The COVID-19 pandemic has reshaped the commercial real estate market, creating a divide between winners and losers. A variety of factors that include retailers and brands over-expanding, changing consumer behavior and macroeconomic forces such as inflation have set the stage for these conditions to continue for some time.
Here, Dan O’Brien, executive vice president and partner at Hilco Real Estate, shares insights into the current state of the market while also exploring how the market has changed, which sectors are thriving, and what challenges remain for struggling businesses.
WWD: How would you describe the state of the current commercial real estate (CRE) market?
Dan O’Brien: Generally, I think the CRE market is being broken into the haves and have-nots amongst tenants and landlords, where there are some that are thriving and some that are struggling. For example, luxury retail is still doing well. Other approachable-luxury or mainline brands have found their path in different areas of retail. In contrast, many over-expanded pre- and post-COVID[-19] operators are struggling to meet obligations and keep pace in the ever-challenging brick-and-mortar world, namely in the restaurant sector or service industry (see health care). And then you always have certain retailers that simply succumb to the fads of time, as we are ever-increasingly fickle consumers.
Similarly, the industrial/data center/logistics world is a relatively hot marketplace. Still, some operators’ business models have proven untenable, and we’ve seen struggles and restructurings.
In the office sector, you have concept companies trying to stabilize a relatively new way of doing business in that traditional arena as we all collectively seek a balance in light of the more recent work-from-home trends. For office landlords, you have A/A+ assets that have been reinforced (and amplified) compared to non-A assets’ struggles. Similar with retail real estate landlords, certain asset classes, markets and properties are stronger now when compared to other non-performing competitors, and the difference between the viable real estate and the non-viable properties is becoming more apparent.
In short, the healthy part of CRE is narrowing, with fewer and fewer replacement tenants and properties backfilling underperforming areas; the prosperity is there, for some, but not nearly as widespread. And for those struggling, it’s back to the drawing board to see what creative solution there might be or a time to decide if they must cut bait and admit the market has moved away from them.
WWD: How has the market changed in the post-pandemic period?
D.B.: Similar to the above, we now have enough distance from the pandemic where we are seeing who is performing and who is not, and changes are coming based on what is working and what is not. Over-expansion post-COVID[-19] is the simplest area to see, as that mistake is time-tested well before 2020, but you have also seen a shift in shopping habits and patterns, for better and worse.
A perfect example is online shopping. We see the prevalence of the channel and consumers’ willingness to maximize their buying power, but it does not mean that online buying simply replaces in-person shopping. Brick-and-mortar has been enhanced in many respects because it has been proven that one channel alone does not work. Omnichannel retail, marketing, sales, etc. has been further reinforced in so many ways, but operators are scrutinizing each channel’s margins alone, as well as their overall machine, so what tenants can pay for real estate has been affected.
WWD: What must retailers do to mitigate risk to their holdings or leases? How can they protect their portfolios?
D.B.: I have my theories on operations, but it is very unique to each user. From a commercial real estate angle, we strongly encourage our clients to have a proactive approach to managing their real estate assets and liabilities. We underwrite to the conservative and manage real estate matters similarly. We know that’s not always the most popular opinion, and we never want to undersell opportunity, but we see ourselves as liability managers. There are marketing teams and operations groups that can work to improve top-line performance, but real estate is a cost. Like every expense, it must be managed proactively to maintain margins and protect profitability.
With that, there are lease terms and conditions that should be scrutinized before documents are signed, and deal points that should be included in order to provide maximize flexibility throughout a lease, but once underway we encourage our clients to regularly review their sites, engage in constructive dialogue with their landlords and constantly self-assess where improvements can be made.
WWD: What do retailers need to do when assessing their real estate portfolios?
D.B.: The most common answer is likely for a retailer to understand market rent, but we see that as a secondary aspect. “Market” is driven by revenues that can be achieved operationally. Therefore, how is your P/L [profit and loss] compared to initial projections? How are revenue results compared to the original budget? How are costs being maintained? How is your profit margin holding up?
Outside of their own P/L, has the property lived up to expectations? Has the landlord managed the site properly? Have co-tenants been successful with the landlord delivering a compelling merchandising plan that drives traffic? Is that traffic your target shopper? Have you converted that shopper to being a customer? Can you improve conversion or drive more traffic? Did the site miss the mark? Has the market shifted? What can be done better to improve performance?
Those financial, operational and real estate questions then help support an approach to the landlord with a potential plan, if needed.
WWD: How will the commercial real estate market evolve over the next year?
D.B.: We believe for the proactive and candid retailers in their internal operational assessment, it should reveal what is working and what is not. From there, if the problem is with the tenant, they will research operational or financial solutions they can consider. If the problem is with the real estate, then they must address what they see as deficiencies with the landlords. If it is a mixed set of circumstances, a comprehensive plan must be devised to address what is not working. But to delay is to deny yourself the opportunity to truly fix things. And if someone avoids the truth of the matter, they risk the future of their success.
I believe landlords and tenants need to form a true partnership, yet with certain respectful boundaries. If that is the case, then mutual success should be the goal. It doesn’t always mean that the outcomes will turn out the way we hope, but it gives both parties the best chance to maximize success and minimize distress, as best as possible.
