Operators moving forward with plans to open new locations are bumping up against a trifecta of site selection challenges: higher costs, stiff competition and limited space options.
There’s no question that the ongoing appetite for new locations is a bit of a mixed bag. While some brands are slowing growth due to higher interest rates and economic uncertainty, others are keeping their foot on the gas for franchise sales and new store openings, particularly in the quick-service restaurant sector. Overall, the retail sector absorbed nearly 76 million square feet of space last year, which is the highest level since 2017, according to commercial real estate firm JLL. Among the most active categories for announced openings in 2023 are restaurants, discount retailers, grocers and apparel stores.
“It remains a very active market. We’re seeing a lot of new to market concepts trying to break in that are franchisee driven along with existing concepts that are looking to continue to expand,” says David Gabbai, an executive vice president and retail site selection specialist at Colliers in Orlando.
Those tasked with site selection, however, are navigating a tough market due to limited availability, with the average U.S. retail vacancy rate declining to 4.2 percent at the end of 2022, according to Colliers. Low vacancies are being exacerbated by less new construction and existing space that is being razed or repurposed into non-retail uses.
Competition for space is even more heated in high demand markets, especially in the Sun Belt where retailers are attracted to growing populations. In Orlando, for example, Gabbai frequently sees three or four concepts vying for the same space. That demand is giving landlords the ability to pick and choose which tenants they want in their centers. A shortage of existing space is forcing brands to consider new development. However, rising interest rates, higher construction costs and longer lead times are creating a “perfect storm” where it is more difficult to get deals done these days. Successfully navigating current market challenges requires keeping a close eye on key market trends.
Geno Coradini
Value-engineering real estate
The big issue on everyone’s mind is construction costs. According to the Associated General Contractors of America, cost inputs for new nonresidential construction has improved, with year-over-year increases dropping to 2.7 percent in February. However, there is still considerable pricing volatility and delays that are impacting some building materials. Although lower levels of increases is welcome new, operators are still struggling with the cumulative effect of surging construction costs over the past three years.
Overall, higher costs on both new builds and tenant improvements are forcing companies to pursue a variety of cost-saving strategies that include smaller footprints, value-engineering store designs and searching for more cost-effective second-generation space versus new development. “It’s nearly impossible to find new construction at a price at anything under $40 per square foot these days. This has made second generation spaces more attractive and more affordable,” said Jennifer Watson, senior managing director, National Retail Group at Newmark.
Shrinking stores
Cost isn’t the only factor driving smaller store formats. During the pandemic, restaurants and other businesses were forced to downsize their footprints to account for less dine-in patrons and more to-go business.
“This trend has maintained post-pandemic with groups such as full-service and fast-casual restaurants,” said Watson. Reduced interior seating, high occupancy costs, shorter queue lines and more efficient back of the house layouts are all factors allowing restaurateurs to decrease their overall size, she added.
The National Retail Foundation also has predicted that smaller footprint stores will flourish as retailers continue to experiment with those formats.
Ground leases are in vogue
Landowners are more reluctant to sell for a variety of reasons, which is causing operators to enter into ground leases on pad site locations or choose a build-to-suit development. More landowners would rather get a steady return on their land investment rather than selling it and taking a lump sum payment.
“The return they can get on those properties today with a ground lease acts as an annuity that continues to generate monthly income,” noted Geno Coradini, managing director, Americas Retail, Integrated Portfolio Services at JLL.
For operators, ground leases can be a little bit tricky, because the franchisee is still responsible for building. They have to go out and find their own general contractor or project manager to build the project. For unsophisticated operators, it can create greater risk exposure to things like fluctuations in building costs.
“Franchisees have to be careful that they don’t get themselves in a situation where they have signed up for a 20-year ground lease, and all of a sudden the building costs considerably more than they anticipated,” said Coradini. Although most franchisees would prefer to control the land their building sits on, ground leases are typically structured with very long-term agreements with a base term and extension rights that extend 50 years or longer.
New development fills up early
In a market where demand for space is outpacing new supply, franchisees need to move quickly. “You have to stay ahead of the curve. If you have to wait for new projects to come out of the ground to commit to space, you’re already too late,” said Gabbai.
In order to get financing and the green light to move forward with new shopping center projects, developers need to have the majority of their projects leased before construction starts. So, tenants need to be on the front end of those new development opportunities.
“Keeping your finger on the pulse of the market is extremely important, because you have to be ahead of the curve in order to secure space as soon as it hits the market,” said Gabbai. Although that is especially true of high demand pad sites and end-cap locations, it’s really true of all types of retail and restaurant space because vacancies in some markets are extremely tight, he added.
Leveraging AI for smarter site selection
The use of AI, machine learning and predictive analytics is becoming more the norm in site selection processes and strategies. Brands are relying more on data and analytics to better understand the psychographics of their customer at a more granular level.
Mobile data in particular is providing more insights into customer behavior and traffic patterns. That customer data can be layered on top of other known variables, such as the sales history and physical characteristics of top performing stores, to better understand what locations will produce optimal traffic and sales. “It doesn’t always tell the whole story, but any tools that you can use, whether it is analytics or demographic information coupled with artificial intelligence helps our clients make better decisions,” said Coradini.
Landlords push for higher rents
Rent growth has been relatively modest across many metros. According to CoStar, retail rents are projected to grow by 3.3 percent in 2023. However, retail landlords that missed out on capturing high inflation are now looking to change they way lease deals are structured. In some cases, landlords are negotiating for annual rent bumps that are tied to the CPI with a cap, or a fixed percentage.
“We are seeing landlords push for higher annual rent increases, such as demanding either a 3 percent annual increase per year or a 15 percent increase every five years,” said Watson. One way to counteract that as a tenant is to negotiate a lower base rent for year one so the rent increases deal less of a blow with regards to overall occupancy costs for the life of the term.
Another tip for tenants is to structure leases to account for potential delays in assuming occupancy for their spaces. “It is important franchisees tie their rent commencement dates to when they receive their permits, otherwise they could be paying dead rent if permit times are excessive,” added Watson.