By Jim Tancredi and Joseph Latina, SIOR, LMT Commercial Realty, LLC/Corfac Int’l.
The retail real estate market is experiencing significant shifts due to the current economic climate. With construction costs soaring over the past seven years from a low of $75 per square foot to as high as $150-$200 psf currently, businesses are turning to second-generation retail spaces as a cost-effective alternative to new construction. However, this transition comes with its own set of challenges and strategic responses.
The allure of second-generation retail space lies primarily in its cost effectiveness. As the costs associated with new construction continue to escalate, existing spaces offer a more affordable route for businesses looking to expand or establish their presence. Existing retail spaces and shopping centers demand much lower rents and purchase prices, especially when new construction rents are starting in the $35 psf range and can be as high as $60 psf in our local market. Despite their appeal, the limited availability of existing space is creating demand that the market is struggling to meet: Current retail vacancy rates are at a 10-year low, with some markets as low as 5 percent vacancy.
As businesses face a shortage of second-generation space, some tenants are compelled to consider new construction, despite the financial challenges. In response, landlords and developers are adopting value engineering techniques to help control costs, paying closer attention to the cost of specific building materials and at times substituting lower-cost alternatives. This approach could translate into rental rate savings of up to $2.50 psf for some tenants. Although the savings might appear minimal, it adds up considerably over a five- or 10-year lease term.
This scenario is placing pressure on both tenants and landlords. Tenants face the tough decision of either stretching their budgets to afford new construction or settling for less-than-ideal second-generation space. On the other hand, new construction landlords must balance the risk of prolonged vacancies against the potential for lower rental income.
This balancing act is making extensive lease negotiations much more common, with outcomes heavily influenced by broader economic indicators such as interest rates, inflation and consumer spending. Lower inflation could trigger increased consumer spending, thereby increasing retailers’ sales and cash flows. Likewise, a reduction in interest rates could reduce developers’ carrying costs. These factors would certainly ease some of the pressures, aligning tenant capabilities with landlord expectations more closely.
Until the market experience some impending shifts, businesses and developers alike will continue to seek innovative ways to mitigate costs and optimize investment returns. As we watch these trends unfold, the resilience and adaptability of the retail market will undoubtedly be tested, shaping the strategies and structures of retail real estate for years to come.
Jim Tancredi is principal and Joseph Latina, SIOR, is managing principal at LMT Commercial Realty/ CORFAC International.
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