In part 2 of this discussion, Terry Montesi and Byron Carlock continue their conversation about emerging CRE trends.

They discuss rethinking retail and other uses post-pandemic, e-commerce trends and long-term market share, department stores, and the future of conventional bricks-and-mortar.

Byron also shares his thoughts on experiential retail, and what retail places must do to attract customers out of their houses.

Byron is a CPA, currently a governor of the Urban Land Institute (ULI), a member of Real Estate Roundtable, NAREIT and AFIRE. He is also a board member of Harvard Club of Dallas and a board member emeritus of Harvard Business School.

Transcript

Terry Montesi: Welcome back to Trademark Property Company’s podcast, Leaning In. This is the second part of an episode, and you can find part one on the podcast page. Thank you for tuning in.

On today’s episode, I complete my conversation with Byron Carlock, national partner, real estate practice leader for PricewaterhouseCoopers. We look at rethinking retail and mixed-use projects and other uses post-pandemic. We look at e-commerce trends and ultimate size of e-commerce. And we look at malls, department stores, retail, and brick-and-mortar.

Byron also shares his thoughts on experiential retail, and what retailers and retail places will need to do to attract customers and get them out of their houses.

Regarding the multifamily business, how do you think COVID-19 will impact this business? And share your thoughts on locations, product types, and changes that we’ll see over the next 10 years.

Byron Carlock: Well, we went into the pandemics about 7 million units short, according to Fannie Mae, and 29 million millennials still live at home. So, we have a great need for housing. And I think that the market is screaming for different types of housing, not necessarily all Manhattan luxury apartments. So, if you look at vacancy in Manhattan, it has climbed and it’s repriced. Same for San Francisco, which is now around 9% as of October, but rates are down 10% year over year in San Francisco, and 20% down from the peak. In New York, you’re seeing rates down 8% to 20% depending on the neighborhoods. But you’re seeing strong demand in the smile markets, the Sunbelt smile markets where a supply demand is either well-balanced or still building and rates are holding their own.

I do think we’re seeing a need to pivot towards some more affordable product, and not as dense. And that seems to be a preference. I attended a builder’s summit for single family about three weeks ago that was hosted by a horticulturist named P. Allen Smith. I don’t know if you’ve ever seen P. Allen on PBS, but he has a theory that the American dream does not require that you live on a golf course in a suburban gated community, but there’s a desire to live in mixed-use settings with green space and front porches, and really a lot of the things that the Congress of new urbanism has been telling us ever since Seaside was developed in the panhandle of Florida: smaller houses with more community interactions centered around green spaces, dog parks, floral gardens, shared vegetable gardens, those kinds of things. So, I think what we’re learning is that not only is there a need for housing, but there’s also a need for a different type of housing. So, as we look at redeveloping a concrete parking lot and, and over-retailed centers and neighborhoods, the opportunity to deliver that new kind of housing if you can make the numbers work on the land price will satisfy a desire that frankly has not been there since the 1920s, when you saw the cute bungalows and the neighborhoods really looking at design as a primary amenity, like we’re going to bring design back as an important amenity as we watch this popularity of the McMansion continue to fade.

Montesi: Great. Thanks for that. Byron in the report, you mentioned office workers were quite productive from March through June. After that productivity started to slow down and since then depression and loneliness are up. I know we experienced working hard on being productive March through maybe July, August, and then it started to get old and you really started to notice that what was missing was the ability to train, and learn, and collaborate, and spontaneously go down the hall and explore an idea.

And so, I think there’s a lot of sort of new business ideation that’s missing, but not so much heads down work, like you said. What is your view of the office sector post-COVID and how should that impact your client’s office investment and development mindset going forward?

Carlock: Well, I think it’s taking a pause for sure.

We’ve got 9 million square feet of sublease space on the market right now, biggest overhang we’ve ever seen of sublease space. And it’s going to take us a while to work through that. However, I think we’re going to see some of that sublease space come off the market as some people go back to the office and realize they want more space as they spread desks out, as they bring back cubicles, as they bring back some enclosed office options, as they expand the size of conference rooms and collaborative centers, as they increase their audio-visual technology for larger audiences to be able to communicate with folks at home and around the world.

And so that may actually require more space. It will certainly require a different kind of space. And so, I’m not ready to give up on the office space as an attractive investment opportunity, because I think we may need more space of relevant buildings that have 5G and the capabilities to do what users are wanting with the lead certification and the carbon footprint that investors are requiring.

80% of our office stock was built in the 1980s or before. So not to the extent of retail, but a lot of that space needs to be demolished or repurposed. So, you’ll see some of the buildings come down and you’ll see some of them become housing units. And I think that is – back to our ULI discussions earlier – helping a piece of property find its highest and best use is what our industry does.

And there’s probably a lot of redevelopment that needs to happen in the office sector as well as some new development for relevant use.

Montesi: That’s my view. And I’m really glad to hear you say that because I think a little like retail, we have too much space overall, but I’m not sure we have too much great space.

And so, I think that’s the same in office as people get more selective regarding the health and wellness of their folks, fresh air – all the different things that we’re now learning about. Hygiene, elevators, people rather walk, et cetera. I’m not sure we have too much of the right space post-COVID.

Carlock: That is the litmus test. And you’ll see ESG issues, air quality issues, and technology issues become the litmus test as to whether a building has relevance.

Montesi: Yeah, no doubt. Let’s go back to the retail sector for a minute. When you think about tenants, retailers, retail types, and you think of the different sectors daily needs, lifestyle, power center malls, et cetera.

Give us some of your other thoughts on the brick and mortar side only of the retail business going forward.

Carlock: Well, here’s a pretty stunning statistic. The savings rate during the pandemic has grown to 13.3% up from 8.2% pre-COVID. That’s a trillion dollars of embedded savings. 20% of annual retail sales and we are a 70% consumer driven economy. That tells me to your point earlier, people are dying to get out and they’re going to unleash some of that savings on some interesting expenditures and become consumptive again. And that’s going to contribute to the rebound. Now we’ve got a big question as to whether this rebound is going to be a U shape, a V-shape, a W shape as we work through the vaccine timetables, and some have confidence, some don’t, and then we go back into shutdown, like we’re watching some cities do now, or is it going to be a K shape? And I’m becoming a K Shaper where you’ve got a portion of the economy that really shoots up. And then we’re still looking for ways to deal with the downward K because we’ve got 40 million people that are either unemployed or underemployed that are really struggling for survival. And so, we’ve got a bifurcated economy right now that that portion that returns to some consumption is going to really benefit retail. And it’s going to be an important piece of the recovery.

Longer term, I think we’re probably in for structurally lower growth, much like Japan and Western Europe. We have aging demographics. Our population growth has dropped below 1% as a natural population growth. We’re looking at recession frequency elongating. We used to have recessions every four and a half years. Now we’re down to about two and 20 years. And so, we’ll probably have a sustained growth in the one and a half, maybe 2% range.

And that’s going to alter the way we look at spending investing returns on our investments and savings.

Montesi: That’s a very interesting point and we certainly see that happening and you know, there’s good and bad to that. It’s a little more predictable when you have 0% interest rates and predictable, slow growth, but slow growth has it has its problems as well. And I think we’ve started to see some of that.

Talk about gateway markets and how the urban Exodus we’ve got these great big old American cities that for now are suffering a little, less people escape the most dense places during the pandemic. You mentioned an example in the report, 500,000 people a week leaving the five boroughs of New York city.

Carlock: 5,000 households a month.

Montesi: I think it was 500. Well, whatever you say, it’s an awful lot of people leaving the five boroughs of New York. Add a little detail on what

you think this is going to mean long-term for the cities. Do you think they’re going to have trouble over the next 10 to 20 years attracting folks back? Will they be more tourist centric and less stable relative to folks living there? What are the gen Z folks going to do? What’s this going to mean for our great dense American cities?

Carlock: Well, I think we have to begin watching the boomerang effect of folks getting confidence to come back after the vaccine begins to be administered.

There’s one aspect that cannot be replicated, and that is the cultural infrastructure of the great cities of the world. And we’re already seeing a bit of a boomerang back to London, even though they’re in the middle of deciding what a post-Brexit London looks like, you cannot replicate that cultural infrastructure.

Same in New York, the cultural infrastructure once the theaters reopened and music venues reopened, and the opera begins singing again. You just don’t have that in every city. There’s also a big population in New York that left because they were given the permission to work from home and that whole analyst community largely did not renew their leases and went home. And they’ll have to go back. With rent levels reducing, will they have to be stacked in apartments the way they were two and four deep? Maybe not. But I think the boomerang will probably be more successful in New York than San Francisco. And Chicago is hurting too. DC has had a dip as well, but I think a new administration and government seems to never stop growing. I think DC will be fine. And you’ve got Amazon HQ too there. But the New York, San Francisco, and Chicago are going to have to address some leadership issues, some social unrest, and some taxation issues that have driven people to tax friendlier jurisdictions. And that that’s big, that’s big. And it’s going to have to be addressed to enhance the quality of life of those important cities.

Montesi: I think the pendulum swings and some of them may have gotten a little arrogant and thought they could just tax people like crazy and not really have effective practical leadership, and that home values and interest in their city would just go up forever. And this pandemic may just be a little bit of a wakeup call, like you say, for leadership in those big cities.

Carlock: Agreed. For years, the institutional community was only focused on gateway cities – Boston, New York, DC, Miami, San Francisco, LA. I think the pandemic will also shift investment preferences. This is the first recession we’ve ever had where the feds took the actions they did to prop up the capital markets and keep them open.

It’s the first recession that we’ve had, where all the major banks are healthy. And we’ll be coming into the recovery healthy and it’s the first recession we’ve had that real estate was not really damaged and we’ve got $400billion of dry powder in the private equity real estate space coming into this recovery.

And the beneficiaries I think, are going to be these 18-hour cities that show the most promise for growth. Probably to the detriment of some of the gateway cities that you mentioned earlier, but for Boston, which has created itself as distinctive in the life sciences in the industry and those cities that remake themselves around life sciences, and artificial intelligence, and research collaboration, and partnerships with their universities, and creation of knowledge. Workers will probably be okay long-term, but they’re also going to have to address the climate change issues – sunshine flooding in Miami, the issues associated with waterfront preservation, as well as affordable housing and workforce housing and the sustenance of these technological changes as we move into the fourth industrial revolution.

And some of that change is happening in the 18-hour cities in very important ways. And I think that’s one of the reasons Raleigh Durham showed up at the top this year.

Montesi: That’s a great point. That’s much of where we’re focusing our development and investment attention. So, I have a question to see if you guys have done the research or if you’ve done any thinking around e-commerce penetration long-term, when it really starts to reach equilibrium. Is there a ceiling on e-commerce penetration, and have y’all done any forecasting or thinking about where and when it levels off and why?

Carlock: Well, I think that that brings us to a great series of points before we close. JLL just projected that e-commerce will hit a trillion and a half by 2025, and that to get there we’ll need another 300 million square feet of industrial because the square footage to sustain that growth  benefits the industrial space needs. And so, our industry is going to be busy building warehouses and different kinds of warehouses. This new two- and three-story warehouse is really interesting with  higher tech picking capabilities and the tenants putting in as much or more as the landlord and getting the building delivered.

And that’s why industrial is number one in the development preferences for the next several years. So, if you look at the development and investment preferences between industrial number one, and then single-family homes, number two, and multi-family number three, it really speaks to all that we’ve been wrapping into our conversation today.

E-commerce is driving industrial demand as well as manufacturers and distributors onshoring what they had previously offshored and they learned some big lessons in the pandemic too, about having component parts and ingredients to support the manufacturing process onshore and ready for production. That’s driving industrial demand as well.

And then single family, we talked about the changing housing preferences and the market preferences, and then multifamily, we’re looking at  new product, maybe not as dense. The garden department is coming back in ways that you and I haven’t seen in years. And it’s in suburban locations. And I think this quest for a little lower density and a little more green space is something to watch.

Montesi: So, on e-commerce penetration percentage wise, it’s at 16% today, have y’all done any thinking or forecasting around where that levels off and when and why?

Carlock: So, the only thing I can point to data wise is the JLL study that just took it up to a trillion and a half by 2025. And you can look at the breakdown between what is per capita growth and what is new e-commerce expenditure. It’s at 84% brick-and-mortar, 16% e-commerce now, I could see it being 75%, 25%, maybe even 70%, 30%. We are a time-starved nation, and we are 70% consumer driven, but I don’t think we’re ready to give up on product trial and demonstration, and in store experience, and learning and just downright selfish customer service. We like to be served when we’re spending our money.

Montesi: Yeah. So, you think if it’s at 16% today and it were to go to 25% or even 30%, that 30%, it doubles roughly from today, you think it’d be hard for it to keep accelerating much beyond that?

Carlock: That’s my current feeling. Yes.

Montesi: Great. Hey, Byron, thank you for your time, pal. I really appreciate it.

Carlock: Terry. Thank you so much. Take care. Bye bye.