Thanks to the savings in cost and time to opening, retailers are craving second-generation spaces these days. Landlords like to backfill those spots with like-kind tenants for the same reasons.
Phillips Edison & Co. senior vice president of leasing Ron Meyers’ first choice to replace a departing retailer is a similar business: a hair salon with a hair salon or a restaurant with a restaurant. “This generally leads to significant cost savings and shortens the time between occupancy, as much of the required infrastructure is already in place,” he said. While the cost and time depend on the situation, “it costs approximately half and takes about a third of the time to repurpose space for a like-use retailer as compared to a total buildout for a new category of the retailer,” he said.
Such locations usually require little more than a gentle renovation or rebrand and perhaps a few tactical equipment upgrades, which can come available at substantial discounts, said Rappaport senior director of brokerage Pat O’Meara.
He noted that demand for second-gen spaces from retailers has increased, too, especially for restaurants. “Raising money, both from traditional lenders as well as private investors, for restaurants can be challenging these days, given what took place during the pandemic. The apparent never-ending increase in construction costs certainly doesn’t help either. If a restaurateur can drastically cut the necessary capital to open a restaurant by taking second-gen space, why wouldn’t they first focus on those opportunities? Even great sites that happen to be new construction are having a hard time competing with sites that might be inferior real estate but have the valuable infrastructure in place.”
When infrastructure is mostly in place and the updates are mainly cosmetic, then completing drawings, securing permits and sourcing materials become more efficient. “Ultimately, for us and for the retailer, we like having the incoming retailer go to market as fast as possible so they can start generating income,” Meyers said. “This is what makes second-generation spaces so important. With so much demand for these spaces across all our markets, finding a replacement for a departing retailer has been highly efficient for us, especially when it comes to medical, restaurant and salon uses.”
Jaime Sturgis, CEO of South Florida-based Native Realty, said second-gen spaces are hard to come by in his area thanks to tenant relocation from the Northeast. “It can save tenants 12 to 24 months, depending on the condition of the space and a lot, if not all, of the necessary permitting, change of use, parking reductions, impact fees, etc.” Ultimately, he said, “these second-generation spaces can mitigate a lot of the risk and uncertainty around the timing and let the tenant focus on their business.”
There’s strong demand for second-generation food-and-beverage space in California’s Los Angeles and Orange counties, too, according to SRS Real Estate Partners managing principal Terrison Quinn. “Even if the cost savings are specific to things such as taking over an existing grease interceptor and upgraded utilities, it still makes a material impact to the savings for the tenant and therefore also for the landlord,” he said.
Where Tenants and Landlords Can Work Together
“Landlords often have the upper hand in negotiations for improved space and typically receive multiple offers, so long as the improvements are somewhat generic and the space is well located,” Quinn said of his region. That goes especially for quick-service restaurants. Full-service, sit-down concepts are more likely to want a specific buildout.
“Many South Florida second-generation spaces command ‘key money,’ which means the tenant is paying a lump-sum fee upfront to walk into and assume all the infrastructure that is in place,” Sturgis said. And Edge Realty Partners senior vice president Andrew Shaw is seeing landlords offer a year of base rents and tenant improvements. “This is still profitable for them because it’s significantly less expensive than building new shell space,” he said. “Construction costs and delivery are still high, so it’s cheaper for the landlords not to have to carry that additional cost. The primary benefit to tenants in second-generation space is that they don’t have to cover the full cost of buildout.”
Matt Milinovich, a principal in Avison Young’s Phoenix office, said tenant improvements for second-generation restaurant spaces range from $10 to $30 per square foot in his market. Some dated spaces that need upgrades may require $50 to $75 per square foot. “Every restaurant space is different. If the equipment is too old, it will have no value to the new tenant. … The landlord might just remove it, sell it or give it to the new tenant and let them decide what they can use and what they may need to sell or get rid of.”
NewMark Merrill vice president of development and construction Luca Giovanardi said construction cost increases and extensive tenant work letter requirements cause some deals not to pencil out. For others, the payback time frame will be long. “We’ve found that the way to making a deal profitable requires building trust with our tenants by sharing our pro forma and working with them and their most trusted contractors to value-engineer the scope to get to a number that makes sense,” Giovanardi said.
Milinovich said the main cost for landlords that backfill space with the same use is replacing outdated HVAC units. Nowadays, though, that can add time, too, thanks to supply chain issues. Thus, The Providence Group retail broker Darrell Palasciano said, maintaining existing, aging HVAC units is among the concessions a tenant could make to get a second-gen space. Other potential scope compromises: at-grade loading rather than recessed docks, reuse of existing electrical gear, roof overlays rather than replacement, reuse of existing openings/minimal facade changes, elimination of wall furring, keeping bathrooms in existing locations, parking lot slurry seal in place of mill and overlay and product or manufacturer substitutions wherever possible.
Even national chains may be willing to negotiate. Pebb Enterprises senior vice president of construction and development Evan Rosenblatt said his company has worked with national tenants willing to make sacrifices to their prototypes to backfill particular spaces, whether the motivation is location, lower investment or accelerated opening.
And of Course, There’s Been Little New Construction
Palasciano said developers until recently have kept up with soaring construction costs by raising rents. Retailers have absorbed the cost by increasing sales, decreasing their footprints, engaging in e-commerce and implementing operational efficiencies.
But in March 2022, the Fed raised interest rates, the first in a series of hikes. “This was another major blow to development costs and perhaps the final straw,” Palasciano said. “Projects that were difficult to underwrite at already inflated rents in 2022 have quickly become impossible to move forward due to interest rate increases. Many developers have seen construction loan rates double since underwriting began a year ago. In [the Carolinas], tenant demand has not slowed, but a steady stream of new development certainly has.”
High construction costs are a hurdle not only for new construction but also for renovations. “We have seen box renovation costs for junior anchors such as Marshalls, Burlington and Ross increase by as much as 100% over the past five years,” Palasciano said. “By the time a lease is signed and plans are permitted a year [after a letter of intent is negotiated], costs may have increased by 25%. To deliver a vanilla shell in an existing building, he said, costs have increased from about $40 to $50 per square foot in 2018 to $70 to $90. For junior anchor spaces, they’ve risen from $45 to $75 or more.
When Landlords Should Consider Opening Their Wallets
Despite an inclination to minimize costs, Acre founder and CEO Marty Arrivo said, “it may be beneficial to consider making a substantial investment to attract a high-profile tenant who can change the dynamics outside the four walls of the space. If I can attract a highly sought-after tenant that becomes an amenity to the office building or shopping center, I can find profitability through increased rents across my other spaces.”
And the environment for new construction may be imminent. A landlord has an underlying basis in an existing structure, said Vestar vice president of development Ryan Ash maintained, but that’s a sunk cost that shouldn’t be contemplated when analyzing future leasing activity for a vacant space. “We are seeing rents grow to a point where new, ground-up retail development starts to make economic sense.” He’s optimistic construction costs will stabilize. Then, he said, “we will be able to begin developing new shopping centers for our tenants and local communities.”
Article by Paul Bergeron – Contributor, Commerce + Communities Today for ICSC
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