Retail reset: navigating Manhattan’s cooling market

Less than three years ago, it seemed Manhattan’s retail market had no ceiling when it came to pricing. Asking rents in parts of Midtown and Soho grew by double-digit percentages, and investors spent billions of dollars for stakes in retail spaces with the expectation of big returns. Now, by most accounts, the market has surpassed its peak. Tenants are increasingly reluctant to ink leases at the record prices that some landlords want, and online competition continues to undercut in-store sales. Availability rates across Manhattan saw a 25 percent increase during the first quarter of 2017, according to data from CBRE. The average asking rent in the borough declined 2.7 percent, to $850 per square foot from $874 per square foot during the same time last year. And asking rents fell in 12 of the 16 corridors the real estate services firm tracks, with Fifth Avenue between 42nd and 49th streets showing the largest drop at just over 17 percent. From cutting their rents to offering generous concessions, retail landlords are doing what they can to fill vacancies in their buildings — some of which are encumbered by hundreds of millions of dollars in debt. “Landlords are trying to keep their existing tenants rather than create opportunities to jack up the rent by 20 percent,” said real estate attorney Joshua Stein.  Whether you call it a bubble, a correction or a plateau, the market has undoubtedly softened. This month, The Real Deal asked six experts in the industry how those changes are affecting their deal activity and how things will shake out in the future.

Alexander Brodsky
Principal, Brodsky Organization

How would you describe the state of Manhattan’s retail market? The retail market has definitely softened in the last 12 to 18 months. There are more vacancies, and the market is kind of in a correction in terms of rents. I’m hoping that within the next six to 12 months, retail vacancies and rents [will stabilize]. The market is also getting back into the types of businesses that Manhattan residents really interact with, which is positive. That’s different than what you had in the ‘60s and ‘70s — all very nice, very expensive retail. But who is really going into Graff Diamonds to buy a 40-karat diamond ring on a whim after lunch?

Do you think the slowdown is affecting the value of retail properties in Manhattan? Retail in Manhattan will always have a strong value, but the sector overall has been hit because of online competition. I think retailers are always going to want to be here, so I don’t think there will be a huge shot to retail values.

Is competition from online retailers the largest contributor to the softening retail market? For sure. That’s what I hear from a lot of tenants of ours, and it’s on their minds — if they can sell it online, why have a store? It’s very specific as to who will want that brick-and-mortar space.

Has there been a shift in tenants looking for space or have you shifted the way you evaluate tenants? I think it’s more how we’re looking at tenants. Recently, a pet store moved out of one of our properties on Ninth Avenue and West 43rd Street, and we re-rented to a nail salon. People use nail salons. People will always go there, because you [can’t get a manicure] online.

Do you think rents will climb back up to where they were one or two years ago? In terms of the grande-dame locations, I don’t think that they’re going to go as high as where they were, let’s say two years ago. I think those will certainly soften.

Have you had to offer concessions, such as free rent or tenant improvements, to ink leases? We haven’t really done any tenant improvements — not only because of the monetary issue. It’s so tenant-specific that if we do the build-out and they don’t like it, that’s another issue. In our minds, it’s more of an office tenant situation. We’ve definitely provided a little more free rent so tenants don’t have to pay rent when they are doing their build-out.

Jared Epstein
Vice president and partner, Aurora Capital Associates

Generally speaking, is retail leasing slowing down, remaining steady or speeding up? Things are starting to pick up, especially Downtown. My email inbox and phone voicemail are filled each day by brokers and tenants who are interested in pop-ups in Soho or long-term deals in the Meatpacking District. The majority of the pop-up inquiries for Soho are from e-tailers that are ready to test brick-and-mortar retail with the expectation of turning the pop-up into a long-term location.

How do you attract tenants in a market that is continually changing? Relationships play a key role in the good times and the bad. Strong retailers are looking to capitalize with new stores that are built with the help of landlord incentive packages and which feature rents that will likely look cheap down the road. These retailers are represented by the best and brightest brokers. Landlords that have good real estate, relationships with these brokers and are willing to sign leases in the current environment will have the greatest likelihood of success.

Does the softening market concern you as a developer with a significant number of retail projects coming online, like Gansevoort Row? Fortunately, the majority of Aurora’s current developments are in the Meatpacking District with anticipated delivery dates in 2018. I don’t believe there is a neighborhood that is in more demand than the Meatpacking District. We are confident that the majority of the 100,000 square feet of retail and 300,000 square feet of office space we are developing will be leased prior to construction being completed.

What advantages do you see for landlords in the current market? Long-term owners will fill their vacancies by offering tenant-friendly deals and will seize on the opportunity of acquiring properties at better values.

Do you see the softening having an effect on the value of retail properties in the city? The value of stabilized retail properties has declined by approximately 50 basis points simply due to the fear that is associated with the word “retail” today. Once the fear subsides, these values will come back. Vacant retail and development sites with large retail components have softened more significantly, and this was needed because pricing was based on rental projections that were unrealistic and/or comps that were an anomaly.

Would you call it a retail bubble? Yes, this was a bubble, but thankfully it is deflating safely due to the strength of Manhattan. The bubble was created by the vast amount of capital that backed many unsophisticated purchasers who were projecting unrealistic retail rents to justify their record-priced purchases. These new landlords will either lose these properties or accept the reality of lower rents and lesser profits, if there are any at all.

Joshua Stein
Principal, Joshua Stein PLLC

How is the retail slowdown affecting lease negotiations between tenants and landlords? Tenants have a lot more strength today than they did two or three years ago, and landlords are trying to keep their existing tenants rather than create opportunities to jack up rent by 20 percent. Landlords really want to keep those tenants: A real live tenant who is happy and paying rent is a great thing these days.

Joshua Stein

How can landlords retain tenants? Unless [a store goes] out of business, they’re going to stay until the end of their lease. If you are a landlord looking ahead, you may want an early renewal because you don’t want a tenant looking for alternative space. You may even lower the rent in exchange for an early renewal — that might make sense if [a landlord has a quality tenant] and the rent is really difficult to pay. If you lower their rent now, you have an assurance. [If you go vacant], your vacancy could be there for months.

Are you finding landlords offering shorter-term leases? It’s not something I’ve seen, but I think it’s a good idea. It lets retailers try a space without becoming totally committed to it, and it brings in some income and excitement. The question is whether the space is capable of fulfilling the needs of the tenant in its current condition. What ends up happening sometimes is the old tenants go in and demolish everything when they move out, so there’s a lot of concrete, steel, visible cabling — is that space suitable as a pop-up? Those tenants don’t want to invest capital dollars for such a short-term lease.

Are you seeing the most problems in the high-end retail sector? I don’t think it’s limited to high-end retail at all. As far as I can see, it’s all levels of retail. Fifth Avenue is supposed to have all high-end retail and a lot of it is high-end vacancy. You also see a lot of the local Chinese restaurants, hardware stores and shoe stores going vacant when their leases are up. The issue is high rents. When do landlords start to adjust rent to get spaces full? How long will they hold their breath before they decide to lower rents to fill those spaces? There’s a limit.

Are you worried about a potential uptick in loan delinquencies, defaults or foreclosures? I would think so, yes — that with the slight increase in interest rates and the increase in available retail space, there would be some uptick in delinquencies. The defaults would still be low, but there’s already been an uptick in those.

George Doerre
Vice president and commercial real estate group team leader, M&T Bank

What are some of the biggest changes in Manhattan’s retail market that you’re seeing as a lender right now? What we’ve seen across the board is that momentum in rents has stopped, but I say momentum because there are places where rents are holding. That tends to be in markets where it’s already been established between $150 and $300 per square foot.

Do you see the leasing market slowing down, remaining steady or speeding up? I don’t see retail rents suddenly exploding, but I also think there is room in locations where there is always a demand and a lot of foot traffic — areas like lower Fifth Avenue and near Herald Square, Union Square and Penn Station. Rents may not have upward momentum, but they will level out, and those are good locations to add value.

Are things more stable on the lower end of the food chain, when it comes to more mom-and-pop shops? I do think so. A certain amount of neighborhood convenience retail will sustain. Your carry-out or counter-service food shop is hard to displace.

Does that make it a safer bet for a bank? It’s such a bland answer, but it’s all about the cash flow and the sustainability.

How is the state of the market affecting the way you do business as a lender? Our view is to just always have a good understanding of rents. Sometimes that means our ability to lend is going to be less than someone who has a more aspirational view of rents, or someone who is going to look at a lower debt yield. That’s what has kept us out of trouble and that’s what we continue to be very cautious about.

Are banks underwriting retail deals more conservatively? We’re being more conservative in terms of having a careful approach to the rents we think landlords can get. Sometimes when people say banks are being more conservative, people think we’re fleeing the market or we’re only doing it for certain customers. If I have a customer who comes in and says they’re going to take a building and redevelop it on spec, chances are that it’s a very good, longstanding customer who has a track record, a balance sheet and is going to give us all kinds of credit enhancements and structure. We’re absolutely open for business on retail. It may sound a little bit boring, but as long as we’re careful with our cash flow, we’re happy to entertain retail.

Do discounted rents and increased vacancy impact the value of a building? We’ve already seen some places where the tempering of rent expectations has driven down some of the appraised values, but it all depends. If you’re talking about retail condos, [that’s already happening]. You saw some lofty trades a few years ago, and I think you’re seeing less of that. If you have a whole building, whether it’s apartments or commercial, and retail is an add-on, the retail can take a little shot to value in the short run. Depending on how large the overall building is, it might not dent its financability too much.

Do you think we’re in for a significant correction? The correction is in the process of happening. There’s been a realization for some folks that some of the aspirational rents are not there. This cycle, bank lending has been fairly disciplined, so you have sponsors who are saying, “I have to settle for less rent than I had aspired, but I can find a way to make my current financing work or it may be worth it to resize by debt.” There are some people who really [over-leveraged] and expected big things to happen and won’t be able to deliver. There will be some pain there, but I do think Manhattan is a fairly efficient market. Landlords will cut prices and we’ll see tenants coming in. There are still tenants that want to be here. There are still workers and residents who need these services and are willing to pay.

Peter Braus
Managing principal, Lee & Associates

Is retail leasing slowing, steady or on the up? When there’s a correction, there are always retailers to pick up the slack. During the Great Recession in 2009 and 2010, we saw lots of vacancies, and a lot of local retailers stepped in and started leasing space. Landlords also got creative. On Madison Avenue, for example, landlords signed a lot of three- and five-year leases at lower rents. My thought is that will happen [again]. New York City is not one of these places where it’s so economically depressed that a site just won’t get leased because there are no tenants [to lease to]. I don’t think that’s the case. Most parts of Manhattan are still desirable at a price.

Peter Braus

To what degree are you seeing landlords discount rents? There’s no hard and fast number. I have leases out now that are within 10 percent of my asking rent. I have other situations where the owner has come down 20 or 25 percent.
I think it’s site-specific. Some parts of the city are certainly more susceptible to a bigger spread, and then, of course, it’s landlord- specific.

Do some landlords offer concessions and tenant improvement dollars before discounting rent to keep the face rent up? Well, no. It’s all in the sauce at the end of the day. Some tenants are not as concerned with getting TI. Stores that are in very good condition don’t sit on the market as long because there’s much less of a financial burden to open. Some of these stores, particularly in a new development, where there is a first-generation raw space, landlords are more likely to [offer tenant improvement funds], particularly to a tenant they want. If it’s a marginal tenant, I don’t think you’re going to see a landlord doing that sort of thing. But we’ve had deals recently where the landlord just really wants that specific tenant in their development and is willing to do stuff that you might not have seen a couple years ago, where they’re funding the entire building of the store because they think it’s going to add big value to the apartments upstairs or what have you.

Would you call this a retail bubble? I certainly don’t see a retail bubble right now. If we were in a bubble, it would suggest that you’re just seeing deals done at unrealistic numbers, and I think that time has passed. Now, we’re certainly in a corrective state where landlords are pricing their spaces in accordance with what it’s going to take to get a space leased.

Richard Skulnik
Executive vice president, Ripco Real Estate

How would you describe the retail market in Manhattan? There are certain Manhattan submarkets that are still seeing more lease transactions taking place, and there are secondary and tertiary markets that have slowed, so you net out at stable.

Which neighborhoods have the greatest potential for rent growth in 2017, and are you already seeing growth there? Yes, there are deals being done on the Lower East Side and in the East Village. The comps are being bettered with the additional deals — so in other words, the rents coming in are better than the last rents paid.

Richard Skulnik

Has the market affected the way you negotiate on behalf of a tenant? In general, tenant brokers and tenants have been more aggressive in what they’re asking for: lower rents and tenant improvement allowances.

Have you found landlords are willing to entertain those ideas and work them into leases? Yes, they are.

What are the most common concessions that landlords are willing to agree to? It definitely changes based on the tenant’s credit-worthiness. For credit-worthy tenants, landlords have been willing to give extensive build-out and tenant improvement packages. While one tenant might take an extended free-rent period, others may benefit more from having a tenant improvement allowance check. It’s case by case.

Would you call this a retail bubble? No, I don’t think it’s a retail bubble. For a long time, Manhattan has been somewhat protected from retail closures. It’s only recently that we’re seeing companies such as Ralph Lauren deciding to close down their Fifth Avenue store. That’s a very significant statement and has a lot of us thinking.

Are things more stable when it comes smaller retailers, like pizza shops, nail salons and so on? There’s definitely a place for mom-and-pop-owned service businesses in Manhattan. We have such a huge residential population, and everybody needs these services. If the more residential-focused markets have seen rents stabilize or fall, then those types of retailers could make deals [at affordable rents], and [the possibility of them] being kicked out of their spaces is lessened.

Are there any other businesses that are bucking the trend? Casual food and fitness are still out there making deals. It’s not necessarily the full-line gyms. It’s more the boutique, class-based, pay-as-you-go models.