid 2018 performance continued in the first month of 2019 with brisk job creation, but faltered abruptly in February. Seasonally adjusted employment growth was a paltry 20,000 positions in February, compared to a robust gain of 311,000 the previous month.
Initial unemployment claims trended upward through the beginning of the year after hitting a 48-year low in September, feeding concerns that employment growth is slowing. Unemployment claims totaled 226,250 as of March 2. Despite increased jobless claims, the national unemployment rate remained exceptionally low at 3.8% in February 2019, 20 basis points lower than in January and 30 basis points lower than in February 2018.
Retail industry woes to continue
So far, it doesn’t look like 2019 will bring the retail sector any improvement over 2018’s abysmal performance. On the contrary, it seems retail store closings have only accelerated since the beginning of the year, with the number of announced closures already tallying nearly 5,000 according to Coresight Research. Major retail chains with stores newly on the chopping block include J.C. Penney, The Gap and Family Dollar. Payless ShoeSource stated it would close its U.S. and Canadian divisions entirely.
A lack of overall retail spending clearly isn’t the culprit behind the closures, as consumer expenditures remain high and the critical holiday sales period saw a whopping 5.1% year-over-year increase in 2018, positing the best numbers in six years, according to Mastercard SpendingPulse.
Federal government shutdown
The Q4 2018 edition of Insights observed that “the risk of another federal government shutdown during 2019 also has increased substantially” due to turnover of party control in the U.S. House of Representatives. That forecast may have been an understatement, as even before the new House members took their seats in January, the federal government ran out of funding for non-essential operations.
The shutdown’s exact cause was the inability of Congress and President Trump to agree on an appropriations bill, forcing nine executive departments to temporarily close. The dispute was largely tied to partisan differences over funding for a fortified wall along the U.S.-Mexico border.
When the 35-day shutdown—the longest in history—finally came to an end, it had cost the U.S. economy $3 billion in the fourth quarter of 2018 and $8 billion in first quarter 2019. While this may seem like a drop in the bucket in a $21 trillion economy, the figures do not directly capture broader, indirect fallout from the shutdown, such as interruptions in public services and damage to business and consumer confidence. Furthermore, at the local level, the direct economic fallout was especially damaging in certain markets, such as the District of Columbia, which lost $47.4 million in revenue.
GDP growth slows
As expected, annualized real gross domestic product (GDP) growth slowed somewhat to 2.6% during fourth quarter 2018. This was 80 basis points lower than the rate of expansion in the third quarter, and 160 basis points lower than in the second quarter. The deceleration brought the total rate of economic growth for 2018 to 2.9%, still a solid improvement on the more tepid pace of economic growth seen in 2016 and 2017. It is widely agreed upon that the recent tax cuts are the primary driver behind stronger GDP growth in 2018. It stands to reason that we can expect a return to more subdued growth in future quarters.
GDP growth in the fourth quarter of 2018 was again driven primarily by solid growth in personal consumption, with fixed private investment also contributing to economic expansion. Growth during the quarter was held back by a deceleration of government spending (at both the federal and state/local levels) and weakening net exports. Residential investment also extended its year-long streak of negative growth.
Stock market turnaround
Since the final quarter of 2018, the situation in the financial markets has again changed sharply, this time in a positive direction. After the markets entered a tailspin in the final quarter, the new year brought an extended rally reclaiming most of the losses from the late 2018 sell-off. The positive streak (which seemed to lose some momentum in early March) was partially sparked by a newly reserved approach toward interest rate increases by the Fed. As of March 21, the S&P 500 stood at 2,855, up 13.9% for the year.
Just as they played a large role in the stock market skid, the tech giants (particularly Apple, Microsoft, Netflix and Amazon) have contributed heavily to the recent rally. In fact, the decade-long bull market can be heavily attributed to the tech sector. This does raise some concerns for the near future: With market value so concentrated in a single industry, some economists feel that there is (slim) potential for a dot-com bust repeat.
A (temporary) end to interest rate hikes
As expected, the Federal Open Market Committee (FOMC) voted to raise the federal funds benchmark rate another quarter-percent at its December meeting, pushing the target to 2.55%. However, at its first meeting of 2019, the FOMC signaled a more patient approach to rate increases, and at the March 2019 meeting, the Fed further curtailed its plan to raise rates, saying that there would be no rate increases in 2019, mainly due to slower projected economic growth domestically and globally.
Higher interest rates have increased borrowing costs for companies and driven up the value of the dollar, which hurts the overseas business of U.S. companies. The ongoing trade war with China and the recent election has also heightened angst in the marketplace. A slowdown in recently rejuvenated inflation also influenced the Fed’s decision.
Consumer price inflation averaged 2.4% in 2018—the highest rate of inflation since 2011. However, there has been a marked decline in price growth over the last few months. According to the CPI-U index, average consumer prices in January 2019 were just 1.6% higher than they were a year prior, which was the smallest 12-month increase since June 2017.
"The bull market isn’t over yet, especially with the Fed’s more dovish approach to interest rate increases."
The inflation slowdown can be directly attributed to the protracted decline in energy prices, particularly gas prices. Prices at the pump hit a three-year low in annual growth in January of negative 10.1%. For perspective, the rate for the same figure three years ago was a positive 20.3%. The inflation rate for items other than food and energy remains near 2%.
Bond investors, pricing in the Fed’s plan to hold interest rates steady, lowered their inflation expectations and sent the yield on the 10-year Treasury plummeting to below the three-month yield on March 22, inverting the yield curve, which is a frequent precursor to recessions.
The economy will grow more slowly in the coming quarters than it did in 2018. The temporary stimulus from tax cuts will fade, allowing job growth, consumer spending and economic output to subside. Further economic slowdowns overseas will lead to weakening demand for exports. That said, the bull market isn’t over yet, especially with the Fed’s more dovish approach to interest rate increases.
The federal government will continue to be a very unpredictable wild card. The government already started the year on a bad foot with the shutdown and, if the president’s recently proposed budget is any indication, contention between the executive and legislative branches of government will only worsen in the near future.