Key Occupancy Data Hits 11-Year Low, Indicating More Retail Vacancies May Be Ahead
There's been a lot of talk in the retail industry in the past decade about the balance between store occupancy and vacancy rates weighing favorably for property owners, boosting rents and profitability.
But that’s changing.
The initial three months of 2020 marked the first time in 11 years that retail property has had negative net absorption, or more tenant space going empty than filling up. The change in the total amount of square feet occupied from one quarter to the next dipped into negative territory.
As the second quarter closes out, that downward angle is steepening, according to CoStar Market Analytics, which is projecting net absorption could be on a slippery slope through the start of the third quarter in 2021, plunging to its deepest level at the end of this year before starting to ease up.
While the coronavirus pandemic required all but the most essential retailers to turn the lights off for nearly three months, a seismic transformation that already was underway in the industry fast-forwarded from roughly a 10-year span to five years or even less time.
Retailers are immediately whittling down their footprints. Bankruptcies are soaring. Others are just giving up completely.
Cumulatively, that’s a harbinger of what could be steeply rising vacancies, falling lease rates and property values. None of that has happened. Yet.
“It’s likely to,” said Brandon Svec, director and market economist in CoStar's Chicago office. “This is a forced rightsizing of the industry.”
For landlords, it represents a big red flag as they brace for dark storefronts of every size and shape while even the healthiest of tenants see their revenues ravaged. Those retailers waning ahead of the pandemic have already either disappeared, such as Pier 1 Imports, or are thinning their store ranks, such as J.C. Penney and Macy’s.
More tenants moving out than in is expected to put even more pressure on owners who were looking to fill big holes before COVID-19. On top of that, there’s uncertainty about whether experiential features such as fitness centers and food halls will still be people magnets a year from now.
“This is a little ripple before the tidal wave of what we’re actually going to see,” Svec said.
CoStar is forecasting about 100 million square feet of negative net absorption between all of 2020 and the first half of 2021. The fourth quarter alone is projected to total slightly more than the three previous quarters combined as the physical process of closing stores accelerates. New retail space is expected to spike by 24 million square feet in the third quarter right before a 40 million-square-foot plunge in absorption in the fourth quarter, according to CoStar data.
Key Industry Indicator
Net absorption reflects supply and demand and is a good measure of the muscle of any sector of the commercial real estate industry. When it’s positive, it means demand for space is elevated, occupancy rates are healthy and rents are competitive. When it reverses course, vacancy rates creep ahead and effective rental rates tend to sink.
Data tends to lag because net absorption is gauged by the physical occupancy at properties. If a retailer says it’s going to close 100 stores by 2021, the net absorption rate doesn’t actually change until each store is vacated and then left empty.
At the same time, if that retailer were to clean a store out on a Friday and a new big-box tenant were to set up shop Monday — something akin to a logistical magic trick in this environment — the net absorption rate would stay static.
It falls into the minus column when there’s no one to take that vacant space, something expected to be commonplace as the pandemic wears on and leasing activity slows.
Landlords are finding out weekly which stores are likely to close, but it may not actually impact absorption levels until liquidation sales are completed and the keys are handed back.
When all is said and done, the retail landscape will look dramatically different, and the cost of leasing space could drop considerably.
In a worst-case scenario, real estate firm JLL is projecting retail rents will slump some 7.1% on an overall basis. That’s in the event of an ongoing pandemic with a more severe impact and store closings ahead. In a more moderate setting, rents are expected to fall 5.5%. But if consumer confidence and retail sales rebound faster, that so-called V-shaped recovery, rents might drop back only 2.1%.
That’s a bad-news scenario on any level, but it’s not an across-the-board issue because some segments and markets will be better at squaring net absorption than others, said James Cook, director of retail research for the Americas at JLL.
“It’s going to depend on what market you’re in and depend on what retail property type we’re talking about,” Cook said.
Transformation Speeds Up
Indeed, the acceleration of the retail transformation is fast at work: Some segments, such as indoor shopping centers and malls that are department- and chain-store heavy, are expected to get hit hardest, while open-air lifestyle settings with grocers as anchors and discount centers should be relatively spared.
“The markets where it will be especially tough in the near term are those that are tourism focused, that depend on travelers for revenue,” Cook said. It is expected that domestic travel will pick up more quickly than international travel, especially after the European Union’s ban on all travelers from the United States.
“Markets like Las Vegas and Orlando, Florida, that rely on domestic and international travelers will be slow to return,” Cook said.
Big urban markets could bounce back sooner, according to Anjee Solanki, national director of retail services at Colliers International.
“The deal flow is very active in New York, for example,” she said. “I would have thought that it would be slow, considering how big it is and the COVID there, but there’s a lot of positive push from chains and national brands that have actually been performing quite well during the COVID outbreak.”
By her reckoning, that’s the silver lining of more tenant space going vacant than filling up for those who were priced out of markets such as New York, Los Angeles and Chicago, for example. That's even the case in smaller emerging markets such as Austin, Texas, or Raleigh, North Carolina, before the pandemic.
“They have the ability to get onto certain streets and certain locations that are now more open,” she said of tenants.
For would-be leaseholders, it’s a blessing they’re looking to get. An East Coast health food restaurant entrepreneur, who didn’t want to be identified because he’s negotiating deals, started a small chain of quick-serve stores in 2015 and hopes to expand into at least two more this year.
“Before the pandemic, you didn’t have to convince people to come to your restaurant and eat, you just had to be a good restaurant,” he said. As economies across the country are reviving, he’s reopening his sites and putting the legwork in again to find new locations.
“Of the deals we’ve already looked at, we’re not being cut a deal on rent but getting cut a deal on tenant improvements,” he said. “At the end of the day, it’s just a math equation, and it’s working really well for us now.”
That could change, according to JLL’s Cook, but it’s too early to see it. “All the asking rents are the same they were before COVID-19,” he said. “Sure, the effective rents are probably being negotiated lower, but we don’t have a ton of visibility on that yet.
“One thing’s for sure, rents are certainly not going up,” he said.