A commercial real estate apocalypse?! Part 2: Branch neighborhoods

AUTHOR’S NOTE: I presented a speech on this topic in early December 2019, before COVID-19 was part of our daily news. Now, with the introduction of COVID-19 and everything it introduced into our world (like social distancing and shuttered bars and restaurants), the long-term outlook for most commercial sectors turned from questionable to bleak. This series presents a likely scenario for commercial real estate, as well as actions you should take to prepare your credit union.

In Part 1, I predicted that certain commercial real estate (CRE) sectors will face an apocalypse. Some of the culprits include Amazon, “big money,” technology (5G and Artificial Intelligence), and changing consumer habits.  And, within the past few months, the most recent development (COVID-19).  As I also discussed, CRE is not in a “bubble” . . . these CRE sectors will be down and out, and it will happen within 5-7 years.

Does 5-7 years seem too quick for such a radical decline?  Ask a taxi driver in NYC how quickly things change. In NYC and certain other large cities, taxi drivers need a taxi medallion for the privilege of operating a taxi – only a limited number are offered.  A single NYC taxi medallion was worth slightly over $1 million in 2013. Back then, most considered them to be “as good as gold.” Taxis were ubiquitous in the Big Apple, so how could they ever lose value?  Answer: Uber and Lyft. NYC taxi medallions have since cratered in value. Last summer, three medallions sold for an average $137,000 each; thirteen up for sale received no bids. An 86 percent decline in value in six years. Now that’s fast! 

A similar transformation will impact certain segments of CRE.  CRE sectors that are most susceptible to an apocalypse include retail, restaurants, and special-use facilities. Least susceptible include residential, warehouse, and light industrial.

In this article, we’ll explore the particulars of this transformation, and the impact of the CRE Apocalypse on your branches.  Not specifically the value of the branch properties (that’s the next article in the series), but the “neighborhood” each branch lives in.

Why minor traffic reductions have such significant impacts

Almost every sector – grocers, restaurants, retailers – has seen a drop in traffic, thanks to the likes of Amazon and UberEats, and most recently COVID-19. No one has proven immune to the new technologies and the shifting consumer habits. And, minor traffic reductions can have an outsized impact on a business’ ability to survive. This is particularly evident in sectors with higher fixed costs. As a simple example, let’s say a restaurant serves 100 customers daily; the first 85 cover the fixed costs and variables; the last 15 cover variable costs and provide the profit margin.  If business drops just 10 percent – just 10 fewer customers walk through the door daily – two-thirds (67 percent) of the contribution toward profit margin evaporates. Another five percent drop causes all profit margin to vanish, leaving no reason to keep the lights on.

Nearly all industries realizing significant disruption

It’s no secret that retail stores have suffered at the hands of online retailers.  The best outlook in retail is for those retailers who are specialized or offer specialized service.

Experiential retail (things at which you need to be physically present to experience) was once thought to be safe but now is subject to disruption. Until about five years ago, restaurants were largely safe. Now, a host of alternatives are eating into (no pun intended) restaurants’ volumes.  And, meal delivery is not a panacea; first, the delivery services take a large cut of the ticket; second, delivery cuts out high margin products (e.g. drinks and desserts).

In the not-too-distant past, fitness centers were seemingly “safe”, as it was something you needed to be there to experience.  Not only did they have the equipment, but they also had the community – encouragement from other gym rats to help you meet your goals. Now, with new entrants like Peloton and Mirror, even a workout can be achieved from home, along with the community (brought to you digitally). So, maybe that gym is no longer as safe as it was just a couple of years ago.  Again, a small drop in volume may represent a loss of the margin that allowed them to survive.

So few businesses are immune to volume reductions. And, as we discussed, small volume reductions can have outsized impacts to a company’s bottom line.

CRE Neighborhood Outlooks

Our branches reside in different “neighborhoods,” and the outlook for each such neighborhood differs.  Below are some of the typical neighborhoods and their outlooks.

• Strip malls, negative: The typical strip mall contains too many CRE uses that are in decline, such as retail, restaurants, and gyms.  Further, these properties are not easily converted to other CRE uses.  We can expect most strip malls to struggle greatly in the short term, and many risk going dark in the next 5-7 years. One big differentiator is whether the strip mall in which your branch is located is a destination or is along well-traveled roads. Destination strip malls face a more dire future, as consumer trips to the strip malls will drop, resulting in fewer trips near your branch.

• Grocery store-located branches, neutral-to-negative: The good news is that everyone needs to eat. The bad news is that the number of grocery store trips is declining, a victim of grocery delivery both by the local grocery stores and the national providers, as well as meal plan delivery (e.g. Freshly) and restaurant delivery.  In response, grocery store sizes are shrinking, and/or shifting to a “market” style offering.  The outlook for in-store branches is mixed. If your grocer partner is willing to continually invest as necessary to retain its market share, then the outlook for your in-store branch is neutral (neutral, and not positive, because the need for branch visits will continue to decline). If your grocer partner is unwilling (or unable) to continually invest as necessary to retain its market share, then your outlook is negative. 

• “New urban” / city centers, positive: The most recent innovation in many cities is the “new urban” development.  These areas offer a population density akin to a downtown urban area as opposed to suburban sprawl.  Much the same as in our lives, balance is key and the new urban neighborhoods offer a balance of different CRE offerings. These areas offer restaurants and bars, experiential retail, residential, and office. As such, the new urban centers have a great chance to thrive in the new future.  If a new urban area near you is looking for a credit union partner to build a branch, jump at the chance!

• Near/in office park, unclear: It is challenging to foretell the future of office parks, the scenario for most office parks is negative.  Three factors come into play in the way we work: co-working solutions, remote work, and traditional (single tenant) office space.  First, the upward trajectory of co-working space (e.g. WeWork) was knocked back down to earth by COVID-19.  While WeWork was already in trouble before, COVID-19 may be the final nail in its coffin. By contrast, remote working has been on the rise as a result of COVID-19. Many employers and employees may see remote work as a win-win in the long-term.  Finally, some companies will want to maintain control over their work environment, supporting the traditional office space.  Of the three scenarios, the most likely is an increase in remote working and reductions in traditional and co-working, pointing to a negative outlook. 

• Near/in residential, positive – Thirty or so years ago, branches were often situated adjacent to residential areas.  Those locations may now be back in vogue as members spend more time at/near home and less time at work, retail shops, restaurants, grocers, etc.  These locations may be the best positioned to provide convenience and service.

Actions for your branches

Assess – Assess the outlook for your neighborhood, including your branch’s neighbors, the business they are in, and whether the properties can be easily renovated to alternative CRE uses.  If you lease, assess your landlord (e.g. grocery store owner or strip mall owner). Owners may come under stress if they own significant volumes of similar properties that all begin to sour at the same time.  As well, they may come under stress if they are a small owner, as they lack the financial wherewithal to renovate properties as tenants move out.  Assess your proximity to rooftops.  Assuming we work from home more and venture out less, are your locations close enough to consumers to be convenient?

Act – A variety of options exist for your branches.

• Maintain
• Renovate
• Shrink
• Collaborate to drive more traffic (e.g. coffee shop, café, co-working space, etc)
• Convert to e-only branch 
• Add ATMs, ITMs, e-branches
• Move
• Sale-leaseback
• Close

While many of the alternatives presented will require a capital investment, the return with increased traffic, reduced costs and member satisfaction will be worth the investment.

Branches, the Real Estate Factor

In the next article, we’ll discuss the impact on the value of the branch properties, and different options to minimize the downside and maximize the upside.