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McNellis: Is Retail’s Middle Earth Flat?

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John McNellis, McNellis Partners, Palo Alto

By John McNellis

John McNellis Partners Making it in Real Estate Palo Alto commercial real estate advice how to be a developer advice lessons
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We own and develop suburban neighborhood shopping centers within about a two-hour drive of San Francisco. We both build new projects and manage a portfolio of centers that we have developed over the past thirty three years. We thus have leasing opportunities almost weekly. Unfortunately, our opportunity is usually to lease the same space for less money than we did ten or even twenty years before. I’m not talking inflation-adjusted less money, I’m talking less money.

Before diving into the weeds, I should point out that we tend to own “A” locations in “B” to “B+” cities. That is, solid, middle-class cities with decent incomes and at least a measure of growth. We also own several “A” locations in a decidedly “A+” town—Palo Alto, but more on that later.

This week we agreed to lease a 3,000 square foot space in our center in Modesto for thirty cents a foot a month less the previous tenant was paying. Last week, we reluctantly signed off on a letter of intent for a new casual dining restaurant to replace a failed restaurant at a great freeway exit on Interstate 80. This new tenant will pay about 90 percent of what the original operator’s rent was in 1998. Last summer we shook hands on building a new Bay Area store for a major supermarket chain at a rent about 20 percent a year less than the last deal we did with this same chain a dozen years ago.

We find ourselves happy—nearly giddy—when a tenant exercises an extension option without demanding to renegotiate it. And we are more than content to extend leases upon virtually the same terms the tenants are now enjoying. I can go on, but you get it: Our world is flat.

And if our hotbed of economic development—the greater Bay Area—is flat, what’s that say about the rest of the country? Plenty. According to the ULI Real Estate Consensus Forecast released the end of October, retail’s malaise is nationwide. Retail’s national vacancy rate remains a tick above its 20 year average at just under 11 percent and, while rental growth for this year is estimated at 2 percent (slightly higher than the 20-year average of 1.4 percent), this slightly good news is offset by the ULI’s prediction that rental growth will falter and drop below average over the next several years.

Of the many excellent ways to go broke, relying on national averages to predict that most local of industries—real estate—is among the top. If the average national rent growth is already as flat as a newly-poured foundation, what are the chances your region is negative?

We, at least, cannot blame the internet. Because we only develop grocery-anchored neighborhood centers, we enjoy a niche—necessity retail—that is, for all practical purposes, immune to the depredations of the internet. Whether the net truly poses that formidable a threat to retail in general is a topic for another day, but only the wildest-eyed futurists think it will disrupt grocery stores, pharmacies, pizza parlors, nail salons and the other habitués of our centers.

If it’s not the net, what is it? What’s keeping retail catatonic? The usual suspect: greed. Greed in the form of a legacy of overbuilding. According to Forbes, we have about 50 square feet of retail space for every man, woman and child in the USA. By comparison, Europe has 2.5 square feet. The one economic law that we should all grudgingly respect—supply and demand—cannot, pardon the expression, be trumped. If a tenant has a choice of even just two competing locations, one landlord goes broke while the winner goes home with less than he had hoped.

In addition to the universe of empty storefronts, retail is staring blankly at the hollowing out of the middle class. The “nothing more than a dollar” strip centers seem to be doing as well as the ultra-luxury high end boutiques. It’s the middle-of-the-road retailers that have the clerks listlessly playing Candy Crush on their smart phones.

Back to our portfolio. Our middle-class centers are staying leased because we have the best locations in town. We are those winners going home with less. But until we have real, sustained income growth for our citizenry, we will be forever pushing string when trying to increase our rental rates.

Exceptions don’t prove rules, that canard has never made any sense. But they do highlight a rule’s general applicability. In our “A+” town, Palo Alto, we have had real rental growth. Yesterday, one tenant and I agreed that rates had increased about 26 percent over the past four years. Why? Because, as the brains, if not the heart of Silicon Valley, Palo Alto is on fire, with both explosive job and income growth.

Properly viewed, retail is a national economic mirror. The “have-a-lot-more” locations are doing splendidly. The rest of the country is limping.

John E. McNellis is a Principal at McNellis Partners in Palo Alto, Calif.

mcnellis-book-coverTo read more from McNellis, please consider his book Making It in Real Estate: Starting Out as a Developer.