Challenges and opportunities for retail development

Jason Schmidt
Managing director, capital markets, JLL
and Colorado board member, ICSC

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Despite overreaching concerns of e-commerce negatively impacting bricks-and-mortar shopping centers, the retail fundamentals in Denver are thriving. Fueled by continued growth in consumer spending, population and employment, consumer confidence in Denver is high and its residents have buying power. The market is at a high watermark for both occupancy and lease rates. Current vacancy remains in the mid-4% range, which is the lowest in over 15 years, and retail rents in Denver have increased annually by at least 5% during the last five years, according to Costar.

Tyler Carlson
Managing principal, Evergreen Devco
Inc. and Colorado board member, ICSC

Contrary to standard laws of supply and demand, the lack of available space has not created incrementally more construction. Throughout the last 35 years, the metro area has constructed, on average, roughly 3.5 million square feet of new retail space annually. Currently, we are operating at a fraction of these historical figures. In the last five years, the Denver market has averaged just under 1 million sf of net new construction. This year it is anticipated to be slightly under that mark and is projected to be even lower in 2020. Annually, 1 million sf of net new construction appears to be the new normal, a figure that is under 1% of the current inventory of total retail space in the market.

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Daniel Ryley, CEcD
Executive director, Arvada Economic
Development Association and Colorado
board member, ICSC

While some of the reduction in space growth is due to a lack of speculative development (Costar has the preleased figure for new projects at 67%), much of this reduction is due to three factors: increased development costs, increased property taxes and few expansions of large-format users who can afford these aforementioned higher costs. Let’s discuss each of these points briefly.

First, according to the Mortensen Construction Cost Index, development costs have increased significantly since the Great Recession with construction costs increasing 46% since fourthquarter 2009 and municipal tap/ impact/permit fees increasing dramatically as cities look more and more to private property owners to pay for public capital improvements since their municipal general revenue funds increasingly are pledged to maintenance, pension and human resource obligations. Additionally, municipalities demand enhanced landscaping, hardscaping and architectural features that add expenses to a project budget and further increase the rents required by tenants.

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Second, the combination of the TABOR and Gallagher Amendments creates an unsustainable commercial property tax environment in Colorado that each year increases the effective subsidization of residential property tax rates by commercial property owners with no recourse – the ultimate taxation without representation. The state Legislature is aware of these challenges but has not found a way to untie the Gordian knot of Colorado’s byzantine tax structure. We must, however, find a way if we are to remain economically competitive and if municipal budgets predicated upon sales tax revenues are to remain solvent. By way of example, in the past decade, retail property tax assessments paid by tenants under triple-net leases have increased from $2-$4 per sf to $8-$10 per sf in “normal” property tax areas and have reached mind boggling $12-$14 per sf in high property tax areas within metropolitan districts. This dramatic increase in property taxes has “sucked the wind” out of potential rent increases from our growing economy since tenants are focused on their gross rent of building rent plus taxes. Since costs have increased dramatically and new construction rents have remained fairly flat in the last decade, developers and tenants have had to rely upon shrinking profit margins and record-low cap rates to justify new construction, which isn’t sustainable.

Finally, as a result of these increased development costs and gross rents, fewer retailers and restaurants can afford ground-up construction as the sales thresholds required for profitable operation increase. This is especially true for grocers and hard/ soft goods retailers, where margins and sales continue to compress due to both internal and external e-commerce competition. In today’s environment, nearly every large-format retailer is focusing its capital dollars on e-commerce distribution and logistics instead of bricks-and-mortar expansion as these companies look to increase relevance and convenience in our technology-driven society. Consequently, with fewer large-format users anchoring fewer large shopping centers, the retail space growth today is primarily driven by smaller-format projects that drive a smaller retail footprint going forward, a trend that isn’t likely to change.

To be sure, the retail environment has not been kind to everyone. According to Retail Drive, 16 major bankruptcies have led to more than 7,000 stores closing nationally this year, which is a record number of annual closings. However, Denver retail has proven to be resilient with e-commerce resistant tenants such as restaurants, fitness and entertainment leading the way to back-filling vacancy and creating new construction. We also are likely to benefit from a refocus back to physical retail stores by e-commerce players. Early reactions to e-commerce pit it against physical stores; however, a new study from ICSC shows that offering both online and physical store options boost overall sales for retailers. Additionally, since nine out of 10 retail dollars spent today are in physical stores, these bricks-and-mortar locations increase online traffic and brand awareness dubbed the “halo effect.” In the study, customers who shopped first at a store and then went to that retailer’s website within 15 days ended up increasing their spending by an average of 167%.

Although Denver’s retail environment will continue to evolve, it has remained strong. By showing discipline in times of uncertainly, it has continued to thrive even through the “retail apocalypse.” Physical stores will continue to play in vital role in how people shop, and Denver’s robust economy will provide the purchasing power for a healthy environment. Even if there is a national decline, Denver will outperform its peers. Looking forward, the thing that will have the greatest impact on the health of Denver’s retail real estate environment is its interaction with the public sector.

With consumer and retailer trends reshaping how people shop and generate tax revenue, municipalities and the private sector need to respond in partnership to ensure a positive outlook for the retail industry. Local governments that proactively update land development policy, including zoning and development standards to allow for more creative and mixed uses of traditional retail centers, will be better poised to attract investment from innovative owners. Furthermore, the local governments that reinforce a community’s vision for retail activity and placemaking through aligned public improvements and economic development, such as integrated open space and multimodal transportation infrastructure, will competitively position themselves for transformational redevelopment. Overall, the removal of investment barriers and mitigation of investment risk will foster an environment that can attract the types of retail activity more resilient to changing consumer and retailer behavior.

One trending economic development tool that mitigates development risk is the opportunity zones program. The program allows investors to place eligible capital gains into qualified opportunity funds, which when directed into specific economically distressed areas, or qualified OZs, yield significant tax benefits. Properties inside OZs can now access an entirely new and lucrative source of capital, which may help drive redevelopment efforts in existing, tired shopping centers, and new projects in higher-risk markets. With a wide breadth of eligible types of OZ projects and businesses, the program can encourage the mixed-use placemaking that will foster sustainable retail activity. For more information on opportunity zones, visit https://www.irs.gov/newsroom/opportunity-zones-frequently-asked-questions#qof.

Featured in CREJ’s November 2019 Retail Properties Quarterly

Edited by the Colorado Real Estate Journal staff.