Marcus & Millichap’s Hessam Nadji on the Economy and Marketplaces as the New Darling of CRE

We keep hearing of a looming recession. Whether short or long in duration, what would that do to consumer spending and retail operators?

Although there is concern about the risk of an impending economic downturn, numerous economists suggest that a soft landing could be increasingly probable. Barring an unanticipated shock, the strength of the current labor market points away from any serious recessionary forces arising soon. The economy boasts 3.3 million more jobs than ever recorded before, yet there continue to be more job openings than people looking for work. This ongoing labor shortage is sustaining a historically low unemployment rate and above-average wage growth. Although the tight labor market is also contributing to elevated inflation, taking some of the wind out of recent pay raises, consumers have demonstrated remarkable resiliency. Core retail sales have increased 31.1% since the onset of the pandemic and are up 5.1% year over year. An additional $4.1 trillion accumulated in U.S. savings deposits since February 2020, which is backstopping greater spending.

Consumers’ durability is translating to retail property performance. Vacancy at a national level has been stable at 4.7% since the middle of last year, outperforming 2019, while rents have continued to grow by 3 to 5%. A major supporting factor has been the lack of substantial retail construction, extending a decade-long trend of modest deliveries in most markets. The overbuilding concerns faced leading up to the global financial crisis are not present today, and expanding retailers are focusing on existing floor plans as experiential retail has come back strong since the height of the pandemic. That includes food, fitness, health, beauty and entertainment. Pent-up demand for these types of services is supporting spending at these retailers even as prices have gone up and uncertainty about the economy has increased.

The economy does face some downside risks. If recessionary conditions were to become more prominent than expected, retailers would likely be impacted. A substantive drop in consumer sentiment could push many to fall back on necessity purchasing. Consumers are already taking on more debt, and delinquencies rose in recent months, which is somewhat concerning. Although drug and convenience stores, as well as value stores and lower-cost grocers, would likely weather these challenges readily, other retailers offering more costly discretionary items or experiences would see a pullback in receipts. Luxury retail is already seeing a cooling trend.

Last fall, you said retail sales were growing and consumption was still on the rise, adding: “We are overconsuming because it is so easy to consume thanks to e-commerce.” Do you see that trend continuing?

During the pandemic, the U.S. government injected an unprecedented $5 trillion into the economy. While in retrospect, this may have been excessive, it was also necessary at that time to avoid severe recession risk. It also generated a major stimulative ripple that ultimately led to the current high inflation environment. In the U.S., part of what facilitated elevated consumer activity from fiscal stimulus payments during a time of lockdown and social distancing was e-commerce. The share of retail sales made online jumped roughly three years ahead of the long-term growth trend line during the health crisis. Yet, as time has passed and stores reopened, much of that spending has shifted back to in-store purchases. That does not mean that online spending will not continue to represent an expanding component of overall retail sales but rather that the trend has returned to the slower, pre-pandemic pace. Amid this normalization, overall consumer spending is continuing to grow, with some of the strongest gains made over the past year at bars and restaurants, which offer a social experience that was missed in past years and is not replicable online. And as both the physical and digital retail landscapes continue to evolve, we see a growing connection through omnichannel systems.

Multichannel operations for retailers continue to be a big deal. Has this “strategy” peaked in terms of operational benefits, or do you see even better efficiencies being developed to take it to a higher level?

Despite early apprehension from the growing adaption of e-commerce, the retail sector has successfully reinvented and repositioned itself over the past 10 years and is one of the more solid-performing property types this year. A major competent of this evolution has been the embrace of multichannel or omnichannel offerings by retailers, drawing a closer connection between the physical storefront and online marketplaces. Prominent examples of this reinvention include in-store pickup and return, integrated inventory management systems that allow online consumers to see if products are available at their local store, smartphone apps to make the physical shopping experience more convenient and leveraging social media to expand customer reach. In addition, the entrance of digitally native brands to the brick-and-mortar world, including Amazon, has been well documented.

Moving forward, as the consumer landscape continues to evolve and change, how retailers leverage omnichannel will adapt, as well. One focus is the increasing personalization of the customer’s shopping experience. Another is the streamlining of supply chain operations through better demand forecasts and other measures. Overall, the retail sector has clearly — and successfully — adapted to the e-commerce environment, and as that aspect of consumerism evolves, we expect the ways in which physical storefronts benefit from the omnichannel approach will also evolve.

Big-box retail store conversions seem to be a viable option for struggling landlords. Is this still an attractive play for those asset owners?

Many big-box retail spaces have been able to recover from losing a legacy tenant that failed due to an outdated business model. The bankruptcy of Toys R Us seven years ago is a prominent example of this. Most of their spaces were in good infill locations, near centers of commercial or residential activity, where opportunities for new retail development are scarce. The issue was not with the real estate itself but with the tenant. This has been reflected in subsequent years, as most of the old Toys R Us locations vacated in 2017 or before are now leased to new tenants — including off-price retailers, grocers and craft stores — or adapted for other uses, such as fitness or self-storage. The recent bankruptcies of Bed Bath & Beyond and Party City are likely to prove similar catalysts for other retail spaces. Unlike in 2007, the retail sector overall is not overbuilt. As such, returning some of these infill locations back to the market will allow stronger brands to shepherd them toward more optimal uses. Of course, opportunities will vary on a case-by-case basis and not every shopping center will have the same outlook. Locations in Class B and C malls could be challenging to adapt. Overall, the outlook for off-mall, big-box locations is generally positive.

Inflation seems to be everywhere, with minimal pullback only recently. What materials, energy and other items affected by inflation are most impacting the retail industry?

While prices are still rising, the pace of inflation is cooling. April’s headline CPI inflation rate of 4.9% is half the 9.1% peak level set in June 2022. Electricity and natural gas prices, which can be volatile, drove much of the initial wave of inflation but have declined in recent months. Fewer consumer goods are in short supply, leading to recent price dips for items such as home furnishings and groceries. Used vehicle prices are also trending down, which represents important savings on what is a major discretionary outlay for most households. Climbing prices elsewhere are nevertheless impacting consumers and retailers. Restaurants are contending with higher labor costs, while steeper prices at the pump and for housing are affecting consumers’ discretionary budgets. Some shoppers could step down in the quantity or quality of the items they are purchasing to save money, directing them to different stores. These influences are likely to linger. Although inflation is cooling, it remains elevated from a historical standpoint, and it will most likely take a prolonged timeline to move it back to the U.S. Federal Reserve’s target rate of 2%.

The Fed has taken a transparent approach lately about interest rates. How have its moves affected the marketplaces industry?

The [Federal Open Market Committee] has been less aggressive this year than it was in 2022. The Fed has raised the overnight lending rate by 75 basis points through the first five months of 2023, compared to 425 basis points over the span of 10 months last year. The more deliberate pace this year is helpful for retail and shopping center investors.

A federal funds rate of 5% is not the main challenge for commercial real estate. That rate is roughly in line with the historical average. What disrupted commercial real estate investment sales was the speed at which the Fed moved to 5% from a starting point near zero. That disruption, where rates moved dramatically in a very short time, created a significant expectation gap between buyers and sellers. The Federal Reserve increased rates by 300 basis points in just 140 days, making it exceptionally difficult for investors to underwrite property values. In addition, lenders faced significant challenges in setting terms and lending policies, making the debt capital market more volatile. This was further compounded by bank failures with otherwise healthy banks becoming more cautious over the past few months and further contracting liquidity in the market.

Notwithstanding the interest rate shock, buyers continue to show demand for well-priced shopping centers and single-tenant retail. This is a function of improved retail fundamentals and consumer strength driving the lower vacancies. We are seeing multiple offers for realistically priced assets even if it means lower leverage. A more stable interest rate climate will help reduce the capital market's challenges. If interest rates remain rangebound for several months, more buyers and sellers should be able to align on terms and pricing, supporting increased transaction activity.

Is it fair to say that the supply chain challenges of the past years are over? If not, what is still problematic for retailers?

Supply chains are certainly much-improved relative to during the pandemic. Congestion at ports has diminished, and the cost to ship freight by sea from China to the West Coast has declined by more than 90 % since April 2022. Some issues remain, however. New motor vehicle inventories are still below typical levels, a lingering effect of production shutdowns and chip shortages, while some medicines are now in short supply following health issues that became more prominent during the health crisis. Labor is perhaps the most substantial shortage created by the pandemic and one that will continue to challenge other aspects of the supply chain over time as various organizations hunt for personnel. East Coast port workers are also now in early discussions ahead of a 2024 contract expiration, which could have implications soon. These disruptions may continue to affect retailers, although the impact is much reduced from the height of the health crisis.