scroll down
    You can also download a PDF file of this edition of Insights

Insights

October 2017 Edition

A Closer Look
Charles Hazen


Cover Story
Retail Re-Told:
Facts Counter Myth of Malls' Demise

Nick Hernandez


Investment: The Other Risk Management
Scott Fitzgerald


Halls of Learning Emulate Workplace Design
Phil Utigard


A Rebound, but with Uncertainty
Jonathan Chambers


© 2017 TRANSWESTERN    transwestern.com



Transwestern is a privately held real estate firm of collaborative entrepreneurs who deliver a higher level of personalized service – the Transwestern Experience. Specializing in Agency Leasing, Tenant Advisory, Capital Markets, Asset Services and Research, our fully integrated global enterprise adds value for investors, owners and occupiers of all commercial property types. We leverage market insights and operational expertise from members of the Transwestern family of companies specializing in development, real estate investment management and research. Based in Houston, Transwestern has 35 U.S. offices and assists clients through more than 180 offices in 37 countries as part of a strategic alliance with BNP Paribas Real Estate. Experience Extraordinary transwestern.com and @Transwestern.

Transwestern is actively working to further the use of paperless communications.
Sign up today to join our mailing list community.


Transwestern's Twitter Feed  Transwestern's Facebook Page  Transwestern's Youtube Channel  Transwestern's LinkedIn Page  Transwestern's Instagram Page  Transwestern's Flickr Page  transwestern's SlideShare Page  Transwestern's Pinterest Page  Tranwestern's Vimeo Channel  Transwestern's RSS Feed  Transwestern's LinkedIn Page

A Closer Look

A Message from Charles Hazen



We are in one of the longest-running economic growth periods our nation has ever experienced. It is natural to ask whether commercial real estate values are near their peak, and whether there are still viable investment opportunities available.

If we resist the temptation to paint markets with a broad brush, we find a wide range of property performance. Yes, there are attractive opportunities to acquire assets for value-add strategies, and there are markets and submarkets where demand exceeds supply, creating prospects for steady income and value appreciation. We also find property markets where either waning demand or supply saturation is creating headwinds that impede income and value growth.

Investors, as well as developers, tenants and landlords, must look beyond national headlines to make the most of their real estate decisions. We expose pitfalls and unearth opportunities by digging into market dynamics at the local level.

“We are in one of the longest-running economic growth periods our nation has ever experienced.”
Tweet this quote

In this issue of Insights, Transwestern explores some of the strengths and challenges that may otherwise be glossed over in high-level discussions of market performance. These include:

  • How retailers and their landlords are adjusting to changing consumer habits;
  • How educators are reining in costs and supporting new learning styles with flexible space designs; and
  • How Transwestern continues to find and vet investment opportunities.

There’s no question that we must be cautious in our assessments of commercial real estate opportunities. The smart path is to acknowledge that the economy may slow, and continue to invest in a responsible and cautious manner, relying on research and analytics in the process.

Regards,






Charles Hazen
President
Transwestern Investment Group
Facts Counter Myths of Malls' Demise

Nick Hernandez
Managing Director
Retail
Tweet this article

Headlines and social media have fueled a retail misconception by spotlighting store closures and the growth of online shopping, while largely ignoring retailers and retail landlords that are performing and even prospering in an evolving marketplace.

Facts and figures tell a different story, not of doom for brick-and-mortar stores, but of a U.S. market that is bringing store counts closer in line with other developed nations. Many enclosed malls are successfully adapting to changing consumer habits, continuing to draw tenants and customer traffic to their properties.

A number of chains have shuttered stores, and undoubtedly there will be similar closures announced in the months to come. But it would be wrong to chalk up those decisions entirely to the rise of e-commerce. Landlords, as well as lenders, investors, retailers and consumers, will all have a better understanding of the evolving retail industry if they bear these few points in mind.

Keep E-commerce in Perspective

Online transactions amounted to only 9 percent of U.S. retail sales in 2016, Census data shows, and nearly two-thirds of those online sales were with omnichannel merchants, which sell both online and in conventional stores. That means only 3.5 percent of last year’s sales volume transacted with purely online retailers.

In truth, brick-and-mortar stores remain an integral part of the retail landscape, which is why historically pure e-tailers including Amazon.com, Tesla, Casper Mattress and others are opening physical stores where customers can evaluate their products in-person.

With a clear perspective on the role of e-commerce, we must look for other reasons for recent store closings. And again, statistics provide at least part of the answer.

The U.S. is Over-Retailed

With 2,355 leasable square feet of store space per 100 people, the United States has more than five times the retail space per capita that is available in the United Kingdom or Japan, and over 40 percent more than Canada’s 1,677 square feet per 100 people, according to the International Council of Shopping Centers (ICSC). CoStar predicts the U.S. will shed approximately 10 percent, or 1 billion square feet, of its retail space over the next decade.

Those numbers suggest the retail industry is experiencing a correction, rather than an abandonment of the brick-and-mortar store model.

How well a given retailer performs in a correction is often a question of balance-sheet resiliency, and excessive debt can inhibit its ability to make needed adjustments. And a growing presence of private equity backing, which is often heavily leveraged, may be another factor in widespread store closures.

After Toys R Us filed for Chapter 11 protection in September, for example, in court documents CEO David Brandon cited competition from online and warehouse retailers as a factor in the retailer’s predicament. But Brandon also singled out the $400 million needed each year to service the company’s $5.3 billion in debt, which stemmed chiefly from a leveraged buyout that took the firm private in 2005.

Toys R Us isn’t alone. Consulting firm Alix Partners estimated that more than half of the retailers that announced bankruptcies in the first three months of this year had been acquired by private equity firms, up from an average 31 percent over the previous five years.

“Many enclosed malls are successfully adapting to changing consumer habits, continuing to draw tenants and customer traffic to their properties.”

Change is Constant

The use of smart phones to comparison shop, both outside and within stores, has changed the way retailers market goods, communicate with shoppers and capture sales. Malls are answering consumer preferences for authentic experiences by adding more dining options, theaters, bowling alleys, fitness clubs and even healthcare providers to the tenant mix. Many retailers offer free delivery to stores, allow in-store returns of items ordered online and supplement local inventories with regional fulfillment centers that ship items to customers.

Struggling Malls Find Alternative Uses

Landlords with malls in tertiary markets or trade areas that suffer from reduced retail demand may still revitalize their properties by exploring alternative uses. Most malls command excellent roadway access and parking that can appeal to office tenants, healthcare providers and educational institutions, while excess surface parking may be parceled out for multifamily housing, hotels, restaurant pads or other development.

Depending on the circumstances, these new uses may fill space alongside existing retail tenants or may constitute a complete conversion to new activities.

For more insight into mall reuse strategies, read Transwestern’s report, Why Mall Reuse is Just Beginning, at: twurls.com/malls

The shopping malls and stores that continue to perform well today certainly look different than they did 10 years ago. But those same stores and properties looked different five and 10 years before that, too. Retailers and retail landlords know they must evolve to retain shopper interest. Today that evolution has a few added aspects, including omnichannel sales models and a wider mix of uses to generate customer traffic.

What’s in Store?

Conventional retailers and a growing number of online merchants are realizing the vital role that brick-and-mortar stores play. Contrary to the myth of the mall’s demise, many Class A malls in excellent locations are thriving. Contracting store footprints and closures have required adjustment, but that contraction has created opportunities to bring in exciting new uses. Mall productivity has remained steady and rose 0.7 percent in 2016 to $465 per square foot, according to ICSC.

In the months and years ahead, the shopping mall will continue to evolve, along with the consumer. And rest assured, brick-and-mortar stores will change as well, but will remain an integral part of the shopping experience.




Nick Hernandez
Nick Hernandez
Nick.Hernandez@transwestern.com
+1 713.270.3354


The Other Risk Management

Scott Fitzgerald
Executive Managing Director
Transwestern Investment Group
Tweet this article

The commercial real estate market has enjoyed protracted economic growth since the Great Recession, and the longer this modest prosperity lasts, the more investors deliberate whether we are at or near a valuation peak and in danger of entering a downturn.

“As in the insurance industry, prudent investment strategy is often a matter of assessing and managing risks.”

We may be in the later innings of value appreciation on some fronts, but real estate is predominantly a local business made up of diverse storylines playing out simultaneously. Where we are in the investment cycle varies by market and asset type, by submarket and property subtype, and even from asset to asset.

As in the insurance industry, prudent investment strategy is often a matter of assessing and managing risks. This may be the right time to make a particular investment, provided the opportunity is priced appropriately to its associated risks.

Risk assessment requires thinking independently from the herd. Capital has been chasing stabilized, core assets for several years now. In particular, investors have gravitated to fully occupied office buildings in the dense inner cities of gateway markets. Such core assets have historically appealed to conservative investors, who value a steady return over outsized, riskier income streams.

Recently, however, competitive bidding has driven down capitalization rates on many of these assets to below 5 percent, with limited prospects for value appreciation and little margin for error. It is ironic that these core neighborhoods now represent one of the riskiest environments in real estate.

There may still be reasonably priced, high-quality, stabilized properties available in these popular urban settings. As in any market, the key to differentiating good opportunities from bad is to price risk, which may or may not agree with price calculations based on recent comparable sales. Instead of asking the market cap rate, investors should assess the risk associated with the asset and then determine the lowest cap rate they are willing to accept in exchange for taking on that risk.



GILT Distribution Center: Louisville, KY

From this risk-reward standpoint, a handful of markets and product types may offer more attractive investment propositions, and less downward pressure on cap rates, than the highly competitive core markets. Here are a few possibilities:

Industrial in Demand

Transwestern Investment Group has purchased about 10 million square feet of industrial properties through clients and managed funds, and our heaviest focus today is on this sector. We estimate that e-commerce accounts for almost 30 percent of industrial demand, with e-commerce companies and brick-and-mortar retailers alike seeking fulfillment-center space to support their online sales.

We and some of our industrial investors believe that they are getting significant exposure to the nation’s robust retail sales by way of the e-commerce fulfillment centers we are buying, rather than through acquisitions of conventional shopping centers.

“We estimate that e-commerce accounts for almost 30 percent of industrial demand.”

The news media has chronicled the recent development of massive fulfillment centers measuring 1 million square feet or more for Amazon, Walmart and other retailers. Companies operating the largest fulfillment hubs often locate in regional industrial parks with intermodal transportation access, and may supplement those facilities with smaller fulfillment centers in dense urban communities that reduce the distance of “last mile” deliveries.

User demand is far more diverse than those headlines would suggest, however. With the rise in e-commerce, companies of all sizes need space to receive products and process orders for delivery to customers. A growing number of users select warehouses that afford them two-day delivery access to as many U.S. customers as possible, so many are taking space in the Midwest.

That’s why our discretionary TSP Value and Income Fund has been an active buyer and accumulator of assets in the Midwestern regional distribution markets. For example, a building we own in Louisville, Kentucky, is the only distribution center for GILT, a discount retailer of luxury goods. It is telling that the company chose that spot for its fulfillment operation.

Under-Served Markets

A great deal of multifamily construction in this cycle has delivered luxury apartments, mostly in urban core markets. We believe that a segment of renters has been priced out of those new downtown projects and would lease space in suburban, mixed-use projects that offer strong amenities and a walkable live-work-play environment, perhaps near a major university or entertainment district. The lower development costs outside the city center enable these assets to offer more affordable rental rates that still generate excellent returns.

Across property types, we are quite a few years along into this growth cycle, but fundamentals in many markets are surprisingly healthy. Regulations since the financial crisis have made construction financing challenging to obtain, exerting a greater supply constraint than in some previous cycles and allowing fewer opportunities for overbuilding. Investors must be cautious and appropriately price risk, particularly in today’s low-return environment, but there continue to be attractive opportunities in industrial and a few value-add segments of the market.


Scott Fitzgerald
Scott Fitzgerald
Scott.Fitzgerald@transwestern.com
214.572.9813


Phil Utigard
Executive Vice President
Education Advisory Group
Tweet this article

Just as increased collaboration and changing work habits are reshaping the office environment, market forces are transforming the design of classrooms and schools. These tech-powered, flexible educational spaces enhance the learning experience while helping students to develop collaboration skills that many of them will need in their chosen careers.

Three trends driving these changes are a growing consumerist approach to pursuing an education; the need for cost control; and advancements in teaching and learning. Each of these trends affects schools, universities and for-profit providers and, as a result, has significant implications for owned and occupied real estate in the education sector.

Appealing to the Student Consumer

Today’s young job applicants frequently ask potential employers how their work will add value and fit into a larger mission, and many will choose employment based on their personal values. They are more likely than previous generations to demand social and environmental responsibility from their employer, and to expect a variety of nearby housing, dining and entertainment options, preferably within walking distance of their job and public transportation.

“Educators can cater to students' demands by offering an appealing learning environment and the right mix of amenities for socialization and collaboration."

Many students take a similar, consumer approach to education. They seek practical skills with applications in solving real-world problems. They know the training they want, what they expect to pay for it, and when and where they plan to receive it. If they can accomplish this without making lifestyle sacrifices, even better.

Educators competing for promising students can cater to these demands by offering an appealing learning environment and the right mix of amenities for socialization and collaboration. More and more education centers occupy converted downtown office buildings or even multitenant properties that provide convenient student access and urban, live-work-play amenities, which may be lacking on a traditional campus.

Cost Control Measures

Some education providers are choosing to free capital for operations by leasing instead of owning their space and are amortizing tenant improvement costs over their lease terms. At the same time, creating a more flexible environment with better space utilization that considers new, integrated methods of learning can reduce square footage requirements, bringing down costs.

“Many schools are using sale-leaseback transactions to finance investments."

Lecture halls and classrooms, for example, are being replaced by multiuse rooms with advanced audio-visual capabilities, much like the team rooms in a modern office. Instructors and students simply log in to call up course materials, rather than relying on props and fixtures that would limit a room’s use to a single field of study. Dissimilar courses use the same room in succession with little down time, compared with traditional classrooms that are seldom used more than 40 percent of the school day.

Needs vary widely and depend largely on the coursework offered. A university may need to modernize aging buildings or convert lecture space to laboratories, for example, while another school may seek to eliminate excess square footage and add food services and collaboration areas. Many schools are using sale-leaseback transactions to finance investments in mechanical systems, technology enhancements, aesthetic upgrades and health and safety improvements.

New Thought on Learning

In most areas of study, today’s coursework de-emphasizes lectures and instead puts students to work attacking real-world issues, often collaborating in small groups that may cross disciplines. Off-site practicums augment learning with real-life experiences in the surrounding community, which raises the importance of the school’s location. Because learning takes place anywhere the individual or group chooses to work, building designs must accommodate and encourage this collaboration.

The newest educational facilities offer features that have taken hold in the business world, including Wi-Fi connectivity throughout the property. Libraries, corridors, courtyards and coffee bars offer seating where students can gather, complete with charging stations and glass walls or marker boards for writing. Some gathering spots will include multimedia equipment and large video monitors for student use.

“The newest educational facilities offer features that have taken hold in the business world."

Food and beverage options are critical, because they enable students to remain on the property, rather than sacrifice learning time traveling to and from off-campus eateries. In addition to a café or cafeteria, the coffee bar is another addition that many learning institutions are borrowing from the modern workplace.

Tying It Together

Part of the design challenge in these new learning centers is to retain and project the school’s identity in a multipurpose facility, often in a vibrant urban environment that competes for its students’ attention. This is important for long-term funding, because tomorrow’s alumni contribution is often determined by today’s student experience.

As with companies, each school has a brand that helps to differentiate it in a crowded marketplace. Graphics and color are important elements that distinguish the property and provide branding and cultural messaging. These visual touches also constitute a low-cost solution that helps to build student loyalty.

Given their shared goals of attracting and retaining bright minds, it isn’t surprising that educators and office developers today employ many of the same tactics when it comes to real estate. Both are intent upon cultivating a broad range of holistic amenities at and around their properties, keeping in tune with a live-work-play-learn lifestyle.

William James College

Learn how a graduate school in the Northeast partnered with Transwestern to locate, acquire and convert a former office building into an 83,000-square-foot educational oasis.


Source: twurls.com/wjc

Phil Utigard
Phil Utigard
Phil.Utigard@transwestern.com
312.881.7060
Transwestern’s Education Advisory Group works with public and private universities; for-profit institutions; vocational, professional and charter schools; and private equity firms to address complex real estate challenges. Our national team of experts considers the school’s existing population, anticipates future needs, analyzes financial implications, explores sustainable real estate solutions, and helps inspire learning through operational efficiencies and adaptable space configuration.
The National Economy:



But with Uncertainty

Jonathan Chambers
Senior Associate
Delta Associates
Tweet this article

At the end of the third quarter of 2017, the U.S. economy remains in good shape thanks mainly to strong consumer spending and job creation.

Gross Domestic Product

After yet another disappointing first quarter, real gross domestic product (GDP) rebounded markedly in the second quarter to 3.0% — the fastest pace of national economic expansion since the first quarter of 2015 and in line with our prior predictions. Consumers continue to propel the economy forward, with personal consumption increasing by 3.3% during the quarter. Unfortunately, strong consumer spending has done little to lessen the turmoil in the brick-and-mortar retail sector.

Nonresidential fixed investment, federal spending, and private inventory investment also contributed to robust GDP growth. Holding back the expansion were slowdowns in residential fixed investment and state and local government expenditures.

Looking ahead, we expect the disruption and damage caused by Hurricanes Harvey and Irma to have an impact on economic growth in the third quarter, but the GDP growth rate will still be around 2.5%. The most recent report from the Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters projects real GDP growth at 2.6% in the third quarter of 2017. Looking further ahead, GDP growth is expected to be 2.1% in 2017, 2.4% in 2018, and 2.2% in 2019.

Job Growth

The national economy continues to add jobs, but the pace is beginning to display signs of slowing. Notably, July and August were the only consecutive months to experience declines in job additions on a seasonally adjusted basis during the 12-month period ending August 2017. In sum, the economy added 2.1 million new jobs during the period.

“Most employment sectors continue to see positive growth and have been consistently adding new positions to meet strengthened demand."

Most employment sectors continue to see positive growth and have been consistently adding new positions to meet strengthened demand. This is especially true for the Professional/Business Services and Education/Health sectors, which have a pronounced shortage of qualified workers. On the other side of the coin are the Retail Trade and Information sectors, both of which are struggling from disruptive competition via the internet. Combined, the two sectors saw payrolls drop by just under 100,000 during the year ending in August.

Another area to watch is public sector job growth, which has been trending downward for months due in no small measure to the federal government. The federal government has only recorded a single month of positive job growth in all of 2017 so far.

Unemployment

Initial unemployment claims continued to hover around three-decade lows through most of August 2017, but jumped nearly 32,000 by mid-September. After falling to a 17-year low of 4.3% in May 2017, the seasonally adjusted national unemployment rate ticked back up 10 basis points in August to 4.4%. We expect the unusually low level of unemployment to climb above 4.5% before the end of the year.

Corporate Profits

Following a first-quarter decline, corporate profits before taxes were back on the upswing during the second quarter of 2017, ending the period at $2.14 trillion annualized and seasonally adjusted. Healthy domestic consumer spending continues to be the major driving force behind corporate earnings across most industries, while weak exports and meager productivity growth have weighed on margins. Looking forward, profit growth will remain muted as continued low unemployment places upward pressure on wage growth, increasing unit costs. However, a weaker U.S. dollar should boost real net income from business conducted overseas.

Housing Market

According to the National Association of Realtors, the annualized pace of existing home sales was 5.35 million in August 2017, up from 5.34 million a year prior. The current sales pace is the fastest seen since before the national housing crash in 2007. Sales would likely be even higher if not for a severe lack of inventory. The average sale price for an existing home was $294,600 in August 2017, up 4.5% from $282,000 in August 2016.

Mortgage rates have consistently been in decline since March 2017, but trended upward midway through September. Per Freddie Mac, the average commitment rate for a 30-year, conventional, fixed-rate mortgage rose to 3.83% as of Sept. 21, up from a 2017 low of 3.78% in the two weeks prior. The increase mirrored a corresponding 7-basis-point hike in the 10-year Treasury yield. We expect rates to rebound back above 4% shortly as the Fed winds down its expansionary policy in the coming period. The 2017 annual average is expected to be significantly higher than 2016’s, when 30-year rates bottomed out at 3.42% in October, which was the lowest since April 2013.

Interest Rates and Inflation

The Federal Open Market Committee (FOMC) hiked interest rates by a quarter percent at both its March and June meetings, with another increase likely coming in December. In addition, the Fed has indicated that it will shortly proceed to normalize its balance sheets by winding down its security-purchase program. The decision to end quantitative easing is driven mainly by strong consumer spending and the tight labor market. Unfortunately, weak inflation continues to be a concern, at least in the short term.

Consumer price inflation started off the year strong, but weakened in the spring. However, the rate of price growth has shown signs of rebounding over the summer. The CPI for all urban consumers increased 1.9% over the 12 months ending August 2017, just shy of the Fed’s 2.0% target. The increase was driven heavily by a sizeable 10.4% increase in gas prices as well as 3.3% increase in shelter costs.

Economic Outlook

Our economic outlook for the next several months remains bullish. Consumer sales, the labor market, and business spending remain fundamentally strong. Lost economic activity due to severe weather in some parts of the country will result in a modest pullback in GDP growth in the third quarter, but we expect it to rebound. Overseas, the outlook is murkier and less upbeat, but a number of G7 nations — particularly Canada, Japan, and Germany — have recorded robust economic growth so far this year.

“Domestically, the greatest unknown regarding the future performance of the economy is public policy."

Domestically, the greatest unknown regarding the future performance of the economy is public policy. Congressional Republicans and President Trump have recently shifted their focus from Obamacare to long-awaited tax reform. However, the president’s proposal to cut corporate taxes drastically from 35% to 20% is likely to be watered down, as it would cost the government roughly $1.5 trillion over a decade according to most estimates. The administration has also pledged to increase infrastructure spending across the nation, which would provide another considerable boost to the economy. However, in September, President Trump abandoned his preference for public-private partnerships in rebuilding the nation’s infrastructure, preferring instead to increase the burden of states and localities. Overall, non-defense federal spending is expected to be flat in the period ahead.

Based on the Fed’s schedule of future funds rate hikes and plans to shrink its balance sheet, higher interest rates in the near future are a given. However, relatively flat price inflation and continued uncertainty should keep long-term interest rate increases modest. Despite the higher cost of borrowing, we expect robust consumer spending to remain the cornerstone of the economy for the foreseeable future.


Jonathan Chambers
Jonathan Chambers
Jonathan.Chambers@deltaassociates.com
512.314.3572

Delta Associates