Changing Preferences for Retail and Office Space: Interview with Sam Chandan
2014 Banking Outlook Conference: Challenge, Opportunity, Risk
Donna Fay: Welcome to the 2014 Banking Outlook Conference at the Federal Reserve Bank of Atlanta. My name is Donna Fay, and with me this morning is Dr. Sam Chandan. He is president and chief economist with Chandan Economics. Welcome, Sam.
Sam Chandan: Thank you.
Fay: Sam, where do you see us in the bank recovery with regard to commercial real estate?
Chandan: Regional community banks have been relatively slower to come back, part of that, I think, is a dynamic relationship. Price discovery, property values have been slower to recover in secondary and tertiary markets. We need both the investor in those markets [and] we need the lender to support the investor. That dynamic has accelerated over the last year, even two years, and that bodes well. We need greater credit availability.
Part of the challenge there is that as regional community banks have reengaged, we also have CMBS [commercial mortgage-backed securities] lenders that have come back to these markets. We have investors and lenders that see very limited yield opportunities in the biggest markets and so they're also moving to the secondary and tertiary. What that creates is a scenario where there is significantly more competition for good lending opportunities, but the pool of high-quality borrowers that meet today's relatively conservative underwriting standards, that's not growing as quickly.
So there is a strong desire to lend, and that's a positive, but we need a little bit more happening with the economy, with jobs for the actual borrowers to catch up.
Fay: So let me just shift gears just a little bit and talk about electronic commerce. Electronic commerce seems to be reducing the frequency with which individuals may be going to brick-and-mortar stores for retail. What impact, in your opinion, do you see this having on the commercial real estate market?
Chandan: Part of the challenge is that there isn't a single answer. There are some categories of retail that really lend themselves to substitution and to e-commerce, and we've seen that in a big way with electronics; we have seen it with the technology and books changing in a very fundamental way. But there are other product categories where it's been less significant. Sort of at the most extreme, we can look at something like a grocery store where the share of overall grocery spending that is being done online is a very, very small share of overall activity.
In between, part of what we need to be able to do to really anticipate where some of the risks might arise is to understand that we're not going to always be able to fully anticipate where that next disruptive technology will come from. We have to underwrite and think about investment in a way that does anticipate that, "If this isn't going to be a bookstore two years from now, what might it be?" Is there a new highest and best use? Is it a viable highest and best use when I am thinking about what it is that I might pay or invest to acquire and develop the property?
Fay: So sticking with the technology theme, there seem to be more and more workers telecommuting (working remotely) or in nontraditional office space. Again, in your opinion, what impact could this potentially have in the commercial real estate market?
Chandan: The fact that you and I can read our e-mail and get a little bit of work done outside of the office, it looks more like complementarity than it looks like substitution. It's not necessarily the case that we are working at home as a substitute for going into the office. And that's particularly true in a knowledge economy. If you think about some of the fast-growing metros, there are real returns to collaboration, to being able to share ideas. And a lot of that only comes with collocation—being able to work together to be able to share ideas.
Where there is some shift, we definitely see in the data that for every office-using employee that we create in the economy, we are using a little less space, that has been the case historically. Part of that has to do with the kinds of jobs we are creating. Part of it also in a confounding influence here is that it is a little bit difficult to tease out is that we've obviously had a very unusual recovery in the labor market, and that in itself has meant that overall demand for office space, the kind of leasing activity we have seen, it's been very modest. There are a lot of different things going on at the same time as technology is playing a new role in defining these outcomes that it's very much continue to observe, let's see what's happening, let's see how people use these technologies and how it impacts demand for office space. All things being equal, it lends itself to a smaller footprint overall, but it's not definitive. It's not always in the ways that we think.
Fay: So sticking with this notion of the smaller footprint, and you've spoken about this in terms of the changing-use preference in commercial real estate. Can existing commercial real estate be easily converted to accommodate these smaller footprints or this changing-use preference?
Chandan: In a lot of cases, what we have are whole categories of property subtypes that are faced with the possibility of functional obsolescence. And so we see that in power centers and big-box retail. We also see that when we look at the office sector, there is not only a shift in how we're using office space that implies a smaller footprint per employee, but we have new space coming online. A lot of people in our industry will talk about what helped to put a floor under the commercial real estate downturn was that we didn't have a lot of new inventory coming online.
The inventory in a lot of markets is aging and there is a desire for newer, fresher buildings. We've gotten new buildings coming online where these relatively new assets threaten to displace some of the older buildings in that market.
We can look at Philadelphia, and we'll see an example where one of the most iconic office buildings ultimately found that its highest and best use was no longer as an office building, and now it's a residential property. And so this idea of being able to repurpose space becomes very, very important. Not all space will be repurposed very easily. Philadelphia is an example of how it can work very, very well. They have the benefit of a strong in-migration of residents to center city driving up demand for condos and rental apartments. And so that helped to create, reinforce, this other highest and best use.
But you also have scenarios like what we see happening in the industrial sector. You've got logistics properties. You've got properties that are well located to some of the major deep-water ports. You've got properties of warehouse and distribution that are in the right place, have the right ceiling heights. Some of that electronic commerce; those packages need to move around. And that is some of the best performing space that we've got in any type of commercial property. At the same time, it's very, very difficult in a lot of those cases to understand how we will viably repurpose that property. The variable costs of operating that asset very oftentimes is higher than the kind of revenue it will generate, meaning that allowing that asset to sit empty may be the loss-minimizing option for the owner of that asset. That's a very difficult situation to find ourselves in. Some of those functionally obsolete properties, that's exactly what we're faced with.
Fay: Thank you so much for being with us and sharing your insight into this very dynamic real estate sector.
Chandan: Thank you.