A look at some of the challenges and opportunities facing commercial real estate sectors.
ALL FIVE SEGMENTS of commercial real estate – office, industrial, retail, multifamily and hotels – present significant challenges as well as opportunities. What, specifically, are these challenges, and what opportunities do they offer for developers, investors and others?
Hotel construction is up due to increased travel
The entire hospitality industry, from budget hotels to luxury resorts, has grown exponentially over the past decade. The primary reason for this growth has been the overall worldwide increase in both leisure and business travel. Much of the increase in leisure travel is tied to the growing global middle class, while the economy’s expanding service sector requires increased personal contacts, resulting in more business travel.
In addition, the cost of air travel has dramatically decreased since the industry’s deregulation in 1978. Automobile gas prices have remained a bargain, as compared to other inflation-adjusted consumer products. Demographics are also having a positive impact on travel. Millennials are much more frequent travelers than other cohorts. They may not collect things, but they do collect “experiences,” and have demonstrated a willingness to spend far more money on travel than previous generations.
On the supply side, construction of new hotels has kept up with demand. The big international chains, primarily Hilton and Marriott, have added significant supply by introducing new brands. Marriott now has 30 different hotel brands; Hilton has 14.
What threats does the hotel business face? One of the most well-known is Airbnb, which is now so large that it has a stock market valuation higher than that of Marriott International. Airbnb will continue to be a disrupter for the hotel industry, but not in the same way that Uber has upset the taxi business. Airbnb offers different types of experiences, whereas Uber basically offers the same experience as riding in a cab, but does so more efficiently.
One specific area where Airbnb has made an impact is with long-term stays and during peak demand periods, such as Super Bowl and U.S. Open weekends. In those instances, Airbnb has kept hotels from maximizing their room rates by temporarily expanding the supply of rooms, decreasing the hotels’ ability to raise prices.
The larger threat to hotels is actually more subtle. It comes from online travel agents (OTA), firms such as Expedia, Priceline, Travelocity and Hotels.com. These companies are quietly expanding as consumers book more of their travel plans on these websites. Airlines don’t pay these sites a commission, so the OTAs have to look to hotels, tour groups and cruise ships for their profits.
In addition, the two largest OTAs, Priceline and Expedia, are now going directly after Airbnb by adding home rentals to their sites. Expedia bought Homeaway.com in 2005 and Priceline purchased Booking.com several years later.
More millennials prefer to lease apartments rather than own homes
The multifamily housing segment has also seen tremendous growth. Demographics again have played a role: Millennials are more transient than previous generations and are delaying marriage. Thus they tend to prefer leases over homeownership.
Beyond demographics, other apartment trends include increasing demand for smaller units in more convenient urban locations, rather than larger apartments in the suburbs; in other words, “place over space.” The return to downtown living is now a major trend in cities throughout the U.S., and apartments meet this new demand nicely.
Although individual units may be smaller, that reduction in dedicated space is offset by lobbies and other shared amenities such as roof decks, communal kitchens and swimming pools. In fact, many in the industry now refer to these buildings as “college dorms for older people.” Some buildings even offer “co-living” spaces, shared units that come complete with housekeeping services, community events and more. These units are primarily geared to millennials who are moving out of their parents’ homes.
Another area of growth in this sector has come from the opposite end of the demographic spectrum, “empty nesters,” aka retiring baby boomers, many of whom are looking to downsize and relocate to a more walkable urban setting. One developer has suggested that his ideal new apartment building would provide “microapartments” for millennials on the lower floors and large penthouses for empty nesters on the top floors.
One challenge for the apartment sector involves the rising construction costs that require developers to pursue wealthy renters. Almost two-thirds of all new apartments in the U.S. are now priced at rents requiring household incomes of over $100,000 per year, a market segment that is contracting.
Retail purchases are losing out to experience spending
The retail sector has clearly seen more disruption than any other real estate sector in recent years. National retail chains are filing for bankruptcy, and individual stores are closing on Main Streets and in malls. The origins of this trend are obvious; e-commerce is generally less expensive and more user-friendly for the consumer. Contrary to most people’s perceptions, however, e-commerce still accounts for less than 10 percent of all retail activity.
A less obvious contribution to the retail sector’s current troubles is demographic. People between the ages of 18 and 35 have traditionally been those with peak purchasing tendencies. But today’s millennials, as noted earlier, put a lower priority on buying items than did previous generations. Shopping is no longer a major social activity for them. They are more inclined to spend their money on technology – think cell phones – and experiences – think travel – than tangible goods – think clothing.
Compounding this trend is the fact that the U.S. is already “over-retailed,” with five times as many shopping centers per person as Great Britain.
Is retail as we know it dead? Not exactly. Cities will always have a few upscale shopping malls, and the ubiquitous neighborhood strip centers with grocery stores will continue to thrive. Otherwise, though, in the future most brick-and-mortar stores will be selling goods at the highest and lowest price points. For example, shoppers will still go to specialty stores like Tiffany’s for the personal experience, and discount stores like Dollar General for the low prices, but fewer will continue to go to general merchandise stores like Macy’s.
Retail developers are trying to fight these trends. They are transforming their retail centers into more “experiential” destinations by converting empty department stores into entertainment centers, themed restaurants and bowling alleys. They are also leasing space to churches and even retail medical clinics.
One piece of good news for the retail sector is that restaurants have grown dramatically, offsetting some of the stores’ losses. In fact, for the first time ever, U.S. restaurant sales eclipsed those of grocery stores in 2016.
Finally, some retailer operators are even allowing the e-commerce “devil” onto their turf, with Amazon stores and lockers, where people can pick up or return items purchased online at a convenience store or, preferably – for the mall owner – a central location in a mall. And, of course, it will be interesting to see how Amazon’s acquisition of Whole Foods will play out. The most probable explanation for this transaction is that Amazon is not, in fact, a retailer, but rather an intermediary. Thus owning and controlling a grocer gives the company a new platform to provide another important business line.
The retail sector will remain challenged. The survivors will be those that adapt by converging their physical stores with now omnipresent e-commerce platforms.
Industrial is the strongest commercial real estate sector
The retail sector’s losses are, however, matched by the industrial sector’s gains. Industrial real estate is currently the strongest and most profitable sector in commercial real estate. Items that once would have been bought in stores are now being purchased online and shipped directly to consumers from specialized warehouses, also known as fulfillment centers. Unlike traditional bulk warehouses, these fulfillment centers are generally smaller, located closer to urban areas and contain a much wider range of products. In addition, e-commerce requires about three times more distribution space per dollar spent than brick-and-mortar stores, as it involves a far more complicated distribution process.
Distribution centers are also becoming more automated, which means they will require smaller parking lots, fewer offices and, sometimes, a minimal amount of heating and lighting, as robots don’t care about temperature or need to see.
Interestingly, industrial real estate is now more closely correlated with consumer consumption indexes than manufacturing indexes, another sign that America now consumes more than it makes.
Finally, these retail and industrial trends may intersect in the near future, with old, dead shopping malls being converted to distribution facilities for e-commerce retailers.
Office tenants are becoming more efficient with their space, but putting more stress on common areas
This final segment is also going through significant changes. Many companies are following their employees back to the cities, relocating their offices from the suburbs, into new or renovated urban buildings designed with open floor plans. The goal is fluid office layouts that encourage chance encounters and collaboration among departments – think escalators and open stairways rather than elevators.
The goal of these workspaces is “collisions” among employees. The online retailer Zappos actually tracks the number of collisions per employee per square foot per day in its Las Vegas headquarters, via employees’ smartphones.
Office amenities are morphing from distractions like foosball tables and nap pods to services that help employees save time, such as concierges who can make dinner reservations and travel arrangements. Some even offer pet care and on-site health care.
Companies’ preferred locations within cities are also changing. Some employees now value “character over cachet.” Many tech companies, in particular, are locating in “edgy” sections of town rather than the traditional downtown setting. Twitter’s corporate headquarters in San Francisco, for example, is located in the city’s gritty Tenderloin district, and Google’s Pittsburgh offices are located in a 100-year-old former Nabisco cookie factory building in the city’s East End.
The full-time telework trend seems to have fizzled out. Although some companies still allow employees to work from home one or two days each week, employees still want to be around others, and companies want people in the office for collaboration.
Coworking facilities are an ongoing trend; independent companies typically build out unique space and then sublease desks and offices, or even small suites, to individual entrepreneurs, startup companies and others.
One underlying dilemma for developers in the overall office sector is that tenants are becoming more efficient with their space utilization; they continue to put more people in the same square footage. This trend puts stress on parking lots, restrooms and other common areas.
The Commercial Real Estate Challenge
In addition to these sector-specific trends, some industrywide trends also have major implications for commercial real estate. These include additional impacts from technology, including the growth of the “gig” economy, automation, 3-D printing, virtual reality, big data and even artificial intelligence. (These trends will be discussed in the second installment of this series on commercial real estate.)
The challenge for the commercial real estate industry will be to determine how best to take advantage of these trends and opportunities. Constantly observing the world around you, being as knowledgeable as possible and, most importantly, always being open minded to new ideas will enable you to take full advantage of these exciting times.
By Bill Hunt, president, Elmhurst Group, and Governor and chairman, NAIOP Research Foundation, firstname.lastname@example.org
This article was originally published in the spring 2018 issue of Development magazine. It appears here with permission from the publisher, NAIOP.