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August 20, 2019

The Reckoning: What’s ahead for retail property owners and their lenders.

by Mark Borsuk*
Managing Director
The Real Estate Transformation Group
Copyright 2019.  Mark Borsuk.  All Rights Reserved.


Technology severs the shop from the shopper.  Internet commerce’s overwhelming success requires fewer and smaller stores with shorter leases.  Online shopping by creating systemic fragility is a black rainbow for many property owners and their lenders.  Another worrisome sign is growing political resentment against developers and property owners. The result will be increased taxes and fees.  Finally, wild cards are adding uncertainty to retail property investments. What, if anything, can owners and lenders do?

Why go to the store?

Online commerce reduces store count, location, and size.  The transition questions the long-term lease. In 1997, I began proselytizing that online buying would hurt retail property values.  See www.borsuk.com.  My mostly male audience comprising property owners, pension fund managers, developers, and tenants at the ICSC, ULI, National Retail Federation, the Appraisal Institute, and other venues listened politely.  But what got them howling was my nerve to say women would fully embrace online buying, to the detriment of the store.  

The channel shift was easy to forecast after Amazon’s 1995 debut.  The trajectory was clear; only the Internet’s household diffusion rate was uncertain.  Even in the early days, price comparison sites were accessible by cellphone. The other powerful incentive was free or low-cost shipping.

However, retail property developers and investors ignored the disappearing book, computer, record, and video rental stores along with travel agents, i.e., commodified goods and services providers.  Their willful blindness and self-denial came to haunt them.

My forecasts showed merchants leveraging online sales to become “omni-channel” retailers, a term I coined.  An omni-channel retailer would upend leasing strategy and shift emphasis to small footprint showrooms with minimal inventory.  To maximize flexibility, retailers would seek shorter-term leases with multiple options, perhaps a year.

Many chains dismissed the idea that online upstarts would cannibalize their in-store sales.  A store’s “Achilles’ heel” is high fixed costs where only a small shift in sales can make the store unprofitable.  Retailers largely ignored how Cyberspace sales could hurt them. 

During the 2000s, with the Internet’s diffusion spreading, many busy women considered it a godsend.  Still few thought women would buy shoes, clothing, and other tactile items believed immune from Internet shopping.  These shibboleths quickly toppled along with fears about paying online by credit card. After that, online buying became just another way to shop.

Today, online-only retailers are opening physical locations.  Some retail property owners believe companies like Bonobos, Casper, Amazon Go, and others are returning to the fold.  The need for fewer sites with less space makes their hope unfounded.

Another trend is the Pop-Up.  Before Pop-Ups, there were seasonal tenants like Halloween and Christmas stores.  The new Pop-Ups are designed to enhance an online’s brand or service reputation. Their presence is a win for the landlord since most take the space as-is.

However, the Pop-Up phenomenon carries a risk for landlords in relying on them for a stable income.  The first wave only wants the space for three to six months. The next wave will ask for the same deal plus a one-year option.  After that, landlords become accustomed to offering multiple very short-term options.

Initially, filling vacant space will seem like a good idea until malls, neighborhood, and strip centers began hosting multiple Pop-Ups.  In doing so, they violate a basic real estate tenet: predictable cash-flow. Predictable cash-flow is the sine qua non for investment real estate.  Without it, debt repayment is uncertain and valuation erratic.  

Time will tell whether the short-term leasing model becomes a significant factor for retail real estate.  However, it is not the only thing to dread. Owners and lenders must confront the Death Star’s arrival: Amazon Prime’s one-day delivery service.  

Offering one-day delivery to time-starved consumers raises the question: why go to the store?  If the default decision is to bypass the store, what happens to rents and vacancy levels? Will one-day delivery accelerate retail bankruptcies, undermine market confidence, and destabilize values?

Will national, state, and local politics impact retail property values? 

  • Federal-Tax laws.


The Trump derangement syndrome, “hatred of President Trump so intense that it impairs people’s judgment,” compels some elected officials and their traditional and social media allies to associate developers and property owners with the President.

During the 2016 campaign, the esteemed NYT’s “Common Sense” business columnist James Stewart, a Harvard Law School graduate and attorney, wrote about discovering how generous the Federal tax code was for real estate developers and owners.

Compounding the bien-pensant outrage was the 2017 Tax Cuts and Jobs Act, ushering in many favorable provisions for investment real estate.  Further, the Trump administration withdrew the IRS’s proposed regulations placing restrictions on discounting minority interests for estate and gift tax purposes.  It was a big win for practitioners.  

Expect the outrage to hit a fever pitch should the Administration institute a rule removing the inflation component embedded in an asset’s appreciation upon sale.  The taxpayer would then owe less in capital gains tax.

  • Do elected officials understand what developers and property owners do and the risks they take?  


Perusing elected officials’ CVs most likely shows public service and non-profit experience.  The term non-profit is a euphemism for organizations paying no income or real property taxes, but not necessarily lacking resources or paying good wages.  Many politicians have little or no experience in the private sector. Moreover, elected officials live in a pampered world. Their salaries, medical, and pensions are secure along with nomenklatura benefits.  

Magical thinking tempts them to believe they can solve problems through legislation and administrate policies with little knowledge about the subject.  Without understanding and experience, many elected officials lack empathy with, but have sympathy for, laid-off workers, business failures, foreclosed homeowners, failed investments, and how working people get by.  Also, many fail to consider macroeconomic trends, property cycles, and entrepreneurial risk-taking.  

Another magical belief politicians seem to have is developers and property owners engage in a riskless endeavor, and everyone makes money.

When regime change comes, the revulsion against Trump will likely manifest itself in curtailing or eliminating tax-deferred exchanges (IRC 1031), abolishing the step-up in basis on death, reversing rapid depreciation benefits, and reducing other favorable tax provisions.  Whether the change succeeds in 2020, 2022 or 2024 is unknown, but it will happen.

  • California: Property tax split-roll (Prop 13).


Beyond federal tax changes, California’s property tax protections (Prop 13) are under attack by a 2020 ballot initiative to create a split-roll.  A split-roll will strip long-term ownership benefits by assessing commercial properties at current market values. The measure excludes single and multifamily properties.

Enacted in 1978, Prop 13 limits property taxes to 1% of their 1975-1976 assessed value plus no more than a 2% yearly inflation increase.  If the property is sold or otherwise changes ownership, there is a reassessment. 

While social justice warriors will cheer a revenue bonanza, there are iatrogenic impacts. 

The iatrogenic impact from a split-roll will manifest itself in leases and financing.  Iatrogenesis is a term popularized by Nassim Nicolas Taleb author of The Black Swan and Antifragile.  It means unintended and adverse unforeseen outcomes done by the healer. Taleb extends the meaning to actions by policymakers and activities of academics.

  • Triple Net (3N) leases.  


A 3N lease obligates the tenant to reimburse the landlord for its insurance, property taxes, building maintenance, and other operating costs.  Many 3N leases, especially for smaller tenants, do not limit Prop 13 increases. Long-term owners could expect to see their property taxes rise by thousands or tens of thousands of dollars, if not more with a split-roll.

Since the 3N lease requires the tenant to pay the tax increase, some marginal tenants could find the expense bump prohibitive and default.  Alternatively, the landlord could agree to absorb some or all the burden to keep the tenant. However, reducing net rental income makes the property less valuable ceteris paribus.  

Perversely, a decline in market value gives the owner the right under Prop 8 (1978) to request a reduction in assessed value, thereby lowering the property tax.  The ensuing revenue decline is an iatrogenic impact.

  • Gross leases.


In a gross lease, the tenant does not reimburse the landlord for its operating expenses, and the landlord would absorb the full property tax increase from the split-roll.  As noted above, for long-term owners, the loss in rental income could amount to thousands or tens of thousands of dollars, if not more. Again, the net income loss would devalue the property leading the owner to seek a property tax reduction.

  • Leverage.


Borrowing money to develop and invest in property is time-honored.  A property’s projected or existing positive cash flow is necessary to qualify for and service the debt.  Lenders scrutinize operating costs to verify whether they are consistent with income-to-expense guidelines.  

Reassessing properties held for many years or even decades can make them harder to finance unless the increased property tax passes through to the tenant.  To compensate for lower net operating income, the lender would likely require the owner to invest more in the deal before making a new loan or refinancing an existing one. 

Whether absorbing the tax increase is partial or total, some owners could default on their loans or abandon the property, especially where there are high vacancies caused by Internet competition.  Unlikely? It is possible. A different context provides insight. In Japan, where depopulation is accelerating, there are 3.5 million abandoned homes (akiya) mostly in rural and suburban areas.  

Also, shorter-term leases will compound lender anxiety.  A property’s rent-roll will receive greater scrutiny to determine how vacancies filled with one or more Pop-Ups can impact the income needed to service the debt.

  • Is commercial rent control coming?


A split-roll victory could energize critics to push for commercial rent control.  Consider this scenario: small tenants in a favorite shopping district face rising rents after the split-roll spikes property taxes under their triple net leases.  On social media, the merchants complain, and a sympathetic city council takes note. The outraged politicians quickly pass legislation to prevent “unjust” rent increases and to protect tenant diversity.  

Fantasy?  It already happened here.  Between 1982 and 1987, Berkeley enacted commercial rent control covering several districts.  A property owner filed suit in federal court challenging the law, and later the California legislature preempted the matter by enacting a ban on commercial rent control (Civil Code Sec. 1954.25 et seq.).  Will California’s one-party government revisit the issue?

  • Local: Oakland’s vacant property tax & SF’s storefront calamity.


In 2018 Oakland voters approved a vacancy tax on residential and nonresidential property.  The goal was to raise revenue for homeless programs, and motivate owners with vacancies to rent, develop, or sell their properties for development.  The annual parcel tax is $3,000 or $6,000 depending on the property type unless exempted. It applies if the property is vacant for fifty (50) or more days in a calendar year.

Included in the city council’s magical thinking were vacant single-tenant retail and industrial properties along with parcels with or without buildings held for future development.  When the elected officials proposed the ballot measure, they myopically failed to exempt properties listed for lease/sale or to consider the transaction times associated with leasing or selling properties.  Moreover, their action grew from a deep animus towards and desire to punish property owners.  

Not to be outdone, San Francisco’s notoriously dysfunctional “formula retail” rules are accelerating storefront vacancies.  The City requires a discretionary review for retailers and others to open a ground floor location should they have eleven or more sites worldwide.  Even homegrown businesses have difficulty due to possible neighborhood opposition, excessive processing time, and the high cost to pursue an uncertain discretionary approval.  Despite the City’s oppressive zoning rules prolonging vacancies, one supervisor is pushing to penalize building owners with empty storefronts. What should be a teachable moment for supervisors about iatrogenic boomerangs, instead compels them to double down by seeking to pseudo-criminalize lawful property ownership.

Can wildcards influence retail property values?

A wildcard is a low-probability, high-impact event or a series of interrelated events destabilizing a system.  For example, Pearl Harbor, the 1973 Oil Embargo, and 9-11. 

Can the economy continue to grow while the US is in a trade war with China and other uncertainties surrounding world events?  Conversely, interest rates remain low, consumer sentiment remains positive, and most property values seem insulated from these vicissitudes, especially given limited overbuilding.

But what wildcards could change the risk-reward balance?  

Possible destabilizing ones are:

  • America’s technology juggernaut unexpectedly falters, causing massive lay-offs, and flooding the market with office space.  Can’t happen, you say? Remember the “see-through” office buildings of yesteryear while driving along Highway 101 through Silicon Valley? 


  • An unexpected 2020 election outcome.


  • The Fed grossly mismanages monetary policy.


  • A breakthrough in quantum computing compromises cybersecurity, including passwords.


  • A hacker freezes bank transactions for an extended period. 


  • The Big One knocks out Bay Area freeways and bridges along with severing water and power supplies.


  • A violent solar storm or accidental Chinese EMP (electromagnetic pulse) missile attack on the West Coast burns out the power grid.


Finally, a Black Swan.  A Black Swan is not a wildcard, but an unpredictable event with extreme consequences.  

However, wildcards can brighten attitudes and support the economy.  

Possible stabilizing ones are: 

  • A universal cancer cure discovered.


  • Cold fusion perfected for cheap energy production.


  • Economical carbon capture emerges to protect the environment.


  • Cellular senescence paused to create a Fountain of Youth.


While property owners hope the Goldilocks economy will continue, one must recognize unpredictable political and economic events can induce schizophrenia, so plan for it.  

What are retail property owners and their lenders to do?

Internet and investment real estate transactions operate at different time scales.  The Internet is almost instantaneous while real estate operates at glacial speed with considerable friction.  Buying and selling a property is time-consuming, due diligence intensive, and a document-driven process requiring many professional services.

Once an owner recognizes a property’s tenant mix may no longer prosper alongside online competition, changing tastes and demographic shifts, should the owner hold on, seek new tenants, convert the property to another use, or sell/trade?

There is a cost associated with each option.  The default option is stasis buttressed by prayer.  Next is seeking tenants less susceptible to online competition and other changes or retrofitting the property for new uses, but each has a substantial cost.  If financing, one must anticipate tighter lending standards, including a compressed loan-to-value ratio and shorter debt maturities for suspect tenants or uses.  If selling, will the IRC 1031 exchange tax deferral strategy still be available? If not, what then?    

What about Class A malls, neighborhood and strip centers, and street retail? 

Are Class A malls safe?  There is a historical parallel with the fearsome battleships before WWII.  Battleships were thought to rule the seas before Pearl Harbor. After that, the Navy’s strategy focused on aircraft carriers.  Today, the Navy has no battleships. Decommissioning good malls are unlikely, but their raison d’être will change along with valuations. 

Another suspect class is grocery-anchored neighborhood centers.  They are prized investments, but not immune to online innovation.  Changing buying habits like next-day delivery will force grocery stores to downsize by moving much in-store inventory to strategically located distribution hubs for same or next-day delivery.  The evolving grocery store may be more like a 7-Eleven with its limited selection coupled with a Whole Foods like prepared food section plus some fresh produce. The downsized grocery anchor will change the neighborhood center’s dynamics unless other users can absorb the redundant space, but at what rent?

Strip centers and street retail are better positioned to evolve, given their convenience items or experiential attributes.  An idealized survivable property would be a strip center anchored by a drive-thru Starbucks, a 7-Eleven, and several quick-service food providers.

Overall, coastal California remains blessed but not immune.  As suggested above, regime change is likely to significantly alter the federal tax code’s favorable investment property treatment along with state and local politicians continuing to shakedown owners for revenue.  Owners and their lenders must confront the Zeitgeist’s creative destruction witnessed by ongoing bankruptcies and repurposing redundant malls, community and strip centers, and big-box retail. Let us hope the transition remains bearable, and not be a debacle – adverse tax law changes implemented during a significant downturn. (8-10-2019)

*Mark Borsuk is a San Francisco commercial leasing broker and real property attorney.  He owns and manages retail property. Previously he worked on Wall Street and in Tokyo.




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