Arlyn Stoik, Principal based in Orange County office, featured in this month’s Maple Business Council newsletter discussing “The acceleration of change in commercial real estate.”27 May 2020
In the commercial real estate advisory business, our job is not to predict the future. No one can. Rather we try to interpret and understand the most current data, follow social and economic trends, keep pace with new technology, underwrite the risk in real estate decisions, and help create and execute strategies that provide our clients with the most stable and profitable long-term outcomes.
Well, the first quarter of 2020 was progressing nicely and according to plan with clients experiencing strong business growth, real estate values at all-time highs, and a market where capital was plentiful and inexpensive.
Things were great… until they weren’t. Most of us did not see this coming. As I said before, no one can predict the future… except maybe Bill Gates.
When we talk about the effects of COVID-19 on our society, both short term and long term, it is nearly impossible for us to accurately predict what it will mean for our lives going forward. Without question it is easy and fashionable to overstate the long-term impacts with broad statements like “things will never be the same again” and the ongoing narrative that the sky is falling. Then again, we have to ask ourselves will the challenges we face in the near term radically change where and how we live, work, shop and congregate in the future. Will they completely disrupt how we interact with physical space?
The commercial real estate market is fluid and incredibly resilient. Both owners and occupiers are now being forced to reconsider this relationship in all asset classes. How will these different asset classes be reshaped, if at all, by this current crisis? Some change is inevitable but to contemplate the emptying out of central business districts and the death of the dine-in restaurant experience is likely exaggeration.
Commercial real estate is a broad class of asset types from shopping centers to office buildings, warehouse and manufacturing facilities to data centers, and multi-family residential to hotels. It is an industry of creativity and change, of old traditions and rapidly evolving technology. COVID-19 is having a profound impact on all aspects of society and the commercial real estate market is no different. But not every segment will be impacted in the same way. Below we have provided a quick look at the recent state of the southern California marketplace and a few key changes affecting the office, retail, and industrial market sectors.
During the start of the new year, southern California’s office market experienced overall gains and carried forward momentum from 2019. Leasing activity was robust, employment numbers strong, vacancy rates relatively low, and significant new development activity underway to meet the market demand.
Over the past several years, the office environment has been moving toward higher density, collaboration spaces, open work settings, co-working, and amenity space such on site dining and fitness. While the push has been to create efficiency in occupancy, most organizations now understand that your office environment reflects company culture and is a vital tool to recruit and keep top talent.
Over the past few months, as we have been required to work from home and embrace sometimes foreign technology, the forced acceleration of how companies use of this new technology has opened many organizations’ eyes to how productive their workforce can be working from home. Will this trend continue after the current pandemic ends? Will office space requirements decrease? Will driving to the office in horrible rush hour traffic or riding within packed subway cars be the exception? These questions are still yet to be answered but need to be contemplated.
As we begin to re-open the workplace, new rules and procedures for the re-opening of the traditional office completely fly in the face of the previous trends of densification and in-person collaboration. As social distancing continues to impact behavior in the short term, many believe we will see the density of office space decrease. Ultimately requiring more space per employee and offsetting the decreased demand caused by work from home. Some believe that the demand for office space will actually increase in the long term because of this. And where will those offices be located? In many urban centers, a bigger concern is how employees travel to and from work, which in many parts of the world require the use of public transportation. Will the suburban office movement reverse the trend of the growth of central business districts?
One thing is certain. All organizations will need to show flexibility with their employees as we find our way through this crisis. This flexibility may also create structural changes in real estate ownership as tenants demand increased flexibility. Are long term leases a thing of the past? Will flexibility ultimately rule the day? And how does that affect the value of these assets if long term leases with stable credit worthy tenants are no longer the norm? The future of the workplace seemingly has many more questions than answers.
Retail in southern California, like most regions, has been relatively flat with negative absorption in most submarkets, nominal rental growth, and limited net new development. The saving grace for the region is southern California being a prime tourist destination pouring billions of dollars into the economy. California is also a state of progress and change. It is where new retail formats and concepts will incubate and grow, ultimately reshaping the shopping and entertainment experience of the future.
Retail has been one of the sectors most impacted by COVID-19. With recent reports that over 20 million U.S. workers have lost their jobs in the past month, consumer spending has been dealt a devastating blow that will take significant time to recover. In March alone, brick and mortar stores saw their sales decline 8.7% from the previous month, based upon information from the US Department of Commerce, with apparel being the most severely impacted, seeing sales drop over 50%.
What the current crisis has done is accelerate the headwinds and trends that have already been impacting the retail sector with the growth of online shopping. During the pandemic, with most retail stores being unable to operate and restaurants being forced to survive on take-out and delivery, e-commerce, along with grocery stores and pharmacies, have supplied consumers with their basic needs. This trend will now continue at an accelerated pace as acceptance has been forced on the population.
Beyond consumer trends, as the economy struggles and unemployment increases, the result has been the significant reduction in the purchasing of non-essential discretionary items. The devastation cannot be underestimated. It will have long term implications on retail and the retail real estate marketplace – a sector that has been struggling to find its footing. The news is full of stories detailing the fall of many fashion and soft good retailers, department stores, and restaurants across the country that in many cases had been struggling mightily prior to COVID-19. We expect a number of additional retailers with unhealthy balance sheets, an inferior service offering, and/or those without a strong omnichannel presence will ultimately close for good. Others will rationalize their footprint and rid themselves of underperforming locations. But good retailers with the right concept, story and value proposition will always thrive and we will see incredible new concepts rise from the ashes. We will also see existing brands and shopping centers re-emerge better than ever.
Southern California’s industrial market is one of the most important in the country. Los Angeles is the primary point of entry of goods coming from Asia for further distribution throughout the country. In addition to distribution and logistics, the market is incredibly diverse including manufacturing, aerospace, apparel, food processing and packaging amongst many other categories. It has also been one of the tightest in the country seeing strong rental growth over the past several years. Part of southern California’s challenge is simply the lack of available land for new industrial development.
Industrial has traditionally been one of the better sectors to weather economic challenges compared to other property types. The logistics sector in particular has been very resilient during this pandemic as e-commerce continues to expand at a rapid pace. We have all witnessed the Amazon or Fed Ex trucks whizzing by our homes daily. We have also witnessed disruption to global supply chains which will force many to re-evaluate near sourcing of products and manufacturing thereby strengthening the domestic supply chain. The acceleration of this reshoring combined with an increasing drive for efficiencies via implementation of automation and technology will drive change and adaptation in the industrial marketplace
A New Normal
As noted in the Avison Young report “Evaluating the New Normal for Commercial Real Estate” organizations need to plan ahead, starting with short term-priorities and considering potential longer-term solutions. But claims of a “new normal” that is radically different from the old appear at the very least premature and in many cases misplaced; for now, they should be treated with caution.”