John Zikos: Will Retailers Pay Higher Rents To Keep Up With Rising Construction Costs?

Jul 9, 2014

John Zikos: Will Retailers Pay Higher Rents To Keep Up With Rising Construction Costs?

D Real Estate Daily - July 09, 2014 

There is tension building in retail real estate. Construction costs continue to increase, with estimates ranging between 25 to 30 percent over the last year. Real estate taxes are also rising, as municipalities are re-assessing buildings at ever increasing values, which negatively impacts retailer occupancy costs.

As more emerge from the flat sales of the past and look to open new stores, there is more competition for good real estate, which is causing land prices to quickly rebound. At the same time, cap rates, though continuing to compress, don’t appear to have much room to go down.

All of this is setting the stage for a showdown, with retailers seeing a gain in same store sales comps and desiring to open more new stores, and developers having good development sites under contract but needing to build to a yield acceptable to both investors and lenders.

In the past, anchor tenants have relied on the ability to make very low-yield (almost loss-leader) deals, with shop tenants, pad users, and even cities making up the difference. But even these strategies are tough to execute with rising costs of construction.

A vast majority of retailers, with the Great Recession still very fresh on their minds, are still very cautious to keep their occupancy costs down and make deals that allow them to have a healthy occupancy cost-to-sales ratio. Meanwhile, developers need to build to a yield that will allow them to make money.

I spoke to a developer last week who is working on ground leases with anchor tenants so the retailers can use their own capital, without having to pay a return to the developer on the cost of the improvements, as a way to bridge this gap. Although that works for some retailers, others need to conserve their capital for inventory, remodeling existing stores, and other operations issues.

It will be interesting to see if rising construction costs will choke out much of the planned new development, or if rising sales will enable retailers to pay the rents developers are asking and continue to be healthy and flourish.