Here are the best insights I gathered from the panel of speakers at the June 15, 2017 Commercial Real Estate Forecast Summit, put together by Jeff Johnson and the MN Real Estate Journal. They put together some excellent continuing education events. This half-day seminar focused on current real estate trends for retail, industrial, office and multi-family property types in the Minneapolis/St. Paul market.
Mid-Year 2017 Minneapolis/St. Paul Retail CRE Update
- Online shopping continues to disrupt the retail market. Contrary to what the main stream media would lead you to believe (if you only read the headlines), this is not all bad. The entire retail panel expressed right now is an exciting time for retail and views the current environment as a time of opportunity. With changing consumer trends and demands, the disruption is forcing retailers to evolve and get better. This change is ultimately driven by higher consumer expectations seeking a more satisfying shopping experience.
- Another common theme hammered by the main stream pundits is the retail market in the United States has too much retail space per capita. Someone provided a counter argument to this by citing a statistic that the top eight retail markets in the U.S. account for 33% of retail building square feet. Considering several states such as California and Texas have economies that exceed those of some European countries, the data suggests the high amount of retail is not always as bad as often stated.
- One problem facing today’s retailers struggling to stay open. There are too many similar concepts, e.g. office supply stores or even some of the middle of the road clothing department stores. Stores such as Office Max, Staples, etc. are very similar, offer very little in terms of customer experience and ultimately begin to compete on price with online competition. Similarly, clothing stores that have not adapted to changing customer preferences and deliver exceptional service face a similar challenge.
- Retailers and investors really need to be dialed into their store offerings.
- The expansion of Hy-Vee grocery stores into the Twin Cities is giving Cub Foods a run for their money. Again, they are offering a superior customer experience and greater attention to detail to attract new business.
- Mall properties, such as Southdale Mall in Edina, Minnesota closing the JC Penney and bringing in Lifetime Fitness is viewed as good move. It’s likely we’ll see more of this trend.
- Fitness companies are a strong retail segment with many different smaller space options in the range of 2,500 to 4,500 square feet. They are offering specialty boutique fitness groups, such as cycling, yoga and feature a “community like” feel. It remains to be determined how many different concepts the market can handle.
- Ecommerce in US is reportedly about 8-10% of sales. In Europe, online sales are about 16%. Thus, the growth of ecommerce is likely to continue.
- Omnipresent distribution for retailers will be key.
- Retail is flourishing in the 5 F categories right now, Food, Fitness, Fun, Furnishings, Family/Friends
- A lot of stores closing now should have been closed years ago, such as Sears.
- A lot of thriving stores are helping to create strong customer experiences.
- More national buyers/investors looking at retail property in MN than historically.
- Drugstore sale transaction volume is down in 2017.
- The two largest proposed retail development opportunities in Minneapolis/St. Paul at present time include Orchard Place in Apple Valley and Avienda in Chanhassen. Both are proposed centers in the 400,000-square foot range.
- Some infill retail will continue around new grocery store development
- Retail will continue to see new growth in communities seeing residential growth. Retail follows rooftops.
- Entertainment is becoming more important for driving retail. Additionally, people desire a sense of community and the experience for customers is key.
- Some outstate MN markets have certain stores performing well.
- Will likely see some grocery store fallout in Minneapolis/St. Paul in the next two to five years.
- Restaurant and fast food sales have reportedly surpassed grocery store sales for first time.
Mid-Year 2017 Minneapolis/St. Paul Industrial CRE Update
- The large space users needing 300,000+SF that were active in the market back in 2014/2015 have slowed. Part of this is caused by fewer users with that size requirement needing space and operating with a bit more caution.
- A handful of tenants are looking for space in the 200,000-300,000-square foot range.
- Many tenants looking for space in the 20,000-40,000-square foot range.
- Costs for office buildouts are going up.
- The math on some new, long-term industrial leases are able to pencil out with lower rents due to the tenant signing longer term leases and above average credit rating. An example of this cited was Room and Board, sub $4.00/SF rent with 500,000 S. The lower rate was partially tied to longer term lease and credit rating, etc.
- Conversely, Opus recently signed a tenant for their new spec warehouse building in Plymouth. The building is an infill location with 90,000 SF, 24-foot warehouse clear height and 97% warehouse. The lease rate for this property was much higher.
- In 2017, the Minneapolis/St. Paul industrial portfolio owned by Duke Realty is 99.5% leased. They are now working on a few proposed projects in Shakopee and 50 acres of land under contract in Maple Grove. The panel stated its hard finding good industrial sites at prices that pencil out.
Leasing Trends and Activity
- Distribution users are really looking at cubic volume as a vital metric today – think higher warehouse clear height. Allows them to use less square feet.
- Today, newer distribution centers operate more as fulfillment centers and require greater electrical power, more employee parking, larger land area for security, expansion, etc.
- Finding locations with proximity to key employees and overall labor pool is important, especially with low unemployment rates. It’s requiring employers to be creative to attract employees.
- Groups like Amazon are looking at robotics to help offset challenge of labor shortages. The Amazon Shakopee location is reportedly bussing employees from Minneapolis with wages of about $16-$18/hour.
- At present time, it’s a very competitive investment market with low cap rates. Some seller groups, including a few national REITS have listed their industrial product for sale to see if buyers are willing to bite in the low cap rate environment.
- The panel hasn’t seen a falloff yet with sales activity. Buyer groups range from local to national investors.
- Rooftop solar is likely to increase in coming years as costs come down. It’s most likely attractive for 50,000-square foot buildings.
Mid-Year 2017 Minneapolis/St. Paul Office CRE Update
The first question posed to the panel is What is scaring your right now in the Minneapolis/St. Paul office market? Here is some of the feedback.
- A lot of space coming back on the market, especially with several recent new build-to-suit office buildings for corporate users. The challenge is how will that space be repurposed?
- There is heavy demand on institutional investors to place capital. That is increasing valuations and thus real estate taxes.
- Some brokers are seeing more uncertainty among investors. One factor is the potential for changes in 1031 exchanges. Investors like certainty and when there are unknowns not yet worked out, it creates uncertainty.
- Finding good, skilled workers is a challenge to help spur continued job growth. Landlords need job growth to fill vacancy rates.
- The ability to offer in-building amenities are vital for office space in the current market. Tenants are demanding training centers, fitness centers, in-building collaboration areas and even outdoor amenity areas.
- A recent example of a property owner taking action to backfill vacated space is the Baker Center office building in downtown Minneapolis. Wells Fargo vacated and the owner spent millions to renovate and add several amenities. The space is now reportedly generating a lot of activity.
- Landlords and new buyers are coming in and renovating with amenities. One benefit that is different from past cycles is buyers are not as highly leveraged with debt.
- In addition to amenities, tenants are looking for quality landlords. The experience of the building and being able to tell a story to the market is helpful to attract new tenants.
- The Colonnade Class A office building in Golden Valley is on the I-394 corridor and listed for sale with office rents at $23-$24/SF, net. Stabilized operating expenses are forecasted at about $18.00/SF, resulting in gross rents approaching the low to mid $40’s.
- Tenants are looking at ways to attract and retain employees and looking more closely at price per employee versus purely Rent/SF. The thought here is if a company can keep employees by being able to offer the best amenities, they sometimes are willing to pay a bit more. The higher cost to replace employees can quickly offset rent savings caused by being in an inferior location or building with limited offerings.
- Large buildings with large vacancies, particularly in suburbs are tougher to fill.
Where are we at in the current office market cycle?
- Using a baseball analogy, the office panel generally agreed we’re in the 5th or 6th The capital markets which generally help support the office market are still strong.
- A lot of professionalism coming to office real estate. Buyers are well leveraged.
- Where will new office tenant demand come from is a question in the market.
- Why no new office spec on I-394? Hot spots tenants want to be at right now include the intersection of I-394/State Highway 100, the North Loop, or downtown Minneapolis
- The two most recent speculative office buildings built in the Twin Cities are the T3 timber frame office building developed by Hines in the North Loop neighborhood and Offices at MOA, a 10-story office buildingat the Mall of America. It was reported both buildings took longer than expected to lease up and likely didn’t achieve pro-forma rents. These recent developments were identified as reasons why people remain skittish to go spec. Furthermore, it’s tough to get enough high enough rents to justify the new construction.
- Building amenities will continue to be a driver.
- Record setting trend of office sales will continue in 2017.
- Suburban office buildings will likely begin to add amenities and promote free parking to try attracting tenants from downtown Minneapolis.
- The St. Paul office market is pretty quiet with several dated buildings.
Mid-Year 2017 Minneapolis/St. Paul Multi-Family CRE Update
- Expected new delivery of 5,700 apartment units in 2017 across the Twin Cities market, equates to about 1.7% of total existing stock. While above average when compared historically, the opinion is market is still working to offset limited new construction over many years.
- Minneapolis is viewed quite favorably by investors.
- New Construction supply concern is greater in other markets across the U.S.
- Some cities in the Midwest such as Des Moines, Iowa are bringing in grants, TIF, etc. to support new development and higher end product due to lower market rent expectations.
- IRET Properties recently purchased Oxbo Apartments in St. Paul, MN, a mixed-use project. The property sold at 42% occupancy and the buyer felt the got a slight discount due to below market occupancy. Average rent for occupied units was reported at $1,800. Applying a 8% cap rate to retail space, the $61.5million sale price equates to $301,000/unit.
- Targeted returns on both cap rates and IRR.
- Still seeing cap rates around 4.5% for new urban apartments and 5.25% to 5.5% for new institutional grade suburban apartments across the metro.
- There’s been a slight shift in demand for pre-stabilized assets over past few years. Not quite as strong as a few years ago. Pricing is a bit more of a concern at present time.
- With strong market appetite in recent years, sales volume has been strong. One developer, Sherman Associates anticipates holding more properties over the next 24 months. They reported construction apartment financing has pulled back a bit in some markets in different states.
- IRET Properties will continue to hold existing properties in smaller markets, but is looking to deploy new capital in larger markets such as the Twin Cities.
- With 39,000 new jobs added in last year, and about 9,000 new multifamily units over two years, equals about 4.5 new jobs/unit
- More talk and development of micro units. Units called Junior 1, with partial bedroom wall and units in the 440 to 500-square foot size range have been also built,
- New amenities in multi-family – developers are trying to look at technology, e.g. could tenants just leave their unit with only their phone.
- Working to improving concierge services.
- Larger storage spaces are being added in the units, this is especially important for people such as baby boomers who are downsizing, but moving with more items.
- Trends from Class A amenities will continue to move into Class B projects.
- An amenities arms race is occurring.
- Potential headwinds included rising construction costs and property taxes. Construction costs continue to go up. For now, increasing market rents have helped offset the higher costs.
- Property taxes are a challenge.
- Interest only money availability has helped new construction. If this trend begins to shift, that could impact new construction.
- Tenants are demanding more today. This results in higher human resource costs such as needing to hire better property management and concierge services. With the construction market so strong, repair and maintenance payroll costs are climbing.
Mitchell Simonson, MAI is an expert commercial real estate appraiser and investor. If you have a market related question, please feel free to call at 612-618-3726 or email [email protected].