Matthews™ Spring/Summer 2020 Publication

TM

COVID-19’S INFLUENCE ON CRE THE ROAD TO RECOVERY A RECIPE FOR SUCCESS

IMPACT PER REGION

HOW MARKETS ACROSS THE U.S. ARE FARING

LANDLORD + TENANT LEVERAGE HOW TO ENHANCE PROPERTY VALUE

DOLLAR STORES: THE ONE TO WATCH SELF-STORAGE: LONG-TERM GAIN SPRING/SUMMER 2020

THE VALUE OF A DRIVE-THRU

SPRING/SUMMER 2020

Table of Contents F E AT U R E D

TRENDS

13 Impact Per Region

05 Top 10 Trends in Commercial

66 The U.S. Multifamily Market

75 The Launch of Opportunity Zones

How Markets Across the U.S. Are Faring Insights on the Stability & Predictability of the Sector

92 A Post-Pandemic Reality

Factors Shaping the Future of Shopping Centers

101 The Road to Recovery A Recipe for Success

Real Estate

How to Maximize the Benefits in 2020

86 Cost Segregation

How to Improve Cash Flow

R E TA I L

S P E C I A LT Y

26 Dollar Stores

38 Self-Storage

46 The Value of a Drive-Thru

55 Emerging Industrial Markets

The One to Watch

110 Landlord + Tenant Leverage How to Enhance Property Value

Short-Term Pinch, Long-Term Gain The Top Metros Fueling Demand

120 What is an UPREIT?

Monetizing Healthcare Real Estate Through a Unique REIT Structure

CONTRIBUTORS KYLE MATTHEWS Chairman & CEO

RADDIE ZLATKOV

DUERK BREWER

DAVID HARRINGTON

Chief Operating Officer

Chief Financial & Strategy Officer

CHAD KURZ

EVP & Managing Director

DAVID ROTH

BEN SNYDER

EVP & Managing Director, STNL

EVP & National Director, Multifamily

EVP & National Director, Shopping Centers

MICHAEL PAKRAVAN

MATT FITZGERALD

BILL PEDERSEN

SVP & National Director, Retail Leasing

EVP & Market Leader

MAXX BAUMAN

Market Leader

ANDREW GROSS

Market Leader

Market Leader

Austin Borges

Connor Olandt

Josh Bishop

Austin McLeod

Gary Chou

Michael Moreno

Braden Crockett

Harrison Auerbach

Rahul Chhajed

Brandon Kosek

Johnny Blue Craig

Robert Starrett

Carter Hadley

Jon Prater

Zack Bates

EDITORIAL & DESIGN Leanne Jenkins

Erica Ragland

Victoria Harkrider

Marina Rubio

Alfonso Lomeli

Lori Valencia

This information has been produced by Matthews™ solely for information purposes and the information contained has been obtained from public sources believed to be reliable. While we do not doubt their accuracy, we have not verified such information. No guarantee, warranty or representation, expressed or implied, is made as to the accuracy or completeness of any information contained and Matthews™ shall not be liable to any reader or third party in any way. This information is not intended to be a complete description of the markets or developments to which it refers. All rights to the material are reserved and cannot be reproduced without prior written consent of Matthews™.

TOP 10 TRENDS IN COMMERCIAL REAL ESTATE COVID-19 upheaved the economy and spread uncertainty around the nation, Matthews™ is committed to keeping investors informed on market conditions by breaking down CRE trends and the movements investors should keep on their radar.

MATTHEWS™ | 5

Source: CoStar 45%

2

CHANGING CONSUMER PREFERENCES

It’s no doubt that even under the most optimistic scenarios, American families will be adjusting to a “new norm” for some time. With social distancing mandates in effect, consumer shopping habits shift week-to-week as concerns escalate among consumers. It is universally known that the arrival of the pandemic has caused nearly all shoppers to adopt new behavior. Once social distancing restrictions are lifted across the nation, experts determine shoppers will become more conscious of the product and brand they’re purchasing.

Thus, retailers will need to be more transparent about their global supply chain. Shoppers will practice new safety habits, like contactless and distant shopping, and brands that prioritize consumer health and safety will gain more loyal customers. Consumer confidence is going to take some time to return, but eventually the U.S. economy will return to a healthy place.

6 | SPRING/ SUMMER 2020

40% 35% 30% 25%

0%

Strip Centers

5%

Other

10%

Malls

15%

General Retail

20% Neighborhood Centers

Pre-COVID-19, the Urban Land Institute (ULI) released its emerging trends in real estate 2020 survey, reporting that regional malls, power centers, and outlet centers all have a “sell” recommendation, and neighborhood centers, urban/high-street retail and lifestyle/entertainment centers are considered a “buy” or “hold.” As we reflect on the disruption created by COVID-19, it is evident that essential retailers, such as supermarkets and big-box stores, are projected to continue doing well following the global crisis. Thus, shopping centers with these tenants will fare better than strip centers or malls, whose stores are unable to adjust to meet the changing consumer demand. It is anticipated that a significant number of regional malls will disappear over the next few years, rationalizing the amount of available retail space in the U.S. There will be new approaches to fill vacant space, offering the perfect opportunity for repositioning and redeveloping.

Click here to access the article A POST-PANDEMIC REALITY: FACTORS SHAPING THE FUTURE OF SHOPPING CENTERS.

Power Centers

1

ESSENTIAL RETAIL COMPOSITION, BY SUBTYPE

A NEW SHOPPING CENTER RETAIL MARKET

COVID-19 CONSUMER SHOPPING BEHAVIOR

Contactless and Distant Shopping

Increasing Use of E-Commerce

Supporting Local Businesses

Brand Loyalty

Decrease in NonEssential Spending

Conscious Consumers

POST-COVID-19 FACTORS PROJECTED TO SHAPE RETAIL Consumers will have adopted short-term behavior, that will become permanent

Consumers will emerge from the pandemic in a new economic reality, changing consumer purchasing habits dramatically

Significant consolidation of retailers will fundamentally alter the competitive partner landscape

3

WHAT ARE YOU SPENDING THE MOST ON WHEN SHOPPING ONLINE?

A GROWING E-COMMERCE PRESENCE

Source: Fluent Pulse

COVID-19 has accelerated the migration away from brickand-mortar shopping to e-commerce. For many customers, e-commerce has evolved to become the primary source of shopping as consumers feel more comfortable and safer to purchase online for delivery or contactless pick-up. During the pandemic, shopping conducted through online sites increased by 10 to 30 percent, compared to three to four percent pre-coronavirus. And, while these gains may return to normalcy, it is also likely this new normal will feature a much higher e-commerce penetration rate along with continued growth. In the coming months, more and more retailers will introduce e-commerce to aid in providing their services.

27%

of Americans have increased their online shopping since the onset of the outbreak.

4

■■ Food ■■ Fashion ■■ Technology

■■ Cleaning Supplies Beauty Products Games

7%

Paper Goods Fitness Products

4%

8% 36%

8% 8% 10%

19%

75%

47%

of Americans expect to continue to shop the same or more online as retail stores begin to open.

are making the same amount of online purchases.

LOCALIZATION OF INDUSTRIAL SUPPLY CHAINS

As more retailers introduce e-commerce capabilities, industrial space demand will increase. Before COVID-19, industrial product was already red-hot. For the remainder of 2020, the industrial market will see some dramatic shifts as the growth of e-commerce and trade put pressure on businesses to further reinvent the supply chains from global to local. Digitization will play a heightened role in localization by providing access to real-time data and information, creating more agile and efficient processes and operations. Vacancy rates are near historic lows, and options for relocation are exceedingly limited.

QUARTERLY INDUSTRIAL TRANSACTION VOLUME Source: RCA $45B $40B $35B $30B $25B $20B $15B $10B $5B $0

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

2011

2012 2013 2014 2015 2016 2017 2018 2019 2020

MATTHEWS™ | 7

5

VIRTUAL & AUGMENTED REALITY

Property technology (proptech) has transitioned over from 2019 to 2020 as a significant CRE trend. Technological advances such as the use of augmented intelligence (AI) and the Internet of Things (IoT) have been introduced to the marketplace due to increasing demand for urban and global sourcing and changing workforce needs. These technologies allow for superior experiences that not only engage the tenant but also extend services to the end-user.

Surveyed CRE executives from the ULI report anticipate that IoTenabled smart buildings will have a growing influence on tenants’ leasing decisions in 2020.

6

DEMOGRAPHICS DRIVE HEALTHCARE DEMAND

Although a niche market, medical office real estate will have a significant impact as outpatient care grows, insurance coverage expands, and new treatment options become available.

According to the ULI, aging Baby Boomers in the U.S. are creating a demographic tailwind that’s underpinning the demand for medical office investment. There will be over 70 million Americans aged 65 or older by the year 2028, an increase of about 15 million compared to today. From the commercial real estate stakeholders surveyed in the ULI report, 40 percent gave medical office property a “buy” recommendation. With only 9.6 million square feet of inventory added in 2019, vacancy rates remain low, and rent growth high.

Prior solid fundamentals will allow for a relatively rapid rebound when the economy bounces back.

Click here to access the article WHAT IS AN UPREIT?: MONETIZING HEALTHCARE REAL ESTATE THROUGH A UNIQUE REIT STRUCTURE. 8 | SPRING/ SUMMER 2020

of companies globally will be using AI as part of their sales processes

$38.8 BILLION

2025

is the expected AI revenue from their sales processes

ULI survey respondents that believe smart buildings will be just as or more influential than location or tenants’ leasing decisions

61%

GROWTH IN NUMBERS OF OLDER AMERICANS Source: U.S. Census Bureau; Moody’s Analytics 2015

2020

U.S. Population (Millions)

68%

ULI survey respondents that believe tenants will pay at least 6% to 10% premium to be in a smart building

AT LEAST 30%

2020

2025

2030

2035

2040

2045

2049 0 Ages 65-69

10

20

Ages 70-74

30 Ages 75-79

40

50

Ages 80-84

60

70

Ages 85+

7

SALE VOLUME & GROWTH From 2010 to 2019 | Source: CoStar

THE RISE OF ALTERNATIVE INVESTMENT SECTORS

Alternative or specialized investments will grow in 2020; these include senior housing and care, medical office, student housing, life science facilities, self-storage, manufactured housing communities, mixed-use centers, 55 and older active adult communities, parking lots, and data centers. Alternative investments are steadily increasing in both volume and market share, but have more than doubled since 2010.

Investors are becoming more willing to take on operational risk, especially when combined with the special programs like Opportunity Zones or the Low Income Housing Tax Credit.

Click here to access the article SELF-STORAGE: SHORTTERM PINCH, LONG-TERM GAIN.

8

Past 10 Years

YOY

SENIOR HOUSING & CARE

$57.3B

12.59%

MEDICAL OFFICE

$103B

2.69%

STUDENT HOUSING

$41.2B

20.33%

SELF-STORAGE

$37.2B

9.58%

MANUFACTURED HOUSING COMMUNITIES

$21.1B

20.49%

DATA CENTERS

$3.1B

17.92%

THE RISE OF NEW LEASES WITH RENT REFORMATIONS

In the second quarter of 2020, investors will mostly focus on rent collection, and vacancy concerns as tenants’ ability to pay rent are impaired due to the lack of business. Currently, most retail leases limit a tenant’s ability to claim a rent abatement based on business interruption. Now, retail tenants are aiming to rewrite their leases to include a pandemic escape clause and other additional forms of relief. In the long-term, COVID-19 is bound to have a lingering effect on the way leases are structured and negotiated moving forward. Future leases will likely become more customized with more attention focused on government regulations, timing, reduced budgets, and force majeure language. Landlords may face pressures to renegotiate as many tenants have made it clear that they are not paying rent.

IMPACT OF COVID-19 ON MONTHLY RETAIL SALES DEVELOPMENT IN THE U.S.

■■ January to February ■■ February to March

Source: Statista

■■ March to April ■■ April to May

Food & Beverage Stores Health & Personal Care Stores Building Material & Garden Equipment & Supplies Dealers Electronics & Appliance Stores Gasoline Stations Sporting Goods, Hobby, Musical Instrument & Book Stores Clothing & Clothing Accessories Stores Total Retail -50%

0%

50%

100%

150%

MATTHEWS™ | 9

9

FROM A LANDLORD MARKET TO A TENANT MARKET

Tenants and landlords are seeking creative solutions that allow both parties to remain viable. It’s going to take some time for retailers to go back to pre-coronavirus business. According to CoStar, retail landlords in the U.S. typically collect more than $20 billion per month in rent, but in April, landlords only collected between 15 to 30 percent. The Wall Street Journal also cited that many owners of malls and shopping centers are putting together a “blacklist” of financially stable tenants that are not meeting their rent obligations. Relationships between tenants and landlords have been disrupted, and many are being forced into difficult conversations about lease agreement and lost revenue. Click here to access the article LANDLORD & TENANT LEVERAGE: HOW TO ENHANCE PROPERTY VALUE.

IF YOUR TENANT(S) ASKED FOR RENT FORBEARANCE, WHICH STRUCTURE DID YOU SELECT? Source: Matthews™ Investor Outlook Survey Rent Reduction Rent Deferral Rent Abatement Partial Rent Abatement Application of Deposit Other 0%

10%

20%

30%

40%

50%

60%

70%

PERCENT OF RETAIL RENTS PAID PER MONTH

Source: Datex Property Solutions

10

91.4% March 2020

MULTIFAMILY OWNERS WORK ALONGSIDE TENANTS FOR SOLUTIONS

The pandemic has certainly affected apartment rents, with a record-breaking 30 million Americans applying for unemployment benefits. Many owners and property managers put rent deferral programs in place to deal with COVID-19. This included more frequent payment schedules, deferred payment programs, security deposit conversations, percentage reduction for on-time payments, and credit card payments. Several states also issued temporary eviction moratorium that provides protection for tenants and extends the timeline to repay past due rent related to COVID-19 circumstances. Rent growth for multifamily owners was already slowing at the end of 2019 and has continued into 2020, but the pace of the decline looks to be slowing. Click here to access the article THE U.S. MULTIFAMILY MARKET: INSIGHTS ON THE STABILITY & PREDICTABILITY OF THE SECTOR. 10 | SPRING/ SUMMER 2020

58.6% May 2020

54.1% April 2020

61.0% June 2020

RENT PAYMENT TRACKER: FULL MONTH RESULTS IN 2020 Source: National Multifamily Housing Council 100%

Week Ending ■■ 6th ■■ 13th ■■ 20th ■■ 27th ■■ End of Month

90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

April

May

June

94.6%

95.1%

95.9%

Percentage of Rent Payments Made

MATTHEWS™ | 11

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I M PA C T P E R

PER REGION PENDING DESIGN

The economic uncertainty brought on by COVID-19 is unlike anything the real estate industry has experienced. The effects have been wide-ranging and have caused massive disruption to daily lives and businesses, including commercial real estate. The following article will look at how regions across the United States are faring and how top commercial real estate markets have responded.

MATTHEWS™ | 13

The Impact on the Economy

Just a couple months ago, the economy was doing great, unemployment was at an all-time low, and real estate fundamentals were solid. So far, this is not a liquidity crisis, although certain parts of the market are experiencing issues. The pandemic has already led to the fourth largest decline in global GDP in the last century. In the past, events that caused mass deaths, such as wars and pandemics, have had significant long-lasting economic consequences. In May, retail sales in the U.S. bounced back after falling drastically in March and April, reflecting the reopening of businesses in many U.S. states.

Retail sales were up 17.7% from April to May, following a decline of 14.7% in April and 8.3% in March.

Employers added 2.5 million jobs in May to bring the unemployment rate down to 13.3%.

Economists at the International Monetary Fund (IMF) measured the long-term consequences of pandemics, going back nearly a millennium. IMF economists determined that pandemics lead to a sustained period of lower real borrowing costs and higher wages. The reason being that pandemics often cause a shortage of labor relative to capital. Moreover, pandemics are usually followed by an increase in private savings that leads to slower growth of demand, according to Deloitte.

Summary of Economic Projections Graph (Median)

2022

2.0

2.0

4.1

4.1 1.9

1.8

2.0

1.7

3.7 1.8

2.0

1.6 2021

LONGER RUN

6.5

2020

1.9

1.9

0.8

3.6

3.5

5.0

3.5 2.0

5.5

6.5

9.3

Source: Federal Reserve

Change in Real GDP

GDP December Projection

Unemployment Rate

Unemployment December Projection

PCS Inflation

Inflation December Projection

The good news, pandemics cause a decline in borrowing costs and a rise in private savings. Therefore, the recently massive increase in government debt will be more easily serviced. All other things being equal, the bad news is, it appears that pandemics are followed by slower economic growth, at least initially. There are, however, some caveats to the analysis performed by the IMF economists.

The death of working-age people in past pandemics caused a labor shortage, but today’s advanced medical care prevents such catastrophic deaths.

14 | SPRING/ SUMMER 2020

Governments have taken aggressive measures to offset negative consequences, potentially boding well for a more rapid return to healthy growth.

With these factors in mind, economists conclude that a sustained period of low real estate interest rates is still expected. Low rates should provide welcomed fiscal space for governments to mitigate the consequences of the pandemic aggressively.

Although it is still too difficult to discern what those consequences will be, examining the past is one of the useful ways to understand how pandemics influence economic events.

On the bright side, CRE economists don’t think the downturn will be as bad as the 2008 financial crisis. The Urban Land Institute’s latest Real Estate Economic Forecast shows a short-lived recession and above-average GDP growth in 2021 & 2022.

Jerome Powell, Chair of the Federal Reserve, anticipates this downturn to be shorter than The Great Depression but warns that unemployment could reach depression levels. According to Steven Mnuchin, Secretary of the U.S. Treasury, there could have been permanent damage to the U.S. if the shutdown continued for months. As a result, the Trump Administration reopened the economy, lifting restrictions under particular guidelines. Recovery is dependent on how well the virus is controlled and whether people feel safe to go back to work.

However, as states began to reopen mid-May, at the end of June, states started putting restrictions back in place as cases hit record highs around the country.

For 2020, net job growth is expected to reach negative 10 million, but the forecast estimates U.S. employment at 11.3 percent at the end of 2020, with a decline to 5.9 percent by the end of 2022.

Regional Rental Impacts Source: RealPage, Inc.

5%

4%

GDP is expected to grow 3.9 percent in 2021 and 3.6 percent in 2022, both well above the long-term average of 2.1 percent.

Real estate transaction volumes will decrease to $275 billion in 2020, but forecast transaction volumes over the next two years show a much healthier capital market than in 2008.

Commercial real estate price growth as measured by Real Capital Analytics Commercial Property Price Index (CPPI) is projected to fall by seven percent in 2020, less than the 13.6 and 20.8 percent decrease during 2008 and 2009, respectively.

Economists believe that one reason for this is more debt financing is available compared to 2008.

Rent growth expectations for the next three years is expected to be led by the industrial sector, averaging 2.2 percent from 2020 to 2022.

3%

2%

1%

0%

-1%

Midwest

Mar-20

May-20

Nov-19

South

Jan-20

Sept-19

Jul-19

May-19

Mar-19

Jan-19

Nov-18

Jul-18

Northeast

Sept-18

May-18

Jan-18

Mar-18

-2%

West

According to a survey conducted by the National Association of Realtors, on average, respondents reported a one percent decline in their commercial sales volume during the first quarter of 2020 compared to transactions in the same period last year. Further, respondents reported a two percent decline in the dollar volume of new leases than the level one year ago. Respondents also reported higher vacancy rates for office, retail, multifamily, but rates remained flat for industrial properties. Now, let’s take a look at how regions are performing relative to commercial real estate sectors.

MATTHEWS™ | 15

NH, MA, RI, CT, NJ, DE, MD, ME, VT, NY, PA The Northeast is one of the most affected areas in the U.S. in the number of total cases and deaths, with New York being the epicenter of the pandemic.

There is confidence in the Northeast market’s ability to come out of this downturn with strength given the region’s prior fundamentals, unmatched density, and concentration of workers, residents, and tourists.

Looking beyond the initial wave of infections, the Northeast has allowed the region to begin reopening its economies slow and steady. However, an extended recovery timeline would temper with the outlook. This more deliberate pace of reopening could benefit the region in the next year or two by preventing a second wave of infections.

De-urbanization?

One of the main reasons for New York’s high COVID-19 cases is its population density, making it difficult to engage in social distancing.

There is evidence that New York residents are departing as a result, and the demand for suburban homes has soared as professionals trade their small New York City apartments for larger homes with office space. This move is likely driven, in part by, the need to work from home given the difficulty of enforcing social distancing when traveling to and from office buildings, or in elevators.

16 | SPRING/ SUMMER 2020

The need for affordable residential options, particularly in the Northeast’s largest metros, has become even more critical. Tenants who cannot afford marketrate apartments may look to lower-cost suburban opportunities. Though, as more upper-tier apartments continue to be built, short-term vacancy issues may arise, particularly in Northern New Jersey. The market boasts the region’s highest Class A vacancy, around 12 percent, according to CoStar, and the most significant 2020 development pipeline relative to inventory.

Meanwhile, Baltimore may be the most exposed to lost Class C rental needs. According to RealPage, rent change in the Northeast fell stagnant, compared to the three percent growth in 2019.

In many Northeast states, including New York, Maine, and New Jersey, the high costs of living and doing business could slow the recovery in this region. This outcome would prompt investors to rebalance their risk exposure, likely refocusing on stable assets in areas with strong demographics. Metros with less diversified economies, such as Baltimore, could face an extended period of unemployment that could curb consumer spending and restrain corporate budgets, further limiting hiring and investment in the metro. This dislocation could also cause retailers to contemplate the value proposition of operating high-cost stores in popular locations. If more people opt to live and work outside of the core or do less physical shopping, it may change the importance of these premier storefronts.

The high use of public transportation will limit how quickly employees will return to the office. Companies located in high-square footage high-rises in New York City or D.C. may consider more affordable low-rise space in New Jersey or Baltimore.

Several large projects in New York City are still in the pipeline, with almost four million square feet of retail space expected to be completed by year-end. Many of these projects’ open dates have been delayed due to halted construction across the metro. Fortunately for Northern New Jersey, it does not have to contend with much supply risk, although retailing existing tenant base will be challenging.

Landlords will also be forced to reduce rents in order to attract tenants, as retail drivers and consumer spending slow. In Boston, rent growth outperformed the national average. Over the forecasted period, rent losses are predicted to exceed the national average,

but specific retail clusters could weather the storm based on favorable localized demographics.

Commercial real estate deals in Boston are still getting done, but they are generally expiration-driven or were near the finish line at the onset of the pandemic.

According to experts in the Boston retail market, achieving outsized rents is dependent on cultivating an optimal retail mix. In New York, leasing declined 50 percent quarter-over-quarter. In New Jersey, the industrial market’s impact has been from short-term supply chain disruptions and from keeping supply chains fluid, as many non-essential retailers and manufacturers shut down.

Unemployment Rate

Source: Bureau of Labor Statistics

NH

14.5%

MD

9.9%

MA

16.3%

ME

9.3%

RI

16.3%

VT

12.7%

CT

9.4%

NY

14.5%

NJ

15.2%

PA

13.1%

DE

15.8%

Where the Northeast stands | Q2 2020 Source: RCA

BOSTON

7,190.9

NORTHERN NEW JERSEY

3,710.9

D.C.

2,452.3

Vol ($m)

Vol ($m)

Vol ($m)

200

# Props

234

# Props

51

# Props

MANHATTAN

7,914.5

BALTIMORE

1,938.3

PHILADELPHIA

2,245.3

Vol ($m)

Vol ($m)

Vol ($m)

161

# Props

105

# Props

156

# Props

MATTHEWS™ | 17

WA, MT, OR, ID, WY, CA, NV, UT, CO, AZ, NM The Western region has taken a more pragmatic approach to managing the pandemic, by staying under lockdown for a longer duration than other states, while also implementing statewide and local measurements that support tenants and businesses. As the region begins to come out of the shutdown, the underlying strength of these markets will help in recovery efforts.

Asset classes in the West were some of the nation’s best performers before COVID-19, which positions the region for sound recovery. For example, Los Angeles has some of the most prized and expensive retail real estate in the nation, commanding some of the highest rental rates. However, as states enter the multiphase reopening process, the continued acceleration of cases has occurred in recent weeks, presenting more potential problems for the region. California, Washington, and Oregon already faced substantial hurdles with record-level unemployment.

Technology-focused markets, including Seattle and those in the Bay Area, are the best suited for a rapid, V-shaped economic recovery, as the sector was

less impacted by the temporary shutdowns, and consumer spending will drive stabilization. Seattle attracts both foreign and domestic interest, and in terms of job growth, the metro has outperformed the national average with many additions in high-paying sectors. However, metros geared toward tourism and entertainment, such as Los Angeles, San Diego, and Orange County, may be less likely to recover. The Western logistics hubs could prompt a second wave of infections as workers navigate in and out of the region.

The burdens of living on the West Coast could inspire people to move to less costly areas. Phoenix is the top market in the nation for net migration. Many people living in dense and expensive cities may consider moving to the metro in search of job prospects and a more affordable cost of living.

The multifamily sector may be the more durable asset class as long-term demand drivers remain intact in the West. Over the near term, the sector does face challenges from historic unemployment, which could push vacancy higher as state and local eviction moratoriums expire.

One of the underlying advantages of Los Angeles retail, compared to most national markets, is its relatively low retail stock per capita. Los Angeles only has 3% more total retail square footage than Dallas-Fort Worth (DFW) despite the metro having 58% more people than DFW.

18 | SPRING/ SUMMER 2020

In Los Angeles, vacancies have already exceeded the highs seen during the last recession. With this, roughly 50 percent of households rent their home in the Los Angeles market, one of the highest renter-to-owner ratios of any major metro in the country. As demand is anticipated to soften, this will provide welcomed relief to many markets as the construction pipeline has swelled in recent years. At the same time, construction activity in Phoenix has continued, nearly undisturbed.

About 16,000 apartment units are underway and slated to deliver over the next several quarters, according to CoStar. Rent growth in the region will most likely taper and turn negative, as many Class A units will need to increase concessions to attract new residents.

For office space, the region will see the restructuring of floor plans & a positive outlook with a robust mix of tech-centric companies.

Retail supply growth was moderate over the past cycle, contributing to favorable fundamentals before the pandemic. With reduced inventory growth, the impact on shuttered storefronts will decrease, and the vacated space will create some opportunity for investors. For the Phoenix market, the retail sector is in a better position than in years past, thanks to moderation in new supply. Since the Great Recession, Phoenix’s retail development has been limited to build-to-suits and heavily pre-leased grocery-anchored retail centers. The slowdown in construction has enabled retail vacancies to return to historic lows, and job and population growth will support retail demand in Phoenix. While Phoenix has not been immune to national store closures, some retailers have expanded, especially grocery, restaurants, fitness, and furniture retailers.

Unemployment Rate

Source: Bureau of Labor Statistics

WA

15.1%

NV

25.3%

MT

9.0%

UT

8.5%

OR

14.2%

CO

10.2%

ID

8.9%

AZ

8.9%

WY

8.8%

NM

9.2%

CA

16.3%

Where the West stands | Q2 2020 Source: RCA

LAS VEGAS

1,516.0

LOS ANGELES

7,550.1

PORTLAND

2,385.9

SALT LAKE CITY

1,385.9

Vol ($m)

Vol ($m)

Vol ($m)

Vol ($m)

97

# Props

635

# Props

163

# Props

111

# Props

SAN FRANCISCO

4,183.0

SEATTLE

2,742.5

PHOENIX

4,678.3

DENVER

4,607.0

Vol ($m)

Vol ($m)

Vol ($m)

Vol ($m)

124

# Props

172

# Props

289

# Props

219

# Props

MATTHEWS™ | 19

ND, SD, NE, KS, MN, IA, MO, WI, IL, MI, IN, OH The Midwest region experienced the pandemic later than most other regions. Although there were pockets within the region where the level of impact varied, overall, the region was insulated from severe impact.

This was due to the region’s lower population density and stay-at-home orders. As a result, unemployment fared better in the Midwest when compared to other areas. Since May, all Midwest states have reopened with limitations in place.

rent growth with prices up by 0.8 percent year-overyear; Cincinnati posted growth of 2.8 percent, and Indianapolis and St. Louis saw increases close to 2.0 percent, according to RealPage. Rent growth in Cleveland has trended upward since May after a brief pause in the early weeks of shelter-in-place orders.

Acquiring stabilized apartment properties at low interest rates brings interest to the Midwest apartment market.

In the first quarter of 2020, more than 7,600 apartment units were completed in the top ten Midwest metros.

By the end of 2020, these metros were scheduled to deliver 30,000 apartments, following 22,000 units in 2019. The delivery of these thousands of units will likely be pushed to 2021, putting downward pressure on rents and occupancy. In Cleveland, multifamily development remains high, and units under construction represent over 60 percent of new supply market-wide. However, demand in the market may weaken in the coming quarters, with weakness concentrated at the higher end, due to new supply, and likely the lower end, due to rising delinquencies.

Mass merchants, grocers, dollar stores, and drugstores outperformed relative to other regions, specifically in Chicago, Detroit, Cleveland, and Minneapolis. As far as retail vacancy goes, Chicago and Detroit saw the highest numbers and are considered more at-risk.

The total square footage impacted by store closures in Chicago will hit a post-global financial crisis high, with four million square feet in 2018. Minneapolis and Columbus saw below four percent vacancy heading into the pandemic and have the flexibility to manage shuttering retailers. Older properties located in areas that have experienced significant economic decline will be the first of the store closures in the Midwest. There has been a renewed focus on supporting well-located, high-performing stores, and closing low-performing stores, which has the industry right-sizing.

The Midwest region was the only region to avoid apartment rent cuts in May. The area is still seeing

Cincinnati’s apartment market fundamentals are relatively robust, with a historically low vacancy rate, affordable rents, and manageable development pipeline.

20 | SPRING/ SUMMER 2020

Cleveland’s years of out-migration and economic underperformance have reduced the area’s spending potential and reinforced pockets of extreme wealth and poverty.

Retailers that depend on central business districts (CBDs) are the most at risk, where traffic may take months to resume to normal levels. Core metros, such as Columbus and Cleveland, have seen pockets of strength and may outperform other metros in the short-term. Indianapolis, Kansas City, and St. Louis recorded the lowest change in employment following the pandemic, giving these markets a shorter road to recovery.

Compared to other regions, the Midwest’s lower cost of living and more affordable office rents will attract companies back to the market. The average asking rent per month for office space in the Midwest is nearly less than half of larger coastal gateway cities, which

provides significant cost savings for firms. Operators will need to stay mindful of shifting market trends.

For industrial, the increased need for storage space will benefit significant logistics markets such as Indianapolis, Chicago, and Columbus. Well-located warehouse and distribution assets with credit tenants throughout the Midwest remain attractive to investors.

Manufacturing hubs in the Midwest, deemed essential, have shuttered for short periods due to high rates of employees with COVID-19. Most Midwest markets could outperform the national average in 2020, keeping investors interested in industrial assets at lower entry costs and higher cap rates than in major coastal metros.

Unemployment Rate

Source: Bureau of Labor Statistics

ND

9.1%

MO

10.1%

SD

9.4%

WI

12.0%

NE

5.2%

IL

15.2%

KS

10.0%

MI

21.2%

MN

9.9%

IN

12.3%

IA

10.0%

OH

13.7%

Where the Midwest stands | Q2 2020 Source: RCA

CHICAGO

6,118.2

CINCINNATI

1,047.9

CLEVELAND

COLUMBUS

Vol ($m)

Vol ($m)

357.2

Vol ($m)

1,304.8 Vol ($m)

468

# Props

79

# Props

37

# Props

67

# Props

DETROIT

INDIANAPOLIS

KANSAS CITY

MINNEAPOLIS

697.4

Vol ($m)

1,555.8 Vol ($m)

1,197.1

Vol ($m)

2,723.8 Vol ($m)

67

# Props

99

# Props

92

# Props

200

# Props

MATTHEWS™ | 21

TX, OK, AR, LA, MS, AL, TN, KY, WV, VA, NC, SC, GA, FL The Southern region largely avoided the worst of the health crisis in the first couple of months before adopting flexible and early reopening plans.

Assuming the recent flare-up in cases does not force more businesses to close, the aggressive relaxation of lockdown policies can save a higher number of small businesses in the South. As a result, real estate fundamentals could face lower hurdles as the economy begins to recover. This should bring investors back into the market ahead of areas where economies are slower to open.

Some markets in the South may face uncertain paths moving forward due to reliance on tourism.

These markets include Orlando, Miami, and New Orleans. Before the pandemic, Orlando boasted the most visitors in the U.S. annually, and 20 percent of local jobs were in leisure and hospitality. Though domestic tourism should regain traction as plans around reopening unfold, the consequences of shutting down these sectors could result in a longer recovery timeline.

Southern cities with business-friendly climates, such as Nashville, Charlotte, and Atlanta, are best positioned to recover quickly. Industrial properties and multifamily across the region could rebound quickly if the reopening process goes smoothly. The relatively dispersed population and low public transportation usage should dampen the likelihood of a second shutdown.

If Disney World and Universal Studios have trouble reopening and attracting park visitors, the implications to Orlando’s economy could be significant.

An extended downturn might encourage workers and firms in high-cost markets to migrate to low-cost Southern metros. During the economic expansion, numerous Class A apartments were delivered, providing options for work transitions. After many years of substantial building levels, Charlotte is one of the fastest-growing apartment markets in the country,

Retail and multifamily vacancies are predicted to rise in Miami over the next few quarters, as the upcoming supply is high and demand will suffer from COVID-19 economic fallout. Miami has one of the highest retail construction pipelines in the country, relative to inventory, but has high pre-lease rates.

22 | SPRING/ SUMMER 2020

The South contained a few of the first states to allow retailers and restaurants to open, but as with Texas and Florida, early reopening plans have resulted in COVID-19 spikes and closures, once again. and vacancies are already back near historical norms. According to RealPage, rent prices were cut by 0.5 percent year-over-year, 1.1 percent below last year’s increase. Only South Florida has rents above the national average. In Atlanta, rents have begun to rise once again since mid-May, signaling that the situation might be stabilizing for now. The allure of low interest rates will attract investors to Southern multifamily properties.

This current situation leaves investors with the opportunity to find investments in tourist areas that were previously too expensive. Over the past decade, Atlanta, Nashville, Austin, and Charlotte, saw some of the strongest job growth and household formation,

which helped drive consumer spending and retail demand. This strong demand, coupled with minimal supply additions, allowed landlords to push rents at an accelerated pace heading into 2020, even though rent levels are still near where they were just before the Great Recession.

Affluent suburbs, fast-growing exurbs, and the markets with densifying urban core are set to come out strong.

For example, Charlotte, boasts a median household income of more than 20 percent above the state’s average, which has attracted premium retailers to the metro. Laggards include submarkets with weaker demographic profiles, such as those that overbuilt retail in previous building cycles.

Unemployment Rate

Source: Bureau of Labor Statistics

TX

13.0%

AL

9.9%

NC

12.9%

OK

12.6%

TN

11.3%

SC

12.5%

AR

9.5%

KY

11.0%

GA

9.7%

LA

13.3%

WV 12.9%

FL

14.5%

MS

10.6%

VA

9.4%

Where the South stands | Q2 2020 Source: RCA

ATLANTA

5,779.5

CHARLOTTE

2,727.7

MEMPHIS

1,000.2

MIAMI

2,216.8

Vol ($m)

Vol ($m)

Vol ($m)

Vol ($m)

326

# Props

145

# Props

75

# Props

135

# Props

NASHVILLE

2,217.4

ORLANDO

2,627.9

AUSTIN

2,216.8

DALLAS

9,558.9

Vol ($m)

Vol ($m)

Vol ($m)

Vol ($m)

109

# Props

110

# Props

125

# Props

430

# Props

MATTHEWS™ | 23

Could the Reopening of the Economy Lead to a Second Wave?

Over the last couple of months, there has been a disconnect between analysts and economists in the private sector and public health experts in the United States. Public health experts warned that if economic restrictions are lifted too early, there could be a rebound in the virus outbreak, also known as a second wave. The private sector downplayed the warning and celebrated the lifting of restrictions, anticipating a sharp rebound in economic activity.

If recent large public gatherings accelerate new infections, businesses could once again have to close, such as in Dallas, Austin, and Los Angeles. In this scenario, additional fiscal stimulus would be needed, mainly as many people remain unemployed. While rent collections were better than expected in May and June, unemployment benefits expire in July, and residential eviction moratoriums are lifted in some regions.

Research undertaken by the Federal Reserve found that, in 1918, those U.S. cities that removed restrictions early had a massive outbreak and a slower economic recovery than otherwise.

Reversing

Pausing

Reopening

Reopened

Source: The New York Times

An additional forced shutdown will push retailers to focus more on omnichannel offerings, impacting industrial logistics. The evolution in customer behavior will change how storefronts, shopping centers, and parking lots are designed. Simultaneously, urban office demand will not disappear, but firms might adopt a hub-and-spoke configuration where multiple sizable 24 | SPRING/ SUMMER 2020

suburban satellite offices support a smaller central urban office. Of course, this is dependent on the path of the virus, and until confidence is regained in the market, questions regarding the speed of recovery still remain. For more information on how regions are performing across the nation, please contact a Matthews™ specialized agent.

F O L L O W M A T T H E W S™ AS WE CONTINUE OUR N A T I O N A L E X PA N S I O N .

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The opening of the Matthews™ Operations Center provides us with access to a rich talent pool as we continue to hire employees to support our agents across the country

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MATTHEWS™ | 25

DOLLAR STORES STORES: THE ONE TO WATCH

BY JOSH BISHOP

26 | SPRING/ SUMMER 2020

More than 9,300 retail store closures were announced in the United States in 2019, according to an analysis

by Business Insider. The 2019 closures broke the previous record of roughly 8,000 store closures in 2017. In 2020, Business Insider confirmed that retailers would close at least 5,100 stores. However, beneath the cloud of uncertainty that COVID-19 has presented, some retailers are coming out on top, and fortunately, are thriving in the current environment. Data from Coresight emphasized that from the 2,800 stores opened in 2019, some 1,800 were discount retailers—the segment proving to be resilient in both good times and bad.

In the following article, Matthews™ will explore how dollar stores, the popular discount retailer segment, are expanding and at rapid rates in today’s environment. Dollar stores have gained attention as success stories in the country’s most economically distressed places—mostly rural counties that have few retail options. The two leading discount retailers are Dollar General and Dollar Tree/Family Dollar, which operate more than 30,000 stores nationally and plan to open thousands more, vastly outnumbering Walmart and other retailers. This unique real estate footprint, combined with their value and convenience, remains a competitive advantage during COVID-19.

The dollar store market sells more groceries than ‘high-end’ stores. As of Q3 2019, dollar stores sold $24 billion worth of groceries, while Whole Foods sold $15 billion.

Source: Forbes

OVERVIEW OF THE DOLLAR STORE MARKET Many investors believe the popular narrative that Amazon is crushing brick-and-mortar retailers, and now they are faced with the threat of COVID-19. The top resilient retailers, Dollar General, Family Dollar, and Dollar Tree, were deemed essential as numerous rural and suburban communities rely on them to provide affordable and convenient household essentials. These retailers have consistently expanded as other brick-and-mortar retailers have shuttered.

Dollar General joined those who are hiring more workers to meet the heightened demand during the coronavirus, with plans to hire 50,000 new employees. These companies have withstood the relentless competition from Amazon and Walmart, and now the coronavirus by selling cheaper products to lower-income shoppers.

Facts about Dollar Stores Source: Forbes

Dollar stores have more locations in the U.S. than all the Walmart’s and Starbucks’ combined.

They have more locations combined than Walmart, Kroger, Costco, Home Depot, CVS, & Walgreens—the country’s six biggest brick-and-mortar retailers.

They feed more Americans than Trader Joe’s and Whole Foods.

They open a new dollar store every four and a half hours, an average of more than five a day.

THE TOP THREE DOLLAR STORE TENANTS The retailers entered 2020 from a position of strength, and their retail format makes them well suited for today’s marketplace. The value and convenience that dollar stores offer continue to resonate with both new and existing core-consumers. Not only do the top three dollar store tenants thrive in a strong economy, but they also realize stable growth in times of market downturns. In 2008, the stock that beat all other S&P 500 stocks was Dollar General, rising more than 60 percent that year, almost double the second highest-returning stock. Furthermore, Dollar General’s stock reached an all-time high of $194.84 on June 1st, 2020.

MATTHEWS™ | 27

# OF STORES: 16,000 # OF STATES OPERATING IN: 46 PRODUCT OFFERINGS: Everyday household items, alcohol, tobacco products, and consumables like fresh produce, perishable goods, and drinks.

DOLLAR GENERAL

TYPICAL SQUARE FOOTAGE: ± 9,100

Dollar General is one of the fastest-growing retailers in the U.S., boasting roughly 16,000 neighborhood general stores in 46 states, primarily in the South, East, Midwest, and Southwest regions. The stores in these regions are generally located in rural areas, which typically aren’t saturated by lower-end retailers. With its small-box store model, Dollar General targets cost-conscious consumers that prefer easier and quicker access to items than at super-sized competitors such as Walmart and Costco (which are also much farther away).

Dollar General Store Locations in the U.S. Source: ScrapeHero.com

10

20

30

Scale in Millions, with population data

28 | SPRING/ SUMMER 2020

Roughly 80% of Dollar General’s sales are derived from consumables including refrigerated, shelf-stable, and perishable foods.

An estimated three-quarters of U.S. residents live within five miles of a Dollar General store, and in comparison, just over one-third of U.S. residents live within a five-minute drive to a Walmart.

SOURCE: Global Data Retail

Dollar General has benefitted from a combination of more customers coming into its stores and spending more while there, something many other retailers haven’t been able to accomplish, even when they’ve reported strong same-store sales. This positive consumer response has allowed the retailer to go on a massive expansion campaign.

In 2019, Dollar General opened roughly 1,000 stores, making up 35 percent of the total number of store openings announced during that time. The discount retailer also recently announced having 32 consecutive quarters of same-store sales growth. By the end of this year, the retailer will have over 17,000 locations across the U.S., including sites in two new states, Wyoming and Washington, making it the biggest retail chain in the country.

Dollar General’s remodeling program is aggressive and focused. It’s centered around transforming

existing stores to operate at peak efficiency and open more stores to capitalize on. It has two remodeling types: Traditional: 22 refrigerator-freezer doors and delivers a lift of 4-5% on comps.

Dollar General Traditional Plus (DGTP): 34 high-capacity cooler doors & delivers a 10-15% comps lift. More produce drives comps to the high-end range.

In 2019, Dollar General opened approximately 20 stores per week! More than the total number of McDonald’s in the U.S. and more than Walmart globally.

SOURCE: Global Data Retail

The company is also expanding its fleet of carrier trucks from 80 to 200 and plans to bring FedEx drop-off and collection capabilities to more than half of its stores by the end of 2020. Dollar General also recently released an app where customers can scan and check out on their phones. This cuts down the check-out lines and also allows customers to review the total amount in their cart before they officially check out.

Dollar General’s Q1 2020 Performance

Opened 250 stores, remodeled 481 locations and relocated 17 units.

Comparable-store sales up 21.7% and operating profit up almost 69.2% to $867M, compared with $521M in Q1 2019.

The retailer plans to open a total of 1,000 stores this year.

In February, comparable sales growth year-over-year was 5.5%, but in March, the increase was 34.5% compared to a year earlier.

MATTHEWS™ | 29

Dollar Tree has also been rapidly expanding across the country. In 2015, the retailer purchased fellow discounter, Family Dollar, in hopes of bolstering the competitive position against Dollar General. Even though the deal left just two companies in control of most of the small-store discount market, the Federal Trade Commission approved it. At Dollar Tree, most goods are priced at $1 or less, while the Family Dollar merchandise is usually less than $10. Thus, Family Dollar is more exposed to competition from Walmart and other lower-end retailers than Dollar Tree.

DOLLAR TREE + FAMILY DOLLAR

# OF STORES: 15,465

# OF STATES OPERATING IN: 48

PRODUCT OFFERINGS: Household cleaners, name-brand food, health and beauty aids, toys, apparel, and home furnishings.

The retailer opens most of its stores in urban and suburban areas, with Texas being the largest market with 1,027 Family Dollar stores, followed by Florida with 584 stores.

In 2018, Dollar General’s stock had rallied more than ten percent, but shares of Dollar Tree tumbled nearly twenty percent. The biggest problem that Dollar Tree faced was the dismal performance of Family Dollar, which was squeezed by the top three retailers— Walmart, Target, and Amazon. Dollar Tree’s convoluted top-line growth indicated that it would have fared better without Family Dollar.

In the first three quarters of 2019, the company opened 286 of its namesake locations, and are in the process of renovating more than 1,000 Family Dollar stores after running into problems with the acquisition. In a recent Securities and Exchange Commission filing, Dollar Tree indicated that it believes the U.S. market can support 10,000 Dollar Trees and 15,000 Family Dollars. That’s over 10,000 more stores than its current 15,465, though they aren’t putting a timeline on the expansion.

Dollar Store Openings

Source: Dollar General, Dollar Tree, Family Dollar 18,000

16,000

16,000 14,000 12,000 10,000

8,385

7,080

8,000 6,000 4,000

TYPICAL SQUARE FOOTAGE: 8,000 – 12,000 30 | SPRING/ SUMMER 2020

2,000 0

975

350

Dollar General

200

Dollar Tree

Stores opened in 2019

Family Dollar

Total Store Count

Dollar Tree + Family Dollar Q1 2020 Performance

Plans for 500 new stores by the end of the year.

Dollar Tree’s comparable-store sales increased 7% year-over-year.

Gross profit increased 3.9% year-overyear to $1.79B.

Family Dollar’s comparable-store sales up 15.5% year-over-year.

DOLLAR STORES COMPETITIVE ADVANTAGE DURING COVID-19 When COVID-19 hit, many customers only had access to dollar stores to gather essentials or were forced to shop at dollar stores due to strained finances. The market for dollar stores is only getting stronger as other retailers face challenges as a result of COVID-19.

Discount Retailer Timeline Source: Foursquare

From February 19th to March 18th, discount stores saw an uptick in foot traffic, with visits up 19% nationally.

By the week ending March 29th, Dollar Tree sales trends soared, with the namesake chain up 7.1% and Family Dollar up 14.4%.

By the week ending April 10th, visits returned to roughly normal levels. Traffic was slightly up 1 to 3% in the Midwest and South, but down 3% in the Northeast and down 15% in the West.

By the week ending April 17th, visits returned to slightly below normal levels, down 6%. Visits were down most in the West and less in the Midwest and South.

As of April 24th, traffic to discount stores stabilized, down 7%. Visits are down more in the West, while visits have returned to more normal levels in the South and Midwest.

MATTHEWS™ | 31

COVID-19 Impact on Discount Retailers by Region Source: Foursquare

150% Northeast West Midwest

100%

South

This chart illustrates increased foot traffic to discount stores by region from February 19, 2020 to April 24, 2020.

50%

0% 22 Feb

29 Feb

06 Mar

13 Mar

20 Mar

27 Mar

03 Apr

10 Apr

17 Apr

24 Apr

THE INVASION OF DOLLAR STORES In cities across America, dollar stores trade in economic despair. In these rural areas, dollar stores see an easier revenue stream because they lack competing grocery stores and are located where no other retailers will venture. This is the case for Family Dollar, which targets urban low-income shoppers, and Dollar General, whose customer is in a permanent recession. Dollar store chains capitalize on these conditions, much like an invasive species advancing in on a compromised ecosystem.

Dollar General invested $22 billion as part of a plan to expand rapidly in low-income, rural communities in hopes of economic resurgence. Many residents say that dollar stores are a vital source of cheap staples. Still, as the stores cluster in these low-income neighborhoods, some residents worry that they deter business, especially in communities without a grocer or options for healthful food.

According to a poll conducted by Morning Consult Brant Intelligence, the results indicated that the following retailers had a “positive effect on their community.”

62%

Dollar Tree, Inc.

52%

McDonald’s

57%

Family Dollar

51%

Starbucks

56%

Dollar General

59%

Target

In these cash-strapped towns, low-income shoppers represented 21 percent of Dollar General’s shoppers and 43 percent of its sales.

The Institute for Self-Reliance, a nonprofit advocacy group, argued that “there’s growing evidence that these stores [dollar stores] are not merely a byproduct of economic distress. They’re the cause of it.” Dollar stores rarely sell fresh produce or meats, but they can undercut grocery stores on prices of everyday items, often pushing grocers out of business.

32 | SPRING/ SUMMER 2020

RURAL AMERICA LASHING BACK Moville, Iowa- In 2016, the city’s only grocery store, Country Foods, decided not to rebuild after a devastating fire in 2008. They persuaded Chet’s Food to open a grocery store, but in 2016, Dollar General opened down the street, and sales at Chet’s Food fell by 30 percent. Ultimately, the owner closed Chet’s that year as a result.

Haven, Kansas- The family-owned grocery store, Haven Footliner, lasted exactly three years and three days after Dollar General opened. Sales were on the continuous decline forcing them to shutter the store.

Birmingham, Alabama- Over the last decade, Birmingham had seen over 40 dollar stores pop-up in and around the city lines. By saturating the city’s low-income population, these dollar stores had created a significant barrier for new grocery stores looking for space in the market. Since 2005, Birmingham has seen five supermarkets close.

DeKalb, Atlanta- In this city, there is a dollar store on every other corner, and according to one source, there’s almost 70 of them, a quarter of which opened in the past three years. More recently, Kroger refused to sign a lease in a strip mall that allows dollar stores.

Number of Dollar Stores per 10,000 Residents by State

Source: Dollar General and Dollar Tree Annual Reports | Average Number of Dollar Stores per 10,000 Residents by State

0

0.5

1.0

2.0

2.5

MATTHEWS™ | 33

These stories are not anomalies. Local grocers in numerous communities report that it’s typical for sales to fall by about 30 percent after a Dollar General opens nearby. Due to the thin margins in the grocery business, the disruption a dollar store brings is usually enough to force a local grocery store to close. It might take months or years before the owner finally gives in, though. Research also indicates that grocers are barometers for other brick-and-mortar businesses in town. As the grocery store goes, so do other independent businesses in the community.

Additionally, dollar stores affect the decline in employment as dollar chains rely heavily on the lean

labor model. On average, according to their annual reports, Dollar General and Dollar Tree have a staff of eight to nine people. In comparison, small independent grocery stores employ an average of 14 people, according to federal data.

As a result of the dollar store market intrusion, some towns and cities have adopted bans on stores such as Dollar General, arguing that these businesses create ‘food deserts.’ Other cities, such as Kansas City, Oklahoma City, and metro Atlanta have introduced zoning ordinances that would limit the number of dollar stores in their towns.

Largest U.S. Dollar Store Chains Source: Maptitude

Stores per 100,000 Population 16.00 to 18.00 14.00 to 16.00 12.00 to 14.00 10.00 to 12.00 8.00 to 10.00 6.00 to 8.00 4.00 to 6.00 2.00 to 4.00 0.00 to 2.00

Arkansas Shopper Demographics Source: Bloomberg Businessweek

Median Houshold Income $35,000 Average Age Unemployed Bachelors Degree

Family Dollar

Dollar Tree

Dollar General

Walmart Stores

Whole Foods

$42,759

32.0

36.6

7.2%

10.1%

19.4%

43.0%

Average Population of Surrounding City 26,650

34 | SPRING/ SUMMER 2020

137,990

ARE DOLLAR STORES A GOOD INVESTMENT? The market for dollar stores is only getting stronger as other retailers struggle to keep up with the changing times. Currently, retailers that target middle-income shoppers, like J.C. Penney, Kohl’s, and Macy’s, are losing customers, and dollar stores are getting that business. Dollar stores are becoming the sole shopping choice for many shoppers, even in communities where there is a Walmart location or a large grocery chain. Shoppers will always frequent dollar stores due to the convenience and ease of shopping that the retailers provide.

Dollar General stores fit the ideal triple net lease criteria. They are accompanied by a strong corporate guaranteed lease (15 years on new locations) with zero management responsibility and have a prominent, “branded” location. The retail locations are strategically placed in areas with solid demographics and phenomenal visibility. It is no coincidence that they are near residents who need their products and convenience. Many dollar stores are located near banks, pharmacies, and gas stations.

A Dollar General store has a lower startup cost. It spends as little as $250,000 for a new store vs. more than the $15 million Walmart puts into a new Supercenter.

As for having too many physical locations, the dollar stores have discovered that by strategically spacing their stores out, sometimes just a few miles apart, they

can build customer loyalty without cannibalizing other locations nearby. This is the same strategy used by Starbucks, which, in busy areas, often have Starbucks locations placed across the street from one another to increase sales.

Dollar stores fit the main end-goals of a NNN investor:

#1

Long-term leases backed by investment grade credit

#2

Complete passivity – Absolute NNN lease with zero management responsibility

#3

Recession/pandemic-proof tenant

Growth, stability, location, longevity, and strong lease guarantees all add up to the ideal NNN investment.

Dollar stores meet the expectations of the criteria above and continue to surpass market expectations.

Not only do the top three dollar store tenants thrive in a strong economy, but they also realize stable growth in times of recession. This makes for both an attractive and reliable, nearly risk-free NNN investment.

With COVID-19 impacting commercial real estate investments, dollar stores continue to keep their core customer at the center of their operations while they remain steadfast in delivering long-term shareholder value.

For more information regarding your dollar store investment, please reach out to a Matthews™ specialist.

Josh Bishop josh.bishop@matthews.com (214) 692-2289

MATTHEWS™ | 35

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SELFSTORAGE

S H O R T- T E R M P I N C H , LO N G - T E R M G A I N

BY AUSTIN MCLEOD & JOHNNY BLUE CRAIG

Self-storage is an attractive, niche asset class for investors that desire minimal maintenance, overhead, and operating expenditures. While self-storage owners have adjusted operations and practices around the COVID-19 outbreak to prioritize customer and employee safety, such measures have had minimal impact on overall performance. In this article, Matthews™ will look at what qualifies self-storage as recession-resistant and provides insight on recent investment activity.

38 | SPRING/ SUMMER 2020

THE RECESSION-RESISTANT NICHE ASSET CLASS Experts have often deemed the self-storage industry to be recession-resistant because the demand for storage space stems from life events such as moving, change in marital status, or downsizing. Looking back at the Great Recession, self-storage REITs were among the few real estate investment trusts to produce positive returns. Many experts claim that self-storage got its start from the Great Recession as Americans were forced to downsize or foreclose on their homes, thus turning to storage units to keep their belongings. As a result, self-storage development rapidly increased, and today, roughly ten percent of the current U.S. population rents a storage unit.

major markets across the country created operational challenges for the asset class, such as increased competition for customers, resulting in a decrease in rental rates. According to Yardi Matrix, self-storage properties in the planning stages or under construction totaled nine percent of existing U.S. stock as of May 2020, a 20-basis point increase from April. However, deliveries are forecasted to drop by 40 percent over the next five years.

Despite economic concerns, New York’s newsupply pipeline consisted of 17.7% of existing stock in May, a 70-basis point increase from April.

Self-storage’s reputation as a solid investment led to investors targeting larger markets for projects, resulting in a construction boom that led to oversaturation. Today, such oversaturation is trickling down into smaller markets. As of 2020, there are more than double the amount of self-storage facilities in the U.S. than Starbucks and McDonald’s combined, according to Seeking Alpha. The flood of supply in Self-Storage Sales Volume & Price Per Square Foot

Price/Sq Ft

Sales Volume

$120

$4.5B

$110

$4B

$100

$3.5B

$90

$3B

$80

$2.5B

$70

$2B

$60

$1.5B

$50

$1B

$40

$500M

$30

$0 2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

Sales Volume

Sale Price/Sq Ft

Source: CoStar

2020

MATTHEWS™ | 39

Under Construction & Planned Percent of Existing Inventory Source: Yardi Matrix

18.0% 16.0%

% of Inventory

14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% National

Sacramento

New York

Miami

Phoenix

Nashville

Dallas/ Ft. Worth

Atlanta

Los Angeles

Chicago

Monthly Change in Percent Under Construction Source: Yardi Matrix

8.8%

NATIONAL

Apr 20

Sacramento

18.5%

New York

17.0%

Miami

13.0%

Phoenix

12.8%

Metro

Metro

Metro

Metro

Apr 20

Apr 20

Apr 20

Apr 20

40 | SPRING/ SUMMER 2020

9.0%

May 20

18.5%

May 20

17.7%

May 20

13.4%

May 20

13.1%

May 20

Change

Change

Change

Change

Change

Nashville Metro

Dallas/Ft. Worth Metro

Atlanta Metro

Los Angeles Metro

Chicago Metro

8.2%

Apr 20

7.3%

Apr 20

7.5%

Apr 20

7.2%

Apr 20

4.4%

Apr 20

8.2%

May 20

7.7%

May 20

7.5%

May 20

7.2%

May 20

4.4%

May 20

Change

Change

Change

Change

Change

SELF-STORAGE FINANCING Although there are many challenges in securing favorable debt financing in today’s market, there are multiple options that still exist. As the U.S. begins to emerge from the worst of COVID-19, selfstorage lender activity has started to increase again.

Commercial Mortgage-Backed Securities (CMBS) have not seen much movement in any commercial asset class, self-storage presents a unique opportunity to get financing from multiple avenues, such as:

01

Small Business Administration (504 or 7(a) Loan Programs)

02

Local or Regional Banks

03

Credit Unions

04

Insurance Companies

05

Self-Storage REITs

The biggest changes in the debt market today are the assumptions lenders make on rental growth and occupancy statistics. Interest rates are still at historic lows, and terms can be favorable for investors seeking financing on stabilized assets. Lenders may require more money down to issue the debt, but activity in the space remains relatively high. As self-storage has remained positive in most lenders’ eyes, the selfstorage debt market is anticipated to remain strong in the coming months.

As of early June, a reputable CMBS money center bank has re-emerged in the debt marketplace and is providing much-needed liquidity in the self-storage industry.

Source: Yardi Matrix

May 2020 Year-Over-Year Rental Rate Change for 10’ x 10’ Units

Climate Controlled

Source: Yardi Matrix

Non-Climate Controlled

Los Angeles Phoenix Dallas/Ft. Worth National Chicago Miami New York Nashville Sacramento Atlanta

-14.0%

-12.0%

-10.0%

-8.0%

-6.0%

-4.0%

-2.0%

0%

MATTHEWS™ | 41

SELF-STORAGE DURING COVID-19 Although the demand for space is slowing with 4,500 units absorbed of the 50,000 delivered in Q1 2020, compared to the 45,000 absorbed during the same time last year, the second quarter typically produces the sector’s strongest performance. Vacancy rates for storage facilities were at 14.9 percent in Q1 2020, a 130 basis point increase compared to Q1 2019, which was previously the cyclical high. Rent growth is softening for climate and non-climate-controlled units, with both seeing -1.2 percent and -0.4 percent, respectively, according to Moody’s Analytics.

However, demand is still present despite the slow economic recovery from mandatory social distancing, and scheduled openings for new facilities have been delayed, reducing the competition for new customers.

Additionally, any economic damage caused by COVID-19, such as households vacating virus hotspots, could create a new wave of customers. March saw higher-than-usual demand as college students who lived on campus vacated their dorms with short notice to search for a place to store their belongings.

According to the RV Industry Association, recreational vehicle purchases have increased 170 percent in May throughout the country, indicating the need for more RV and trailer storage.

Although notorious for not keeping up with trends, the self-storage sector has accelerated the adoption of the new reality that involves COVID-19. It wasn’t long ago

that operators installed automated gates and online payment features to their websites. Now, operators have to ensure that staff and customers feel safe, so many are collaborating with technology vendors to make their business more efficient, user-friendly, and contact-free. Among these efforts include:

01

Kiosks/website to make online reservations or rentals

02

Bluetooth to provide unit access through a remote gate

03

Online rent payments

04

Call centers to provide customer service

05

Monitoring the property via cameras

The unemployment rate keeps climbing, and some tenants are unable to keep up with rent. In response, local governments are intervening. California recently amended legislation to prohibit self-storage operators from charging rent and late fees for tenants affected

by COVID-19 within six months after the emergency period is over. Operators used to be able to lock tenants out of their unit if rent wasn’t paid, but with the new legislation, auctioning units will now be delayed.

The legislation also helps maintain stay-at-home orders by minimizing travel from evicted tenants coming to acquire their items. Experts chime in with concerns that tenants will then be provided artificial end dates for the pandemic, an otherwise unpredictable variable.

National Average Self-Storage Rental Rates Source: Yardi Matrix

MAY 2020 YEAR-OVER-YEAR RATE PERFORMANCE Avg Metro Rate 10’x10’ Non-Climate Controlled

5’x5’ Non-Climate Controlled

5’x10’ Non-Climate Controlled

10’x10’ Non-Climate Controlled

10’x10’ Climate Controlled

10’x20’ Non-Climate Controlled

$112

-4%

-5%

-4%

-7%

-2%

42 | SPRING/ SUMMER 2020

SELF-STORAGE OUTLOOK Scheduled openings for new self-storage facilities are delayed with the government mandating social distancing orders to slow the spread of the virus, which will reduce customer competition for existing properties. Undercapitalized developers that unknowingly entered the health crisis with underperforming lease-up properties will face a slow summer leasing season. As a result, operators are significantly dropping rents.

New development prospects are becoming less favorable, turning investors towards existing facility acquisitions to add to their portfolio or get their foot in the business. We will see more conservative underwriting as operators are temporarily restricted

to pushing rents. However, with the lower interest rates widening margins, there is an opportunity to exceed initial returns.

Savvy developers will continue to find opportunities in densely populated markets with zoning restrictions. As the economy stabilizes after the pandemic, operators will once again focus on pushing rental rates and improving their monthly collections. The fundamentals of self-storage — low overhead and maintenance costs, strong occupancy, and the ability to push rental rates will continue to drive investor demand for this niche asset class, and storage will continue to outperform other asset classes post-COVID-19.

For more information, contact a Matthews™ specialized agent today.

Austin McLeod

austin.mcleod@matthews.com (404) 445-1093

Johnny Blue Craig

johnnyblue.craig@matthews.com (404) 410-9201

MATTHEWS™ | 43

MATTHEWS

™

AWARDS & RECOGNITIONS

NET LEASE RISING STARS

TOP BROKERS

MARKETER OF THE YEAR BRONZE

ARON CLINE

CHAD KURZ

LORI VALENCIA

2020

2020

2020

The Stevie Awards

BEST PLACES TO WORK

CRE’S BEST BOSSES

NEXT GENERATION AWARD

2020

KYLE MATTHEWS

ALEXANDER HARROLD

50 UNDER 40

INFLUENCERS: TOP NAMES IN MULTIFAMILY

INFLUENCERS IN MARKETING

KYLE MATTHEWS

DALLAS

2019

2019

2020

2019

POWER BROKER AWARD TOP SALES FIRM DALLAS 2019

™ 44 | SPRING/ SUMMER 2020

2019

POWER BROKER AWARD TOP SALES FIRM

POWER BROKER AWARD TOP SALES FIRM

TOP RETAIL LEASING BROKER IN LA

LOS ANGELES

CLEVELAND

MICHAEL PAKRAVAN

TOP SALES BROKER FOR CLEVELAND

TOP BROKERAGE FIRMS

CRE’S BEST PLACES TO WORK

BEN SNYDER

2018

2018

TOP INFLUENCERS IN RETAIL

POWER BROKER AWARD TOP SALES FIRM

POWER BROKER AWARD TOP SALES FIRM

KYLE MATTHEWS, CHAD KURZ, GARY CHOU

DALLAS

LOS ANGELES

TOP INVESTMENT SALES BROKERS

TOP INVESTMENT SALES BROKERS

TOP INVESTMENT SALES BROKERS

GARY CHOU

GARY CHOU

CHAD KURZ

BEST BOSS IN CRE THE ONE TO WATCH

POWER BROKER AWARD TOP SALES FIRM

POWER BROKER AWARD TOP SALES FIRM

KYLE MATTHEWS

DALLAS

LOS ANGELES

2019

2019

2018

2017

2017

2019

2018

2017

2017

2019

2018

2017

2017

MATTHEWS™ | 45

W W W. M AT T H E W S . C O M

46 | SPRING/ SUMMER 2020

T driving factor for the continued popularity of drive-thrus. With he demand for convenient and quick order fulfillment is the

the introduction of COVID-19, drive-thrus were the top contender for distributing food to customers. In fact, nine out of the top ten restaurants in The QSR 50, a report ranking the top performing quick-service restaurants by QSR Magazine, have drive-thrus, and drive-thru pickup make up for an average of 70 percent of annual quick-service restaurant sales. In a survey conducted by Bottle Rocket, 33 percent of respondents claimed they would get half of their meals from quick-service restaurants. On average, 50 million Americans eat at fast food restaurants every day, generating $570 billion in global revenue, with a predicted annual growth of 2.5 percent. In this article, Matthews™ will explore the value of a drivethru before, during, and after the pandemic.

MATTHEWS™ | 47

TO - GO & DRIVE -THRU TR ANSACTIONS BY RESTAUR ANT DURING COVID -19 SOU RC E: TEC H N O M I C

Week Beginning

Fast-food restaurants

March 22

March 29

April 9

April 12

April 19

April 26

77%

78%

75%

74%

76%

77%

Fast-casual restaurants

49%

57%

55%

57%

56%

59%

Coffee shops/snack shops

62%

56%

62%

60%

56%

58%

Family-style restaurants

41%

52%

49%

48%

42%

53%

Buffet-style restaurants

42%

50%

53%

46%

44%

53%

Casual-dining restaurants

49%

57%

58%

51%

54%

67%

Fine-dining restaurants

43%

55%

58%

48%

48%

61%

THE EVOLUTION OF DRIVE-THRUS Drive-thrus predate the first drive-in restaurant back in the 1920s and have since evolved into road trip staples, located near major highways, allowing for easy access and quick ordering. Today, with third party technology, offpremise restaurant sales soar. At first, this posed a threat to restaurants with drive-thrus, but as COVID-19 spread uncertainty among consumers, many turned to drive-thrus for meals. Rural neighborhoods benefit the most from drive-thrus as they cannot utilize delivery apps because they may reside outside of urban or deliverable areas.

THE HISTORY OF DRIVE -THRUS SOU RC E: C A R R E NTA L S

1903 Founding of the Ford Motor Company

1920

Cars massproduced by assembly line workers

48 | SPRING/ SUMMER 2020

1921-1923

The popularity of drive-in dining grew as cars became commonplace

1920’s

Carhops began utilizing roller skates for faster service

1931

The Pig Stand restaurant in L.A. began served drivers through a window

1946

The first true drive-thru was founded - InN-Out Burger in California

With dine-in areas closing across the nation, drivethrus, takeout, and delivery were in a prime position to thrive during the pandemic. Drive-thrus offer an advantage to customers as it supports social distancing, contactless service, and quick order fulfillment. The NPD Group reported that 46 percent of all restaurant occasions were at quick-service drive-thrus for the month of April. However, the total restaurant industry traffic at franchised and independent restaurants was down 35 percent in April compared to last year.

Zion Market Research has determined drive-thru restaurants are to push market growth, stating that the increase in hectic lifestyles “with dual-income is anticipated to elicit the demand for fast food in the forecast period.” Additionally, customer’s growing fondness towards affordable food without a wait time could further feed into the fast food industry’s popularity and growth.

COVID -19 IMPACT ON FAST FOOD CHAINS

BY REGION SOU RC E: F OU RSQ UA R E ● Midwest

The average American will spend over $1,200 on drive-thru food annually,

totaling $60,000 in a lifetime.

2019 TOP 5 PERFORMING QUICK-SERVICE RESTAUR ANTS SOU RC E: QS R M AGA ZI N E

1 McDonald’s 2 Starbucks 3 subway 4 taco bell 5 Chick-fil-a

● South

● Northeast

● West

125

100

75

Feb 22

Feb 29

Mar 6

Mar 13

Mar 20

Mar 27

Apr 3

Apr 10

Apr 17

Apr 24

Chart illustrates indexed foot traffic to fast food chains by region, where visits for February 19, 2020 is 100. Foursquare used rolling 7 day averages to account for fluctuations by day of the week.

ENHANCING DRIVE-THRU PERFORMANCE

Consumers expect convenience and experience from restaurants. In response, restaurants are stepping up and directing investments in drive-thru technology as an alternative source of revenue that has the potential to surpass third-party delivery. Drive-thru veteran, McDonald’s, recently purchased Dynamic Yield, a tech company that uses artificial intelligence (AI) to enhance and personalize the customer experience, to compete with the likes of Starbucks and Panera. A McDonald’s press release states, “customized menu displays will show different menu options based on the time of day, weather, current restaurant traffic, and trending menu items, ultimately creating a simpler experience for customers and crew.”

Other AI, like Valyant AI, focuses on the more routine aspects of the drive-thru, such as taking orders so that staff can focus more on customer service and food preparation. Good Times Burgers & Frozen Custard stated that after two months with Valyant AI, wait time in their drive-thru decreased by seven seconds, and 95 percent of customers indicated that the AI exceeded their expectations.

MATTHEWS™ | 49

QSR Magazine’s Drive-Thru Performance Study revealed that in 2019, customers spent an average of 255 seconds in drive-thru lines from speaker to pickup window, 20 seconds more than in 2018.

As menu boards continue to transform and mobile ordering contributes to the lane growth, restaurants wanting to keep a competitive edge will learn to adapt and execute new ideas and systems to save customers time.

Even with a straightforward menu and simple breakfast items, Dunkin’ Donuts, who achieved the quickest speed of service in QSR Magazine’s DriveThru Study, still look to integrate digital solutions to save their customers more time. Dunkin’ Donuts implemented another drive-thru lane for those who ordered ahead of time, allowing customers to bypass the long line.

Panera Bread claims that adding a drive-thru window to an existing operation

instantly generates more sales.

SOU RC E: R E S TAU R A NT BUS I N E SS

Chipotle has officially entered the drive-thru competition with its new incorporation, “Chipotlanes,” which are mobile-order pickup lanes. KFC’s drive-thru transactions, accounting for 65 percent of their sales, led to their decision to focus on new technologies such as an AI-powered menu board that will upsell menu items and improve order accuracy.

50 | SPRING/ SUMMER 2020

QSR AVER AGE DRIVE -THRU PERFORMANCE SOU RC E: QS R M AGA ZI N E BRAND

AVG SPEED OF SERVICE (SECONDS)

ORDER ACCURACY

Arby’s

263.46

86.1%

Burger King

235.48

90.3%

Carl’s Jr.

240.51

84.1%

Chick-fil-A

322.98

94.0%

Dunkin’ Donuts

216.75

84.2%

Hardee’s

266.34

80.7%

KFC

243.73

66.1%

McDonald’s

284.05

84.8%

Taco Bell

240.38

83.6%

Wendy’s

230.38

87.3%

TOTAL

255.34

84.4%

Among the restaurants that encouraged customers to get their food to-go during the outbreak are Starbucks, Chick-fil-A, and Taco Bell. All of which utilized their drive-thru lanes more than ever to limit large gatherings while still distributing food. Further, each of these restaurants announced additional measures and precautions to keep employees safe and healthy, like adjusting store hours, limiting operations to the drive-thru, and implementing more sanitary procedures. Now that America is slowly opening back up, some of these procedures will remain in place for years to come.

Top PERFMORMERS STARBUCKS As of today, nearly 60 percent of the 8,500 Starbucks locations in the U.S. have drive-thru capabilities, in which they reported “well outperformed” overall sales comparables. During that same time, Starbucks also announced that off-premise sales accounted for more than half of all orders, including drive-thru and mobile orders. On March 21st, Starbucks announced its decision to temporarily shut doors throughout all their U.S. restaurants in response to COVID-19, keeping only 55 percent open with drivethru capabilities.

CHICK- FIL-A Chick-fil-A ranks the highest in customer service, contributing to their tremendous rate of returning customers, with their busiest locations boasting 300 cars in one hour. To accommodate their traffic, Chick-fil-A implemented dual drive-thru lanes and equipped the ordering crew with tablets that allow them to move from car to car, take orders, and receive payment all at once. Following CDC’s guidelines, staff is supplied with face masks, outdoor hand-washing stations, and limited person-toperson contact.

TACO BELL 2019 was a good year for Taco Bell’s drive-thru sales, with six million more cars than 2018 and averaged seven seconds faster on orders per guest, according to QSR’s Drive-Thru Study.

While seven seconds may seem minuscule, it added four million transactions. To combat the pandemic, the fast food giant introduced the 7 Enhanced Safety Steps, which include protocols such as contactless service, employee protection equipment, and increased sanitization standards that were implemented throughout their U.S. locations.

MATTHEWS™ | 51

DRIVE-THRUS IN CALIFORNIA As of January, drive-thrus have sparked some controversy. In places like Santa Clarita, the City Council placed a 45-day moratorium early in 2020 on the development of drive-thrus due to traffic and pedestrian hazards. Thus, properties that already had drive-thru lanes increase in value. Sacramento, Minneapolis, Orchard Park, Fair Haven, Creve Coeur, Portland, and Indialantic are just a few other cities that have proposed a similar ban as well, all with claims that drive-thru lines pose hazardous conditions.

Further, California is notorious for the difficulty in obtaining a conditional use permit, which allows developers to work with the city to provide a flexible zoning ordinance that will serve beneficial to the community. The economic disruption brought on by COVID-19 halted numerous construction projects across the nation. These drive-thru development hurdles all contribute to the growing value of a drive-thru, especially in places like California, where protests and moratoriums fight developers every step of the way.

As the primary source of revenue during the outbreak, the value of a drive-thru is soaring. Predating to the 1940s, drive-thrus continue to capitalize on convenience and quick order fulfillment and are here to stay. Looking ahead, drive-thrus are likely to increase in popularity, and seeing how cities and the top performers handle increased customer demand will be interesting. For an in-depth analysis of your quick service restaurant, contact a Matthews™ specialized agent today.

Jon Prater

jon.prater@matthews.com (949) 432-4516

Connor Olandt

connor.olandt@matthews.com (949) 432-4504

52 | SPRING/ SUMMER 2020

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Investment Sales | Leasing | Debt Financing

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MATTHEWS™ | 53

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USTRIAL INDUSTRIAL INDUSTRIAL INDU USTRIAL INDUSTRIAL INDUSTRIAL INDU USTRIAL INDUSTRIAL INDUSTRIAL INDU USTRIAL INDUSTRIAL INDUSTRIAL INDU USTRIAL INDUSTRIAL INDUSTRIAL INDU USTRIAL INDUSTRIAL INDUSTRIAL INDU USTRIAL INDUSTRIAL INDUSTRIAL INDU USTRIAL INDUSTRIAL INDUSTRIAL INDU USTRIAL INDUSTRIAL INDUSTRIAL INDU USTRIAL INDUSTRIAL INDUSTRIAL INDU USTRIAL INDUSTRIAL INDUSTRIAL INDU USTRIAL INDUSTRIAL INDUSTRIAL INDU USTRIAL INDUSTRIAL INDUSTRIAL INDU USTRIAL INDUSTRIAL INDUSTRIAL INDU USTRIAL INDUSTRIAL INDUSTRIAL INDU

EMERGING INDUSTRIAL MARKETS

By Austin Borges, Carter Hadley & Harrison Auerbach

The industrial sector has been a hot commodity in commercial real estate for some time for several reasons. In 2019 alone, 277 million square feet of industrial supply was absorbed, ranking as the 2nd highest annual total in the last ten years, as demonstrated by Commercial Real Estate Exchange data. Despite the COVID-19 outbreak affecting nearly every commercial real estate sector, the demand for industrial space is fueled by e-commerce, cold storage, and warehousing. 2020 is expected to deliver strong industrial supply growth, with 200 million square feet of logistics space already added. In this article, Matthews™ will discuss the top emerging industrial markets in the United States and what is feeding into their success.

MATTHEWS™ | 55

strial industrial strial industrial strial industrial strial industrial strial industrial strial industrial strial industrial strial industrial strial industrial DRIVERS FOR DEVELOPMENT DEMAND

E-COMMERCE The primary force behind the strong demand for industrial space remains to be e-commerce. Over the past five years, e-commerce sales have doubled, and 2019 totaled nearly $600 billion, as demonstrated by the U.S. Census Bureau in their Quarterly Retail E-Commerce Sales report. The arrival of COVID-19, followed by nationwide travel restrictions and shuttering of non-essential businesses, has caused a spur in online shopping, which is expected to continue.

In summary, so long as consumer spending and business confidence continue to increase, it will drive the demand for more industrial inventory.

What People Are Buying Online Year-Over-Year Source: Big Commerce

14.3%

APPAREL & ACCESSORIES

7.2%

FOOD & BEVERAGE

18.9%

GIFTS & SPECIALTY

While the outlook for industrial is still to be determined, the increasing e-commerce sales, TOYS & GAMES 7.0% grocery, food-related users, and other occupiers who supply essential businesses should sustain industrial use. The sector’s proven track record of weathering HOME & GARDEN 8.4% economic storms compared to other property types leaves experts optimistic for the future.

I NAccording D U S TtoR I A L A R T I C L E What People Aren’t Buying Online Year-Over-Year RCA, sales volume in Q1 2020 grew by 94 percent year-over-year, but the economic storm caused by COVID-19 began to be felt in Q2 2020 with sales volume tumbling 50 percent year-over-year, despite April surpassing year-over-year growth by 52 percent with 142 transactions, almost twice that of transactions closed during the Global Financial Crisis.

Although leasing and transaction deals slowed because of COVID-19, the industrial sector is primed for continued momentum. In fact, tours and calls are picking up the pace, demonstrating investor demand is active. Investor appetite is present with experts expressing more optimism for Q2 2020, as they anticipate industrial to come out of the pandemic quickly and become a top-performing asset class.

56 | SPRING/ SUMMER 2020

Source: Big Commerce

77%

64% 62%

57%

50%

LUGGAGE

CAMERAS & EQUIPMENT SWIMWEAR

GYM BAGS

STORE FIXTURES & DISPLAYS

In the past, warehouses were purchased in rural and suburban areas where land and rent were cheaper and far from the urban population. Today, the demand for distribution centers in proximity to urban markets is on the rise.

With virtual retail sales expecting to reach new highs by 2022, and consumers demanding quicker deliveries, the pressure to fulfill last-mile delivery is stronger than ever. E-commerce giant Amazon, set high standards once they transitioned from offering seven-day delivery to same-day delivery. As a result, increasing land values have tenants turning to multistory warehouses in proximity to urban and suburban areas.

Amazon’s Last-Mile Delivery Platform 200

70%

175

60%

150

50%

125

40%

100

30%

75

20%

50

Rent Premium

# of Properties Added

Source: CoStar

10%

25 0

09

10

11

12

13

14

15

16

17

18

Fufillment/ Distribution Center

Sortation Center

Delivery Station

Rent Premium Paid by Amazon

Prime Now Hub

Whole Foods

19

20

0%

DATA CENTERS Corresponding with the rapid growth and demand from of data, further contributing to the demand for this e-commerce and telecommuting, tenants are equally space. AI and digital reality technologies are becoming seeking secure and reliable data storage. Cisco the focal point of digital real estate organizations. reported that since 2007, internet traffic has increased According to Million Acres, autonomous vehicles will 20 times, and projects that internet traffic will more continue to explode until 2025, where shipments are than double by 2021. With a large portion of the expected to increase from 64,000 in 2018, to 569,000. population working remotely and purchasing online returns are turning to rather than in-store, there are more active I N Dusers U Sonline T R I A LOwners A R Tlooking Iproperty C Lfor E higher alternative types, and data centers appear than ever before. It’s expected that next-generation to be their solution. It can be argued that they are technologies, like 5G, will create an explosive growth recession-resistant as consumers will use their data Change in Internet Traffic regardless of the economy’s condition, which has Source: Cloudflare proven true thus far. Data centers are absorbing in 1.6x the market 1.6 times faster than they are delivering. In terms of development and investment, data centers 1.4x were the top niche property type in 2019, according to PWC’s Emerging Trends survey.

1.2x

1x

04.16.20

04.07.20

03.30.20

03.22.20

03.14.20

02.27.20

03.06.20

02.11.20

02.19.20

02.03.20

01.30.20

01.22.20

01.14.20

01.06.20

12.29.19

0.8x

BY 2022, 70% OF DATA WILL BE CREATED OUTSIDE THE DATA CENTER OR CLOUD, UP FROM 40% TODAY. Source: Gartner

MATTHEWS™ | 57

LIMITED SUPPLY

As for tenants looking for warehouse space, some are transforming their unused spaces into warehouse-like facilities. Across the country, there are new projects involving the conversion of old schools, factories, libraries, and more into flex space. This trend is likely to continue with incentive programs like Opportunity Zones and Low Income Housing Tax Credit, where these abandoned properties are abundant.

CRE Total Returns by Sector Source: NCREIF Analytics

16% 14% 12%

Total Returns

The limited available supply in several markets and an uptick in lease renewals indicate that demand for industrial space remains strong. Vacancy rates have reached historic lows, and the lack of developable land and increased regulatory barriers have slowed supply deliveries. On top of it all, the global crisis has sparked trading tensions and slowed or halted construction altogether in certain markets that do not deem construction an essential business.

10% 8% 6% 4% 2% 0% ‘12

‘13

‘14

‘15

‘16

‘17

Apartment

Industrial

Office

Retail

‘18

TOP EMERGING MARKETS

ORANGE COUNTY,

CALIFORNIA

Orange County’s favorable proximity to the ports in Los Angeles and Long Beach is a primary reason why investors show interest in this market. Although it has seen five million square feet of negative absorption since 2017, vacancies have remained steady and below I N3.2Dpercent.

U S T The R I life A Lscience A Rindustry T I C Lhas E drawn a lot of attention to its flex product inventory. Big-name tenants, like Edwards Lifesciences, have given the metro a reputation as the medical device capital of the world. At 97 percent occupancy, the constrained industrial supply gives landlords the leverage to continually increase rents, with the current average price per square foot at $240, as indicated by CoStar.

Average Price/SqFt:

$240

Average Cap Rate:

5.00%

Source: CoStar

58 | SPRING/ SUMMER 2020

The majority of investment activity in Orange County involved newer assets. The remarkably low vacancy rate, paired with the 4.1 percent growing rents, has developers rushing to build more space. CoStar reported that for the past three years, Orange County averaged an annual industrial sales volume of $6.1 billion. The most noteworthy sale involved a sale leaseback transaction with Albertsons, who purchased a one million square foot distribution center for $277.7 million, a cyclical record high.

‘19

INLAND EMPIRE,

CALIFORNIA

Average Price/SqFt:

$139

Average Cap Rate:

5.50%

As one of Southern California’s leading markets, the Inland Empire’s cheap labor, relatively inexpensive land, and proximity to the Los Angeles twin ports, has primed the city for industrial expansion. Private equity boosted sales in 2019 to $5.9 billion, over a 50 percent increase from 2018’s $3.8 billion. Over 20 million square feet is anticipated to deliver by the end of 2020, a slowing pace compared to the 25 million square feet delivered consecutively in the past three years. CoStar placed the Inland Empire second for annual deliveries in 2019; however, vacancies remain low, and rent growth continues despite this booming development. For the past three years, sales volume has averaged $4 billion and is expected to continue at this rate with new product delivery.

Inland Empire’s prices for industrial properties are above the national average, and the market holds some of the most expensive assets in the country. A large portion of leasing activity in Q1 2020 involved warehouses and distribution facilities, an abrupt change of pace to the market as roughly 98 percent of the current inventory is logistic space.

The six percent year-over-year growth in sales garnered a historically low cap rate of 4.70 percent but has since increased to 5.50 percent due to COVID-19.

Source: CoStar

LOS ANGELES, CALIFORNIA

Average Price/SqFt:

$219

Average Cap Rate:

4.80%

As the most significant industrial market in the nation, with 930 million square feet in inventory, and four million in the pipeline, Los Angeles boasts lowest vacancies IN D Uthe ST RIA L A RofTany I Cmajor L E metro. In 2019, the metro reached a record of $5.5 billion in sales volume and currently has a 3.3 percent vacancy rate, CoStar data shows. Vacancies are expected to remain tight in large part due to the absence of new development.

The city is a hot market for industrial demand as California’s busiest ports, and largest manufacturing sector resides here. However, the scarcity in developable locations and the trade tensions between the U.S. and China, paired with the outbreak, have slowed absorption.

Conversely, demand for warehouse space is predicted to increase due to expanding delivery services and medical supply demand. PWC’s Emerging Trends in Real Estate reported that with the meager vacancy rates, and the limited available supply, owners could increase rental rates at a robust pace.

Source: CoStar

MATTHEWS™ | 59

ATLANTA, GEORGIA

Home to the busiest airport in the world, Hartsfield-Jackson Atlanta International, Atlanta’s employment opportunities mixed with the affordable cost of living are the ideal fundamentals for developers as global companies migrate to the metro. Although the coronavirus slowed leasing activity in mid-March, leasing volume has spiked in the last few weeks, while sales volume has slowed since the start of Q2 2020. According to PWC’s Emerging Trends in Real Estate, population growth will serve as the primary force behind 2020 development in Atlanta. Atlanta’s robust sales volume, high average cap rates, and increasing pricing are excellent fundamentals for national and institutional buyers.

Average Price/SqFt:

$70

Average Cap Rate:

7.70%

Over the past year, 13.3 million square feet of industrial inventory has delivered, and there are nearly 19 million square feet in the pipeline currently, with 50 percent available for lease, according to CoStar. This impressive pipeline is one of the largest in the country. Atlanta’s rent growth stands as one of the healthiest in the nation, trailing above the national average. CoStar predicts that in the case of faster-than-usual rising vacancies, the current and historical vacancies should cushion the impact of economic slowdowns.

Source: CoStar

DALLASFORT WORTH, TEXAS

Average Price/SqFt:

$90

Average Cap Rate:

7.40%

Source: CoStar

60 | SPRING/ SUMMER 2020

Dallas-Fort Worth (DFW) currently holds a seven percent vacancy rate with credit to demand for speculative projects and a few substantial build-to-suits. Following record level supplies in 2019, 29.5 million square feet is underway with 70 percent available for lease, and 23.4 million square feet has been absorbed in the previous 12 months.

Driving volume in 2020 are portfolio deals, the most recent being a $13.4 billion portfolio sale.

As the most active in terms of construction, DFW still experienced a four percent rent growth, leading all major metros. Emerging submarkets will welcome new industrial projects as other markets start to oversaturate. Among those include Hillsboro, Midlothian, and Denton, which recently broke ground with some large projects.

Amazon opened its first fulfillment center in Texas in May, hiring 1,500 employees for its 855,000 square foot facility.

PHOENIX, ARIZONA

Average Price/SqFt:

$110

Average Cap Rate:

6.90%

Phoenix’s cheap energy costs, affordable cost of living, and the new interstate system continue to attract new residents and businesses. Its prime location along Interstate 10 lures e-commerce players, providing convenient access for speedy deliveries. In 2019, deliveries and vacancies remained steady while asking rent increased, positioning Phoenix for healthy industrial activity, according to Arizona’s Builder’s Exchange. Phoenix achieved a record of $3.4 billion in sales volume, and its average industrial rent is five percent below the national average, a remarkable discount when compared to California rent.

Although vacancies were approaching a record towards the end of Q1 2020, they have since risen by 30 basis points and are projected to reach eight percent by 2021, according to CoStar. With construction considered an essential business, development has continued in Phoenix. A total of 13 million square feet is under construction, and 60 percent is available for lease, ranking Phoenix the sixth top metro for industrial space underway. GlobeSt reported that Phoenix has the most active industrial construction in the nation and has kept a consistent absorption rate since 2016.

Source: CoStar

RICHMOND,

Richmond’s continual pace of record-breaking industrial development is shifting investor focus to the market, with 95 percent of that space already pre-leased, according to CoStar. Before the outbreak, Virginia’s capital was experiencing soaring demand, which has officially outpaced the metro’s average in the last eight years. Since the start of March, large tenants in the market, such as Amazon, FedEx, and XPO Logistics, have signed a total of 430,000 square feet.

Average Price/SqFt:

Vacancies in Richmond currently sit below historical norms at 4.9 percent, and rent growth has averaged four percent for six consecutive years, although it is likely to slow by year’s end, according to CoStar. Sales volume reached $360 million in 2019; the second year the metro has achieved this mark. Richmond industrial properties see positive activity as the below-average vacancy allows for some softening.

VIRGINIA

$65

Average Cap Rate:

8.70%

Source: CoStar

MATTHEWS™ | 61

factors of growth Net Absorbtion, Net Deliveries & Vacancy

Source: CoStar

14%

Forecasted

60M

13%

50M

12%

40M

11%

30M

10%

20M

9%

10M

8%

0

7%

-10M

6%

-20M

10

11

12

13

14

15

16

Net Deliveries

17

18

20

Net Absorption

INCREASED RENTS With major markets experiencing the scarcity of developable land, landlords are hiking rents. As long as e-commerce sales and data usage continue on their current trajectory, the demand for proper warehousing, distribution centers, and secure data usage and storage will continue to drive demand, affecting rents.

CAP RATES The national cap rate average is 6.2 percent, according to RCA. Buyers today look at these deals as long-term gains, and with the rising interest in logistics real estate, cap rates should remain at this level. In fact, RCA predicts even more cap rate compression where investors find deal flow opportunities, such as in secondary and tertiary markets.

LOWER VACANCY RATES

19

21

22

23

62 | SPRING/ SUMMER 2020

5%

24

Vacancy Rate

SUPPLY OUTPACED DEMAND For the first time since the 2008 recession, industrial supply has outpaced the demand, according to Yardi Matrix. Inland markets like DFW and Atlanta, experiencing a boom in industrial development, could be at risk of oversupply as developers attempt to catch up to demand.

Industrial Annual Cap Rate Source: RCA

Warehouse

Flex

All Industrial

8.0% 7.5% 7.0% 6.5% 6.0%

‘15

‘16

‘17

‘18

‘19

‘20

Annual Industrial Vacancy Rate

Source: CoStar

13%

Tenants are renewing leases at higher-than-normal rates, and companies are leasing spaces before development completion. In a survey conducted by the National Real Estate Investor, 49 percent of respondents expect vacancy rates to decrease this year.

Vacancy Rate

Absorption & Deliveries in SqFt

70M

Forecasted

12% 11% 10% 9% 8% 7% 6%

10

11

12

13

14

15

16

17

18

19

20

21

22 23 24

unlocking equity SALE LEASEBACK Sale leaseback transactions can be used as a tool by owners and operators looking to unlock their property’s equity instantaneously. Through a sale leaseback, the owner or operator sells their asset while simultaneously executing a long-term lease through the buyer. As the industrial sector continues to boom, owning and operating an industrial business can grow increasingly difficult. Executing a sale leaseback transaction proves to be beneficial for many reasons, including improved financial statements, flexible and custom lease terms, and immediate access to capital.

The owner-operator can use the unlocked capital to pay off debts, expand their company or operations, or reinvest into their core business.

1031 EXCHANGE Owners with low returns on their property might consider 1031 Exchanges for the opportunity to increase returns. 1031 Exchanges allow investors to sell their property and reinvest into another property of like-kind and equal or higher value. Moreover, the seller is not restricted by location and can explore other markets where they believe they would be more successful.

ARBITRAGE VALUE In the case of California, where land availability is quickly diminishing along with the development opportunities, investors who have concentrated all their investment into one location are more susceptible to higher risks. As an example, the ongoing U.S.-China trade war has caused uncertainty in the market and disruption in the flow of goods. These owners are feeling affects and may eventually experience damage to their returns. Arbitrage may serve as a solution, as the owner can capitalize on market inefficiencies by simultaneously purchasing and selling the same asset in two different markets.

Industrial Indust Industrial Indust Industrial Indust Industrial Indust Industrial Indust Industrial Indust Industrial Indust Industrial Indust Essential businesses looking to expand can utilize this time to lock in favorable lease terms with lower asking rents. Although the pandemic and trade war brought on supply chain disruptions, property values, and rental rates are determined to take minimal impact. The influence of new shopping habits and migrating to e-commerce should further contribute to industrial use and demand. While that space is evolving more and more, one thing remains the same – the industrial sector will continue as an active, strong market.

To learn more or to discuss the next steps regarding your industrial investment, contact a Matthews™ specialized agent today.

AUSTIN BORGES

austin.borges@matthews.com (310) 919-5809

CARTER HADLEY

carter.hadley@matthews.com (949) 662-2260

HARRISON AUERBACH

harrison.auerbach@matthews.com (404) 445-1092

MATTHEWS™ | 63

IMPOSSIBAO ● ● ●

EVERY TENANT DESERVES CUSTOMIZED REAL ESTATE REPRESENTATION. Regardless of size of location, Matthews™ is here to help!

™

We currently represent and assist local businesses, regional franchises, and national corporate tenants in identifying, negotiating, and securing lease locations.

MATTHEWS™ RETAIL LEASING TENANT REPRESENTATION.

W W W. M AT T H E W S . C O M

The U.S. Multifamily Market

INSIGHTS ON THE STABILITY AND PREDICTABILITY OF THE SECTOR COVID-19 has prompted substantial changes to lease activity, operations, renter behavior, and investment activity within the U.S. multifamily market. With growing calls for affordability and rent regulation already taking a toll on investment in the sector, the pandemic’s impact on renters’ employment status added fuel to the fire. Countervailing effects, like a decline in new construction as a response to the economic slowdown, could help normalize rent growth and vacancies. But, if the past proves anything, it’s that the multifamily sector is resilient during downturns, and transaction volume is slow to react as real estate transactions take time to complete. In this article, Matthews™ will review the short and long-term COVID-19 implications and provide information and insight into multifamily fundamentals.

66 | SPRING/ SUMMER 2020

Short & Long-Term Multifamily Implications In April 2020, the unemployment rate peaked at a record-breaking 14.7 percent. June job reports show improvement across the nation, with the unemployment rate falling to 11.1 percent. The federal government supplemented unemployment benefits by providing an additional $600 per week to the unemployed, as well as the stimulus check supplied by the CARES Act, but these benefits are set to expire at the end of July. This could mean a surge in rent defaults, residents moving out, and a shift in migration patterns. Given the unemployment rate, apartment rents could fall ten percent in urban markets, according to Costar.

Rent trends vary by market and product type. Asking rents have stabilized since mid-April and have begun to rise since mid-May as states began opening their economies. Affordable markets, like suburban markets, are seeing a positive change in asking rent. These markets all have similar characteristics.

For example, on average, rents are below $1,000 per month and have limited supply due to difficulty in underwriting new developments. In comparison, expensive, urban markets see rent losses as tenants take advantage of cheaper properties and cities.

Change in Asking Rent Since March Peak S O U R C E : C O S TA R  Suburban  CBD 0% 2% 4% Richmond Norfolk Inland Empire Detroit Memphis Sacramento Kansas City Hartford Columbus Salt Lake City East Bay San Jose Oklahoma City Houston Jacksonville Austin Nashville San Francisco San Jose

In the short-term, properties in the top 40 markets, occupied by those that could be characterized as renter-by-necessity, were outperforming those termed lifestyle-renter assets, meaning they suffered less severe rent declines.

S O U R C E : YA R D I M AT R I X

As employees work from home, many are taking advantage of cheaper properties and cities, driving changes in vacancy and rent growth. Telecommuting will likely continue indefinitely, resulting in less attention to location. There has also been renters move home, moving into their own units, or renting large spaces to accommodate a home office.

According to CoStar, the student housing market is also likely to be disrupted short-term as colleges and universities move to online classes, and rents around campuses suffer. In May, pre-leasing fell below the year-ago rate, as only about 70 percent of beds at the core 175 universities tracked by RealPage were leased for the Fall 2020 academic year. Operators are hoping for a robust summer leasing season to catch up, but many universities have yet to announce their plans to reopen in the fall.

As the economy moves into what resembles a recession, it is most likely that the industry will see delayed effects of the pandemic in the second half of the year. However, investors remain bullish on multifamily investments in both the near- and longterm. With history on its side, multifamily investments perform well during a recession. Now, with the pandemic creating volatility in office, retail, and other sectors, the capital usually directed toward those investments will most likely seek the stability and predictability of multifamily.

Despite the current market disruption caused by the coronavirus pandemic, the multifamily sector still has attractive fundamentals. Long-term job loss and low wage growth will create more demand for rental product. Apartments demonstrate relative resilience amid the pandemic and provide attractive, riskadjusted returns with relatively low volatility.

Palm Beach County (8%) (6%) (4%) (2%) 0%

MATTHEWS™ | 67

Protracted Slump Scenario: Multifamily Fundamentals S O U R C E : C O S TA R

UNITS (IN THOUSANDS)

Completions 350 300 250 200 150 100 50 0 -50 -100

Net Absorption

Vacancy Percent

FORECAST

2010

2012

2014

2016

Multifamily Fundamentals

2018

2020

2022

2024

9% 8% 7% 6% 5% 4% 3% 2% 1% 0%

Rents Payments by Product Class

Although rent collection is an excellent indicator of the current economic environment, it isn’t the only metric the industry is monitoring. Other metrics to track include changes in rental rates for new residents, shifts in occupancy, or variation amongst class types, which are essential indicators of industry performance.

R E N T PAY M E N T S Data from numerous sources indicate that residents are still paying their rent when possible, and the U.S. has managed to recover some jobs in late May and June. At the start of the pandemic, landlord-tenant partnerships played a significant role in boosting rent collections before the government stimulus funds and unemployment arrived. These policies created between landlords and tenants will continue to play an important role.

From the data released by the National Multifamily Housing Council (NMHC), more than 95.9 percent of the 11.4 million households surveyed nationwide paid all or a portion of the rent in June 2020. The industry is beginning to see variations in payment patterns among product class and certain metros; key potential trouble spots include New Orleans, New York, Las Vegas, and Houston.

S O U R C E : R E A L PA G E , I N C .

CLASS A

90.3%

CLASS B

90.2%

CLASS C

84.0%

While overall rent payment results are encouraging, there’s meaningful deterioration in the ability to meet rent obligations among lower-priced Class C apartment buildings. According to the information that RealPage provided for NMHC’s research efforts, the share of residents in Class C properties paying rent by June 6 was 73.2 percent. That share is more than ten percentage points under the collection of 85.1 percent in Class A projects and 83.9 percent in Class B. Asking effective rents are off a little from the figures in May but are still up from the levels seen a year ago. Phoenix, for example, had experienced annual rent growth near the eight percent mark, although the increase in asking effective rents has slowed to 3.8 percent. The annual increase in asking effective rents is between 3.0 and 3.5 percent in Cincinnati and Nashville, respectively.

Asking Effective Rents are Losing Momentum S O U R C E : R E A L PA G E , I N C .

4.0%

National One-Bed Rent | 2020

3.5%

I N C L U D E S P R O P E R T I E S W I T H AT L E A S T 5 0 U N I T S S O U R C E : C O S TA R

3.0%

101

2.5% 2.0%

100

1.5% 1.0%

JAN 1, 2020 = 100 UNITS

0.5% 99

Jan

Feb

Mar

Apr

68 | SPRING/ SUMMER 2020

May

Jun

July

0%

2018

2019

2020

April - Dec

Jan - Dec

Jan - Apr

M A R K E T T I G H T N E S S & VA C A N C Y CoStar cited that the demand for apartments will fall by about 50,000 units this year and vacancy, will top eight percent in the coming months. Even if the majority of unemployed workers are rehired as cities open their economies, the coronavirus may have a lingering effect. The summer is usually the time of year where temperatures increase, and apartment renters move out, by shopping for better deals or relocating to new neighborhoods. Instead, there are multiple indicators of an abrupt and unusual shift in seasonal resident turnover patterns.

Share of Move-out Notices Rescinded*

Percent of Properties Reporting Higher Vacancy

S O U R C E : R E A L PA G E

S O U R C E : C O S TA R

2017

2018

2019

2020

Renters are canceling move out plans and requesting short-term lease extensions, and property managers are offering unprecedented flexibility to accommodate them. We see a spike in rescinded non-renewal notices, which occurs when renters who previously intended to move out change their plans and stay put. Compared to the same time last year, rescinded notices have nearly doubled, according to RealPage.

This strong resident retention for expiring leases helps boost occupancy and provides some cushion to make today’s health crisis more manageable on a month-tomonth basis.

 2019

4.0%

 2020

3.5%

April May June July August September October November December

34%

3.0% 2.5% 2.0% 1.5%

January February March April May June July August September October November December

Jan Jan Feb Feb Feb Feb Feb Mar Mar Mar Mar Apr Apr Apr 18 25 1 8 15 22 29 7 14 21 28 4 11 18 * Rolling seven-day average reflecting renters who decided to stay put after previously panning to move

33%

April executed leases were down 4.5% year-over-year, with the change especially pronounced in Class A assets.

S O U R C E : R E A L PA G E

January February March April May June July August September October November December

32%

January February March April May

40% 0%

10%

20%

30%

40%

50%

Data providers also reported some softness around rent pricing, increased concessions, and noticeable differences in various market segments. Vacancies are higher in tourism markets, and demand could weaken in the second half of the year. MRI software reported that new rental applications decreased 29 percent from March 22 to April 19, 2020. However, limited apartment completions in April could boost the overall occupancy rate as new product delivery was delayed at many properties. In comparison to occupancy figures from mid-2008, April’s occupancy of 95.4 percent comes in 160 basis points over the mid-2008 reading.

MATTHEWS™ | 69

CONSTRUCTION Hoyt Advisory Services completed demand research through 2030 and identified that, on average, 328,000 new apartment buildings are needed at various price points every year to keep up with demand. Nationwide, the industry has only produced that number of new apartments three times since 1989. Figures from the Department of Commerce indicate that April housing starts posted their steepest monthly decline on record. However, the National Association of Home Builders noted that the 30.2 percent drop to an annualized pace of 891,000 units, both single and multifamily, was somewhat better than the forecast. Construction starts in the multifamily sector decreased 40.5 percent to a 241,000 unit pace.

U.S. Multifamily Permits, Completions, and Starts

Currently, the demand for apartment buildings remains unknown. However, NMHC’s construction survey series has primarily shown that multifamily construction is continuing, as jurisdiction deems residential development an essential activity, but they have faced a few setbacks. More than half of NMHC’s survey respondents have continuously noted delays, voicing concerns for permitting delays and start delays. Twenty-nine percent of respondents indicated that a lack of materials has been impacting their construction operations. This also includes price increases for materials, specifically lumber and property, plant, and equipment. Just 25 percent of respondents indicated that they are still facing COVID-19 related labor constraints, a decrease from previous survey results.

(IN THOUSANDS) | SOURCE: U.S. CENSUS BUREAU

Completions

Starts

Permits

New Strategies Implemented by Firms

600

500

SOURCING MATERIALS FROM ALTERNATIVE LOCATIONS

400

STAGGERING SHIF TS TO REDUCE ON-SITE E XPOSURE

300

USING TECHNOLOGY FOR INSPECTIONS & APPROVALS

200

OFFERING INCENTIVES & OTHER BENEFITS TO THE WORKFORCE

100

0

2002

2006

2010

2014

2018

It is expected that the coronavirus will dent new multifamily supply expectations this year. 2020 was supposed to bring some 300,000 units, but federal, state, and local stay-at-home orders and other responses to the coronavirus pandemic will likely reduce that to around 250,000 units. According to MRI, research indicates that the supply in several metros is expected to outpace estimated apartment demand, including Pittsburgh, Salt Lake City, Nashville, and Chicago.

70 | SPRING/ SUMMER 2020

SOCIAL DISTANCING PROCEDURES

Despite these delays, construction is still underway, meaning that many properties currently under construction will begin to see lease-up in the coming months. If short-term issues are presented with this new supply, it will be hard to initially determine whether it is truly a lack of demand for the product or lack of demand for the product that has come online during a pandemic-induced economic shutdown.

Generally, developers are betting that by the time their projects are done, demand would have returned.

SALES VOLUME

Volume YOY Change

There have been significant effects of the crisis on multifamily, such as a reduction in demand and a rise in concessions. In the first quarter of 2020, national average cap rates for multifamily properties compressed ten basis points from last year’s levels to 5.4 percent. Apartment prices rose 10.8 percent in April from a year ago, according to Real Capital Analytics data. Further, April’s $3.5 billion of volume is the lowest tally recorded in the month of April since 2010. The number of monthly transactions in the sector has fallen at an average pace of 31 percent since January.

Despite transactions trending downward, the bid-ask spread is wide. Buyers are opportunistic and looking for a steep discount on multifamily properties. At the same time, prospective sellers don’t see the reduction in price as worthwhile and are waiting to sell until the environment improves.

Cap Rates SOURCE: RCA

All Apartment

Garden

Mid/High-Rise

6.5% 6.0% 5.5% 5.0% 4.5%

2015

2016

2017

2018

2019

2020

SOURCE: REONOMY

2016

2017

100% 75% 50% 25% 0% -25% -50% -75%

THE ROLL OF DEBT & EQUIT Y FINANCING One benefit that the multifamily sector had during the last recession was the stability of financing from the agency lenders. With a steady flow of capital from Fannie Mae and Freddie Mac, some of the worst losses seen in other property sectors were due to a lack of debt capital, which was avoided for most of the multifamily sector. The spread between apartment cap rates and the Ten Year U.S. Treasury is at a record high, but investor perceptions of risk are high. Although lenders’ reaction to the pandemic has created stricter standards for loan-to-value ratios and reserves, interest rates are at an all-time low.

Therefore, creating the perfect rate environment for apartment loans, meaning the returns for investors, should be higher than usual during this particular health crisis. Still, lenders remain cautious when vetting an opportunity.

Leading commercial real estate experts suggest that the flow of capital into the multifamily sector would increase despite the economy heading into a potential recession. The increased supply of capital authorized

by Fannie Mae and Freddie Mac should lower the spread of the Ten Year U.S. Treasury rate significantly.

Quarterly Transactions 3,000 2,800 2,600 2,400 2,200 2,000 1,800 1,600 1,400 1,200 1,000 800 600 400 200 0

SOURCE: RCA

2018

2019

2020

MATTHEWS™ | 71

Legislation Impacting Multifamily T H E E V I C T I O N M O R AT O R I U M

THE HEROES ACT

This suspension is meant to protect homeowners and tenants who lost their jobs because of the economic downturn caused by the coronavirus pandemic. This moratorium suspends foreclosures and evictions through a specific date set by respective state governors.

This $3 trillion proposal is additional relief legislation that promises a second stimulus check, debt relief, student loan forgiveness, hazard pay, six more months of COVID-19 unemployment, housing, food assistance, and nearly $1 trillion in aid for state and local governments so they can pay vital workers like first responders, health workers, and teachers who are at risk of losing their jobs due to budget shortfalls. The HEROES Act also makes changes to the federal government’s new Paycheck Protection Program for small businesses. The plan currently requires small businesses to use 75 percent of the money for payroll expenses, or be forced to pay it back as a loan. The new proposal eliminates the 75 percent requirement, so small businesses could use the money as desired. Currently, the Act is up for a vote in the Senate.

THE CARES ACT Properties with a federally backed mortgage, Fannie Mae or Freddie Mac, or participation in one of the various federal programs covered by the Violence Against Women’s Act or the Rural Voucher Program can request forbearance. Under the CARES act, apartments cannot evict delinquent renters for 120 days, this period runs from March 27 to July 25.

Properties subject to the CARES Act can still apply resident fees as normal, but they cannot charge any type of late fee, nor can they evict for non-payment of any fee for the duration of the federal eviction moratorium. The CARES Act also includes significant benefits for business owners: tax credits, tax payment extensions, small business loans, and other programs designed to help employers meet payroll and keep their business going.

FHFA The Federal Housing Finance Agency (FHFA) on March 23 announced that Fannie Mae and Freddie Mac would offer mortgage forbearance for multifamily property owners, under the condition that they suspend all evictions for renters who are unable to pay rent because of COVID-19. To be eligible, property owners must suspend evictions for as long as they remain in forbearance.

C A L I F O R N I A’ S L AW S TA C K L E T H E H O U S I N G C R I S I S In 2017, California legalized the conversion of existing buildings on single-family lots to Accessory Dwelling Units (ADUs). On January 1, 2020, the law expanded to allow every single-family homeowner to add both an ADU and a Junior ADU. These laws give Californians the tools to ease the housing crisis and, more imminently, the health crisis. On January 1, 2020, this law expanded to allow for ADUs in rear yards and unused areas of apartment buildings (attics, storage areas, and garages) following a model established by San Francisco. Apartment owners statewide are just beginning to explore how these laws will allow them to add a unit to existing properties without disrupting current tenants. Over time, multifamily properties ADUs will become a significant portion of new ADU development.

The Future of Multifamily According to a significant multifamily operator, the multifamily sector will emerge from the COVID-19 shutdown cautiously and in stages. The industry is already preparing to return to post-quarantine life and quickly mobilize to provide a safe home for tenants. As consumers change the retail landscape, tenants change the multifamily landscape.

Numerous architects are rethinking bedrooms, kitchens, and common areas as the coronavirus changes the way Americans live. The coronavirus pandemic has brought radical upheavals to daily habits and work arrangements across the country while generating a renewed focus on health and wellness in the build environment. As a result, designers are working to provide a living environment that is clean, flexible, and responsive to the new space demands made by residents. Nearly half of the U.S. workforce transitioned to telecommuting as of early April, according to MIT’s data, and this shift may become permanent.

Therefore, we may begin to see apartment spaces that incorporate work surfaces.

Other Aspects Incorporated to Multifamily Structures: SPACES INDOOR AND OUTDOOR THAT ALLOW RESIDENTS TO ENGAGE WITH NATURE AND THE COMMUNIT Y FROM A COMFORTABLE DISTANCE

FLE XIBLE INTERIORS TO WORK AND LE ARN FROM HOME

KITCHEN REVAMP TO ADAPT TO COOKING MORE AT HOME

MORE CUBIC FOOTAGE DEDICATED TO REFRIGERATION

CARVING OUT SPACE FOR OFFICE NOOK S

SENSOR-ACTIVATED OR TOUCHLESS TECHNOLOGY IN HIGH-TOUCH AREA S

MORE NATURAL LIGHT AND BE T TER ACOUSTICS

BALCONIES WILL BECOME MORE POPUL AR

MORE STORAGE FOR PACKAGES, INCLUDING REFRIGERATED LOCKERS.

All in all, the multifamily sector will take some hits but will fare relatively well compared to other property types. Consumers, renters, and investors are adjusting to the changing multifamily market and will be for some time. However, this pause will likely create some pent-up demand in the years to come. For more information on COVID-19’s impact on multifamily, please reach out to a specialized Matthews™ agent.

David Roth

david.roth@matthews.com (216) 503-2356

Robert Starrett

robert.starrett@matthews.com (216) 503-1291

Brandon Kosek

brandon.kosek@matthews.com (216) 260-1257 MATTHEWS™ | 73

YOUR BUSINESS BUSINESS CAN CAN GO GO IN IN AA YOUR

MILLION DIRECTIONS, DIRECTIONS, MILLION BUT ONLY ONLY ONE ONE IS IS RIGHT. RIGHT. BUT

WWW.MATTHEWS.COM 74 | FALL/WINTER 2018

™

The Launch of

Opportunity Zones How to maximize the benefits in 2020

In December 2019, the Department of the Treasury and Internal Revenue System (IRS) released the final regulations governing the tax benefits for investing in qualified opportunity zones (QOZs). As part of the Tax Cuts and Jobs Act, this provision is designed to encourage investment and economic growth in specific low-income communities, in turn offering federal income tax incentives to the taxpayer who invests in a business located in one of these zones. This article will serve as a follow up to the two previous Matthews™ articles featuring opportunity zones: Intro to Opportunity Zones and Opportunities in Opportunity Zones. Highlighted in the following piece is the new round of guidance that was released in December 2019. It provides insight into why opportunity zone investment is only beginning to take off and how investors can maximize the benefits of opportunity zones in 2020.

MATTHEWS™ | 75

The Incentive Section 1400Z-2, part of the Tax Cuts and Jobs Act, allows a taxpayer (1) the temporary deferral of capital gains, to the extent the gains are reinvested into a qualified opportunity fund (QOF); (2) the partial exclusion of previously deferred gains when certain holding period requirements in a QOF are met; and (3) the permanent exclusion of post-acquisition gains from the sale of an investment in a QOF held longer than ten years.

Opportunity Zone Funds Tax Benefits SOU RC E: B I L ZI N SU M B E RG

2019 1 - Capital Gain Event 12/31/2019 Deadline to invest and recieve maximum benefits 2 - Opportunity Zone Fund Investment / Defferral of Capital Gains 3 - Project Development / New Business or Substantial Improvement 2024 4 - Year Five: 10% Step Up 2026 5 - Year Seven: 5% Step Up 6 - End of Income Tax Deferral 2029 7 - Year ten: Permanent Exclusion

76 | SPRING/ SUMMER 2020

The Life Cycle of an Opportunity Zone Investment • A taxpayer realizes an eligible gain, that would traditionally be taxed that year as a capital gain • Taxpayer reinvests the gain within 180 days into a QOF and defers the gain for the years of the sale • The QOF conducts a Section 162 business, either directly or by holding qualified opportunity zone business property (QOZBP) or indirectly by holding QOZ stock or a QOZ partnership interest, provided the subsidiary meets the definition of a qualified opportunity zone business (QOZB) • After five years of holding interest in a QOF, the taxpayer receives a 10% stepped-up basis, meaning the taxpayer can exclude 10% of the original deferred gain • After an additional two years, a supplementary five percent of the original deferred gain is excluded, for a total steppedup basis of 15% • Any remaining deferred gain is recognized on December 31st, 2026, unless an inclusion event occurs before that date. Assuming the taxpayer is still holding the investment, the taxpayer must pay taxes on the original gains, after accounting for the stepped-up basis, at this time • After holding interest for ten years, the taxpayer may sell the investment in the QOF, or the QOZB may sell its assets, at which point the taxpayer will owe $0 in taxes on the new gain

Investing in Qualified Opportunity Funds 2019

2024

2026

2029

Investment

5 years after

7 years after

10 years after

JUNE 30, 2024 Taxpayer’s basis in the deferred capital gain investment in QOF increases from $0 to $10 (10%)

JUNE 30, 2026 Taxpayer’s basis in the deferred capital gain investment in QOF increases from $10 to $15 (15%)

JUNE 30, 2029 Taxpayer sells investment in the QOF for $200. Basis in taxpayer’s investment in the QOF is deemed to be fair market value and thus, no tax is due on the appreciation in the QOF investment

JANUARY 1, 2019 Taxpayer sells asset generating $100 of capital gain.

JUNE 30, 2019 (within 180 days of sale of asset) Taxpayer invests entire $100 capital gain in QOF.

DECEMBER 31, 2026 $85 of the deferred $100 capital gain is taxed.

- QOF invest in the $100 in QOZ property - Tax Paryer deemed to have $0 basis in its investment in the QOF

SOU RC E: X X X X X X X X X

Following the 2008 recession, the U.S. saw an uneven recovery. While some businesses experienced business and job growth, others fell further behind. From 2011 to 2015, distressed communities lost an average of six percent of their jobs and businesses, while prosperous communities gained jobs and businesses by double-digital percentages, according to the Economic Innovation Group.

To summarize, the incentive of the opportunity zone program is that taxpayers will invest deferred gains into designated areas in need of revitalization in exchange for tax benefits.

In order to be eligible for this favorable tax treatment, the investment must improve the lives of those living in the opportunity zone by either (1) bringing new business to the zone that creates jobs or expands opportunities, or (2) improving the availability, aesthetics, and value of the zones’ housing options by engaging development projects.

Understanding these two points is critical as the final regulations contain a broad anti-abuse provision that derails any investment that doesn’t adhere to the program’s goal.

MATTHEWS™ | 77

Why Opportunity Zone Development is Only Beginning to Take Off The final Opportunity Zone regulations released in December 2019 provided some muchneeded clarity to investors. These final regulations tie together many loose ends that remained after the two previous regulations were released in October 2018 and in May 2019. Before this, many investors were concerned with the confusing rules, the lengthy required holding period, and the inability to enjoy losses or take the distribution in the early years. Further, developers also expressed trouble finding deals that made financial sense due to the high cost of land in many opportunity zones. Until recently, only a handful of investors were willing to learn the parameters of the opportunity zone program.

78 | SPRING/ SUMMER 2020

More recently, though, as a result of COVID-19 and the economic fallout, opportunity zone deals have suddenly accelerated as capital poured into QOF funds and as investors find more attractively priced deals. Over the past few months, some of the most active investors in the real estate market have continued with their investment thesis in pursuit of opportunity zones, with many closing deals and starting new projects, as traditional sources of capital remain on the sidelines. Several QOF managers and experts say they have noticed a considerable increase in the amount of deal activity occurring in recent weeks, according to Bisnow. A Chicago-based developer also told Bisnow that the coronavirus was a direct trigger to the uptick in opportunity zone investments. The program relies on investors deploying capital gains. The volatility during the pandemic led many to pull money out of the stock market and to park it in real estate instead. Many have chosen opportunity zone funds, leading to a surge in fundraising.

According to Bisnow, a host of opportunity zone deals that had been in the works before the national crisis, have closed on construction financing and broken ground over the last month. A large portion of the opportunity zone projects is apartment buildings with relatively affordable rents in emerging areas, a type of development where investors and lenders remain bullish despite the economic crisis.

Additionally, land pricing has dropped, and construction costs are down, further benefiting opportunity zone investors.

Today some traditional capital sources are pulling out of deals, creating more avenues for opportunity zone investors to step in.

Some even see investors putting money into opportunity zone funds as a way to hedge against the uncertain economic future. There is near-universal agreement that in the future, taxes will go up due to increased government spending, but with opportunity zones, there’s a hedge against future tax increases. If the tenyear hold is fulfilled, profits are not taxes.

Below, Matthews™ dives into the statute, the final regulations, and the COVID-19 lifeline.

Updated Opportunity Zone Guidance Citing the pandemic as the reason, the federal government has extended the deadline for opportunity zone investors and developers to deploy capital and begin construction on projects. The rules previously required that twice a year, the government check to ensure that opportunity zone funds and investors had steered 90 percent of their money into designated projects as mandated. Now, the Treasury Department and IRS have released modifications allowing those funds and investors to hold their money until June 30th, 2021.

Previously, investors and developers were given 30 months to make improvements to their Opportunity Zone property to qualify for the tax benefits. Now, they have an extra nine months, totaling 39 months, not including the months April through December 2020 as a pandemic grace period. Previously, investors would have had to invest capital gains within 180 days to be eligible for the tax benefits.

These modifications and extensions come when property values have decreased, and large institutional investors gear up to pour money into distressed areas.

MATTHEWS™ | 79

A Review of the Final Regulations The final regulations released in December 2019 largely conclude the following: (Source: Steptoe and Forbes) 1. “Gross” 1231 gains are gains eligible for investment upon the recognition of such gains unreduced by section 1231 losses, which, if held for five years, is outside the five-year recapture window. Furthermore, eligible section 1231 gains are not limited to the net section 1231 gains for a taxable year. As a result, an investor doesn’t need to wait until the end of a taxable year to determine whether any eligible section 1231 gains are eligible gains.

2. Resolves two issues on eligible gain. (1) If a taxpayer sells an asset on the installment method that gives rise to eligible gain, the taxpayer may choose to defer each gain recognized over the period until payments are received. (2) A taxpayer cannot sell an asset to a QOF and then reinvest those proceeds into the QOF and have that transaction give rise to the eligible gain.

3. Clarification on the amount of an investor’s basis in its interest in a QOF. A QOF can be structured like most funds that invest in multiple businesses or properties, and previously it required to be sold all at once.

4. Additional flexibility for a partner or shareholder receiving an allocation of eligible gain from a flowthrough entity. The partner or shareholder may elect to start the 180 days on the due date of the passthrough entity’s tax return, not including extensions.

5. Gains can only be deferred, not cash.

6. A taxpayer can choose to postpone gain related to a QOF’s partial disposition by reinvesting those proceeds into another QOF within 180 days.

7. Excludes absolute NNN leases.

8. Clarification that transfers by gift of in a divorce are inclusion events, and transfers upon death are not inclusion events (related rules are adopted for beneficiaries and estates).

9. Clarification that if the entirety of a QOF interest is sold, all gains are non-taxable, but if the individual assets are sold (i.e., inventory, equipment), there is a taxable event.

10.

Expansion of the real property straddles rule to the 70% use test.

11. Reduction of the number of years of vacancy required for the property to qualify as original use, and clarification of the original use test. If a QOF purchases property that has sat vacant for one year on the date, the area was designated as a QOZ and remained vacant until the QOF places it into service, the property will satisfy the original use test and need not be substantially improved.

12. Aggregation of the basis of assets for the substantial improvement requirement, meaning additional buildings and development, can be counted as an added value to the lot itself and are qualifying QOF property. Further, contiguous opportunity zones not described in a single grant deed can be aggregated if used in the same business trade, and the investment improves the functionality of the assets.

13. Clarification that the working capital safe harbor can apply up to 62 months and covered tangible property qualified as QOZ business property.

14. Provides examples of activities that are and are not subject to the anti-abuse rule.

15. Rules providing for including QOFs in a consolidated group.

16. Allows for a de minimis rule whereby up to 5 percent of “sin” business will not invalidate all the activity of a QOZB. This includes any private or commercial golf courses, country club, massage parlor, hot tub facility, suntan facility, racetrack, other facilities for gambling, or any store with the principal business of selling alcoholic beverages.

17. Addresses what happens if an investor pulls out before the ten years. If an investor sells some or all of the investment in the QOF without holding the investment for at least ten years, there is no step-up in basis. Any gain on the sale of the investment is subject to federal income tax.

18. New rules regarding the treatment of investments into a QOF by non-U.S. investors. The new regulations clarify that deferral of a gain generally is available only for capital gain that would otherwise be sub80 |ject SPRING/ 2020 tax but for the making of a valid deferral election. As a result, in order to make to U.S.SUMMER federal income a qualified investment, a non-U.S. investor must have an eligible gain that ordinarily would be subject to

There are still some clarifications that need to be made. Particularly to the 90% test, a measurement that states a QOF must hold at least 90% of its assets in QOZP, determined by the average of the percentage of QOZP held in the fund, as measured on: • The last day of the first six-month period of the tax year of the QOF, and • The last day of the tax year of the fund If a QOF fails to meet the 90% test for any year, the QOF must pay the penalty for each month, failing to meet the requirement. The proposed regulations do not provide examples of reasons for failing to satisfy the 90% test that would satisfy the reasonable-clause exception.

To expand, this means that a QOF that continuously receives contributions of cash from investors need not worry that a significant contribution shortly before a six-month testing date will jeopardize the QOFs compliance with the 90% test. But, at what point does an investor fail the 90% test so frequently and repeatedly that the entire deal is blow up and all the tax benefits to the investors are invalidated?

Maximizing the Benefits of Qualified Opportunity Zones in 2020 The designated Opportunity Zones according to Smart Growth Americas • Account for 10% of America’s land mass.

• Are home to 30 million Americans. 60% of whom are demographic minorities.

• Have a 30% poverty rate and house residents earning on average, 59% of AMI [Area Median Income).

• Employ 73% of residents in commercialjobs and 27 in industrial ones.

Additionally • Only 8.5% of already designated Opportunity Zanes have at least one transit station, 45% are located in rural census tracts, 33% in urban and 22% in suburban, • On average, residents spend 53% of their income on housing and transportation in these zone Although many critics have said that the program only benefits wealthy investors, that it is plagued with corruption allegations, and could accelerate gentrification and displacement in neighborhoods, the program provides unlimited tax benefits which can be applied to a broader base of investments.

MATTHEWS™ | 81

Given the long-term nature of the investments, investors must hold onto the asset for ten years to realize the program’s full benefits, investor confidence in the projects will be able to make it through the recovery and realize value appreciation before it comes time to sell. Investors must also keep in mind that the majority of the benefit stems from the nontaxable gain realized after the ten-year hold.

However, considering that they are investing in a long-term vision of the community to revitalize and rejuvenate under-served areas, the risks are also abundant.

Affordable housing is the asset class that many believe will benefit the most from the opportunity zone legislation. Opportunity zones are focused on underserved markets, and investors find success working in underserved markets. Additionally, affordable housing has a strong and growing demand in today’s market, making it an even better candidate for opportunity zones. With any investment, an investor considers the market fundamentals, including the strength of the investment market, and the proximity of transit hubs and jobs.

Today some traditional capital sources are pulling out of deals, creating more avenues for opportunity zone investors to step in.

Some even see investors putting money into opportunity zone funds as a way to hedge against the uncertain economic future. There is near-universal agreement that at some point in the future, taxes are going to go up due to all the government spending, and with opportunity zones, there’s a hedge against that. If the ten-year hold is fulfilled, profits are not taxes.

Opportunity zones have quickly become one of the most popular investment models in commercial real estate. While capital has flooded into opportunity zone funds, development starts have been slow. Since the final regulations were released, we see projects beginning to break ground. The final regulations provided answers to a lot of pending questions, which will aid in providing confidence when structuring opportunity zones this year. Given the current market conditions, we expect 2020 and beyond to see more activity in opportunity zones. For more information on opportunity zones, please reach out to a Matthews™ specialist.

82 | SPRING/ SUMMER 2020

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MATTHEWS™ | 84

W W W. M AT T H E W S . C O M

CO$T

SEGREGATION H o w to I m p r ov e C a s h F l ow

BY CHAD KURZ

WHAT IS COST SEGREGATION?

Cost segregation, or 179 Deduction, is a strategic planning tool that can assess an entity’s real property assets and identifies a portion of those costs that can be treated as personal property. By identifying personal property to be segregated from the building, the studies can reassign costs that would depreciate over a 39-year period to asset groups that depreciate more quickly or perhaps are even expensed immediately. To improve cash flow, an investor essentially accelerates deprecation of any recently purchased or renovated commercial, industrial, or rental real estate investments by engaging in a cost segregation study. This study can be performed for any asset on the balance sheet as of December 31st, 2019, and significantly reduce tax payment today. This money can also be applied to assist investors with the current COVID-19 environment.

85 | SPRING/ SUMMER 2020

HOW WAS COST SEGREGATION INTRODUCED?

they could now depreciate these assets over a shorter, 15-year period. The bonus depreciation

Renovations got the short end of the stick when it came to the verbiage in the Tax Cuts and Jobs Act as it did not make it into the tax bill, and qualified improvement property took a major hit. Not only did it never become eligible for bonus depreciation, but it also reversed to 39-year property. While investors hope for technical correction, qualified improvement property is currently no better off than real property though renovators can still benefit from a cost segregation study. This study should identify which assets are not qualified improvement property so that they can depreciate those assets over a three-, five-, or seven-year period and qualify for bonus depreciation.

COMMERCIAL PROPERTY BOUGHT OR BUILT

Increase cash flow

Increase current tax deductions Uncover missed deductions Accelerate depreciation

vi Sa Ta x

COST SEGREGATION IN A NUTSHELL

4

2

Tax issue = Useful Life (when needing replacement)

Long-Life • Land • Building Short-Life • Land improvements • Building - Non Structural Trained engineers evaluate useful lives/replacement times per IRSrecommended Cost Segregation study te ca lo ts al os Re C

Reduce tax liability

Accelerated Depreciation • Shortlife assets depreciate over 5/7/15 years • Long-life assets over 27.5 (residential) or 39 years

1

Tax-Paying Business (Need to pay taxes to get tax savings) d xe t Fi e = Ass

THE BENEFITS OF COST SEGREGATION

ng

s

allows individuals and businesses to immediately deduct a certain percentage of their asset costs the first year they are placed in service. This makes used property eligible for bonus treatment for the first time and increased the bonus percentage to 100 percent through the tax year 2022. Prior to this law change, only new property qualified, and bonus depreciation was expected to be only 50 percent in 2019.

”

reclassification into shorter life property.

y

assets. This was great news for renovators as

cost segregation studies on “Typically, A&D facilities can result in 25 TO 50%

St ud

In 2015, before The Tax Cuts and Job Act, the Protecting Americans from Tax Hikes (PATH) was passed. This law removed three property classifications — qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property. When the Tax Cuts and Jobs Act was introduced, it added qualified improvement property, which replaced all the three property classifications above and included the same types of 15-year assets, but also included certain nonstructural improvement assets. Once this law passed, it made it more favorable with “bonus depreciation” and for personal property to be immediately expensed within the first year. This included building improvements like plumbing, ventilation systems, and alarm systems, which were treated as 15-year

3

SOUR CE: PEAK PR OFITS ADVISOR S

Defer income tax

MATTHEWS™ | 86

COST SEGREGATION EXAMPLE By way of example, a taxpayer acquired a building worth $10 million.

After performing a cost segregation study, they can reclassify TEN PERCENT of those costs as personal property.

By assigning these assets a shorter depreciable life, they can apply a bonus depreciation and write off

$1 million of that $10 million purchase price in year one.

A taxpayer with a 25 percent marginal tax rate would save $250,000 in taxes, or 2.5 percent, that first year.

%

$10

10

MILLION

$1 million

PERCENT

$250,000

OF THAT $10 MILLION

IN TAXES, OR 2.5 PERCENT

A BONUS DEPRECIATION SUCCESS STORY SOUR CE: MAZAR S

39-Year NonResidential Rental GDS

5-Year

6.00%

Cost Basis

$32,000,000

15-Year Land Improvements

82.00%

15-Year Land Improvement

10%

$3,200,000

5-Year

$1,920,000

Total

$6,124,998

39-Year Non-Residential

100.00%

$26,240,000

Estimated Depreciation No Costs Segregation Study 7-Year

$445,120

Estimated 2018 Depreciation Expense with Study

Additional Depreciation 1 st Year From Study

2.00%

7-Year

$640,000

87 | SPRING/ SUMMER 2020

Total

$32,000,000

$5,124,544

THE STEPS TO IMPLEMENTING COST SEGREGATION Whether investors chose to buy or hold properties, perform renovations or new construction, owners and developers who retain ownership can benefit from immediate tax savings, sometimes amounting to millions of dollars. Here are the steps to implementing cost segregation into an investment.

A COST SEGREGATION STUDY What is it?

An engineering-based tax analysis that allows real estate owners to accelerate the depreciation of property assets, thereby reducing their federally taxable income. It can also be used for financial accounting, insurance, and property tax purposes.

When to do a cost segregation study?

At the point of purchase or during the early stages of construction.

What is involved in a cost segregation analysis?

For income tax depreciation purposes, there are two major types of assets — sec 1250 (real property) and sec 1245 (personal property). By taking advantage of certain rules in the tax law, property may be further segregated within these two sections by identifying five-year or seven-year personal property, 15-year

land improvements and 27.5-year residential, and 39year non-residential real property.

For every $100,000 of cost or value moved from 39-year to 7-year depreciation, the first year after-tax net present-value benefit is about $17,000 for 2017 and nearly $24,000 for 2018. Since there are quite a few ways to reclassify building components into personal property, performing a cost segregation study is essential. During the planning phase of a construction project, engineers will review the preliminary drawings and make suggestions to improve tax position.

Building components have a recovery period of 39-years, while personal property, depending on its use, has a recovery period of either five or seven years. This means that being able to classify water lines, waste lines, and process electrical power as personal property rather than building components will decrease their cost recovery period and accelerate depreciation — saving the investor money.

AVERAGE RESULTS BY PROPERTY TYPE PROPERTY TYPE

PERCENT ACCELERATED

Apartment (Mid/High Rise) Apartment (Garden Style) Auto Dealership Bank Convenience Store Grocery Store Golf Course Health Care Facility Hotel Industrial Facility Manufacturing Facility Nursing Homes Office Building Pharmacy Restaurant Shopping Center Tenant Space Warehouse 0%

10%

20%

30%

40%

50%

60%

70%

SOUR CE: EISNER AMPER

MATTHEWS™ | 88

THE PROPERTY SURVEY Engineers and architects will survey the property and its application to the allocation of assets. This experienced individual will review appropriate documentation and conduct interviews with relevant parties. These can range from invoices, appraisals, drawings, and blueprints.

ITEMS STRUCTURAL IN NATURE:

Specialty Lighting

Supplemental HVAC

Kitchen Appliances

Wiring for Computer Equipment

Chemical Sprinkler System

Receptacles

Supplemental Plumbing

COST SEGREGATION SURVEY IS EXECUTED AND FINAL REPORT IS COMPLETED During this time, the engineer will complete all measurements, photographs for IRS verification, and substantiation of asset values. After the site survey, reallocation of assets is applied, and additional cost-saving benefits are uncovered. This is where the taxpayer will see the reorganization of assets into lists of groups and the reconciliation of total allocated costs to actual costs.

As a result of the new Coronavirus Aid, Relief, and Economic Security (CARES) Act, qualified improvement property (QIP) was retroactively changed to 15-year property dating back to December 31st, 2017. Many property owners don’t take advantage of these provisions and end up paying federal and state income taxes sooner than necessary. During these uncertain times caused by the COVID-19 pandemic, maintaining operations and staffing is top-of-mind. Cost segregation is an excellent tax tool that can be used to generate cash flow.

FOR MORE INFORMATION ON COST SEGREGATION, PLEASE CONTACT A MATTHEWS™ SPECIALIZED AGENT. Chad Kurz chad.kurz@matthews.com (214) 692-2927

This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

89 | SPRING/ SUMMER 2020

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A P O S T P A N D E M I C R E A L I T Y FACTORS SHAPING THE FUTURE OF SHOPPING CENTERS

The media has long echoed the retail apocalypse rhetoric, yet businesses remained unaffected – until now. Before the pandemic, we were beginning to see the role e-commerce played, as demonstrated by the heightened activity in the shopping center space. While some retailers took the biggest hit, primarily apparel and department stores, there is still positive growth and activity for shopping centers as they learn to adjust to the everchanging consumer sentiment, the rapid advance of technology, and now, the novel coronavirus. In this article, Matthews™ will discuss the performance of the shopping center market leading up to, during, and after the pandemic.

E-COMMERC THE TRUTH OF THE R E T A I L A P O C A LY P S E

Brands that were unable to adapt to evolving consumer preferences witnessed the effects of e-commerce, with brick-and-mortar retail stores playing the most prominent victim. Department stores, the anchors and leading drivers of foot traffic, are leaving behind malls and centers after filing for bankruptcy. In their place, gyms, movie theaters, grocery stores, office spaces, educational centers, and sometimes, even sports venues have moved in.

PROPORTION OF PURCHASES MADE ONLINE

% OF PURCHASES MADE ONLINE WITHIN A WEEK SOURCE: DISQO

19%

22%

76% to 100% 51% to 75%

14%

28% 16%

26% to 50% 1% to 25% 0%

Now that consumers and retailers alike are faced with COVID-19, struggling shopping center tenants are closing, and some permanently. When travel restrictions were enacted across the nation, customers were met with uncertainty, further bleeding the struggling retailers dry. However, this will weed out the weaker competition and provide more available space for expanding businesses. So far, 3,000 stores have confirmed closures, and Coresight Research estimates a total of 15,000 retail store closures by the end of 2020, following the record 9,300 shuttered stores in 2019.

50%

With the pandemic curtailing consumer spending by 50.5 percent, according to the U.S. Department of Commerce,

THE DRASTIC CHANGES TO THE SHOPPING CENTER INDUSTRY ARE ACCELERATING.

SOURCE: COWEN AND COMPANY RESEARCH

According to Moody’s Analytics, retail rents are projected to decrease by 11 percent in 2020. So far, 75 percent of shops around the U.S. have announced temporary closures, and 1.3 million retail employees have been furloughed in response to the shutdown of non-essential businesses by state mandates. Although the drastic decrease in spending is intimidating, this has pushed stores to accelerate the adoption of technology and update operations and systems to catch up with times, resulting in the surviving retailers coming out of the pandemic stronger than ever.

Businesses that are adapting and utilizing e-commerce are finding their place in the current market. Consumer sentiment is shifting, and the retail landscape is becoming more fragmented, so retailers have deviated from appealing to the masses; instead, they are focusing on niche markets. Gen Z is a new demographic that retailers will learn to market to, as they are more digitally native and find comfort in shopping through their phones. With social distancing policies enforced, in-store shopping has dramatically dropped as concerned customers shop online to acquire their products.

MONTHLY SHOPPING ACTIVITY, GLOBAL

YEAR-OVER-YEAR PERCENT GROWTH | 2020 VS. 2019 SOURCE: BAZAARVOICE NETWORK DATA 100% 80% 60% 40% 20% 0%

January

February Page Views

March

April

May

Order Count

Companies promoting wellness, which started as a trend before the pandemic, now dominates almost all of retail. Consumers prefer buying brands that support and enact eco-friendliness and mental health. This is especially true for companies who were quick to react to COVID-19 by prioritizing shopper’s health, donating to healthcare facilities and professionals, and offering sanitary products, like face masks and hand sanitizer.

MATTHEWS™ | 92

E-COMMERCE REVENUE & SPENDING

Revenue

Week-Over-Week % 180%

$18

160%

$16

140%

$14

120%

$12

100%

$10

80%

$8

60%

$6

40%

Some experts argue that just because e-commerce is growing physically faster than retail stores and store closures occur, it does not represent an apocalypse.

In fact, e-commerce only accounted for 16 percent of the total retail sales in 2019, according to Digital Commerce 360. And, prior to the outbreak, Amazon was rolling out brick-and-mortar stores to solidify their brand and promote their assortment of products.

WEBROOMING

A product is researched online but purchased in-store (more common)

SHOWROOMING

A product is researched in-store then bought online.

Furthermore, 90 percent of retail sales in the U.S. occurred in-store, as reported by A.T. Kearney, a management consulting firm. Now, U.S. retailers report a 68 percent year-over-year increase in e-commerce sales as of April, surpassing January’s 49 percent growth. Shopping centers are becoming true participants in e-commerce through a seamless shopping experience, both on and offline.

SOURCE: RCA

Vol ($B)

Quarterly Volume #Props

YOY Chg -65%

$4.6

-73%

652

Centers

$1.7

-78%

178

Shops

$2.9

-68%

474

93 | SPRING/ SUMMER 2020

07/11

07/07

07/03

06/25

06/29

06/17

06/21

06/13

06/09

06/01

06/05

05/28

05/24

05/20

05/12

05/08

05/16

SOURCE: COSTAR Power Center

Neighborhood Center General Retail Malls Strip Center 0%

5% 10% 15% 20% 25% 30% 35% 40% Shopping Centers by Share of Essential Tenants

45%

THE SHOPPING CENTER PERFORMANCE STRIP CENTER

The most popular concept, strip centers, consists of a row of stores or service establishments with onsite parking in front. Oftentimes, the layouts allow for storefronts and signage to be seen from major streets.

Shopping centers share prices rose by 8.6 percent over the last year, as cited by FactSet. Strip centers entail the least amount of essential tenants, and in light of COVID-19, we may see strip centers restructure in the coming years. A healthy tenant mix, which includes routine necessities, provides consumers the incentive to return.

SHOP

YOY Chg

Retail Total

ESSENTIAL RETAIL COMPOSITION

Average Square Feet: 30,000

SOURCE: ICSC’S ENVISION 2020

RETAIL TRANSACTION VOLUME

05/04

04/26

04/30

04/22

04/14

04/08

04/10

04/06

04/02

03/25

03/29

03/17

03/21

-20%

03/13

0%

$0

03/09

20%

03/01

$4 $2

Week-Over-Week % Change vs Baseline

$20

03/05

Average Revenue (In Thousands)

SOURCE: COMMON THREAD

-73%

-60%

CONCERN FOR SMALL TO MID-SIZED BUSINESSES OVER TIME SOURCE: DISQO Not at all concered

9%

9%

Slightly concerned

9%

Moderately concerned

10%

9%

Extremely concerned

WEEKLY ONLINE GROCERY SHOPPING SOURCE: DISQO 30%

20%

18% 19%

22% 23% 23% 23%

24%

21% 20%

23%

20% 20%

11% 10%

23%

34%

22%

35%

24%

36%

26%

36%

21%

41%

34%

33%

31%

28%

29%

Mar 30

Apr 13

Apr 27

May 11

May 25

24%

0%

Mar Mar Apr Apr Apr Apr May May May May Jun Jun 23 30 06 13 20 27 04 11 18 25 01 08

COMMUNITY CENTER 40%

26%

June 08

NEIGHBORHOOD CENTER

Average Square Feet: 30,000 – 125,000 Neighborhood centers have grocery stores or drugstores as anchor tenants and appeal more to convenience and day-to-day shopping needs. ICSC’s SCORE publication noted that supermarkets are popular anchors to neighborhood shopping centers in the U.S. by nearly 50 percent, and drugstores anchor neighborhood centers by about 33 percent.

Average Square Feet: 125,000 – 400,000 Similar to neighborhood centers, community centers offer drugstore and supermarket shopping but are anchored by discount department stores, like Kmart or Target. Moody’s Analytics cited that community shopping centers are seeing less net absorption and new completions as shoppers prefer new over old in any market. However, vacated space is quickly filled by new tenants, creating a more diverse tenant mix.

According to Foursquare data, discount retailers have maintained relatively stable traffic during the pandemic, and are on the rise in secondary and tertiary markets. During market downturns, discount department stores perform well as they transition to become a customer favorite. Big-box locations and grocery stores will likely fare better than strip centers as shoppers rely on their local grocer or supermarket for everyday household items.

YEAR-OVER-YEAR VISITS TO SUPERMARKETS

PPING Supermarkets are investing billions in adapting to evolving shopping habits, with new features like curbside pick-up and delivery, which have accelerated since the outbreak. Additionally, the pricing competition in the grocer space is fiercer than ever among powerhouses such as Costco, Walmart, and Amazon’s Whole Foods. The minuscule profit margins in the grocery business have supermarkets referring to consolidation to avoid bankruptcy. Mid-March saw surges in traffic as social distancing policies were mandated by state officials and consumers stockedup on essentials. By April 12th, grocery store visits returned to normalcy.

SOURCE: PLACER.AI Target

Walmart 3.9% 3.1%

January

11.9% 9.9%

February March

-11.8% -3.9%

April

-32.2% -19.7%

May

-1.7% -7.3%

-40.0%

-20.0%

0.0%

20.0%

MATTHEWS™ | 94

POWER CENTER

Average Square Feet: 250,000 – 600,000 A power center is an outdoor shopping center with multiple big-box retailers, while small retailers, restaurants, and other types of businesses are located in out-parcel strips. Situated in the heart of suburban activity, these centers draw a consistent consumer base. As these rely heavily on national chain stores as anchors and junior anchors, power centers have started to lose their appeal to investors. These tenants include Dick’s Sporting Goods, Barnes & Noble, and Petco, all of which struggle with the threat of e-commerce.

Power centers have experienced a decline in transaction volume in the last few years, yet institutional capital is still chasing after these properties as they are reliable retail assets. Investors find the value in their high visibility locations and are willing to pay the price associated with well-positioned assets. Visits to Walmart and Target see five percent less traffic during the pandemic, primarily in urban areas. However, shoppers aged 45-64 have already regained confidence as their visits are back to preCOVID-19 levels.

REBOUND IN SPENDING ON SOFT GOODS SOURCE: DISQO 35%

Purchased Apparel

Purchased Health & Beauty

30%

25%

20%

SHOPPING MALLS

THE

Average Square Feet: 400,000 – 1,000,000+

Divided into two categories, regional and superregional, shopping malls served as the symbol for suburban consumerism. A typical mall structure consists of anchor tenants, usually department stores, and specialty retailers. Located on a large parcel of land near major intersections, malls draw a large population base.

The number of U.S. malls

GREW MORE THAN TWICE AS FAST as the population from 1970 to 2015, prompting the inevitable fall by oversaturating the market.

SOURCE: COWEN AND COMPANY RESEARCH

Regional malls are experiencing the biggest hit from COVID-19 as they rely on their anchor tenants for foot traffic, with many going out of business, like Sears and Macy’s. Mall-based shops that relied on anchors, including J.C. Penney and Neiman Marcus, are soon to follow after the shelter-in-place mandates were ordered. Big-name brands such as J. Crew, J. Hilburn, and Gold’s Gym have already filed for Chapter 11 bankruptcy protection as sales plummet from mall closures following the shelter-in-place orders. Mall values were slashed in half by Wall Street in March with the introduction of COVID-19. The actions taken today by mall operators and retailers will define the future of shopping.

IMPROVED INVESTOR OUTLOOK ON SHOPPING CENTERS

15%

SOURCE: MATTHEWS™ INVESTOR OUTLOOK SURVEY

10%

APRIL 64.40% MAY 58.78%

5%

JUNE 48.44% 0%

Mar Mar Apr Apr Apr Apr May May May May Jun Jun 23 30 06 13 20 27 04 11 18 25 01 08

95 | SPRING/ SUMMER 2020

% of investors who think shopping centers will be affected by COVID-19

E FUTURE THE FUTURE OF SHOPPING CENTERS

Retail real estate is refining its purpose as it shifts toward convenience and accessibility to consumers.

Shopping behavior is being shaped by the changing demographics, the integration of e-commerce in offering a flexible omnichannel experience, and COVID-19. Owners focus on reimagining their vacant spaces, optimizing opportunities for their property by expanding their offerings, and contributing to the customer experience. In ICSC’s Industry Insights report, evidence is provided that there have been adjustments made with the growing demand for services. Service-based stores are evolving into an essential element of shopping, representing 53 percent of establishments in the U.S., according to ICSC and U.S. Census Bureau data.

?

Will these vacant spaces fill as bigbox brands continually announce bankruptcy and national closures?

How will it affect the future of shopping center development?

COVID-19 IMPACT ON SHOPPING CENTERS SOURCE: YELP 100% 50% 0% 5/3

5/17

5/31

6/14

NEW CONSUMER SHOPPING HABITS

ANNUAL RETAIL CAP RATES SOURCE: RCA

All Retail

7.5%

Shops

Centers

7.0% 6.5%

It is universally known that the arrival of the pandemic has caused nearly all shoppers to adopt new behavior.

Even stores are enforcing new practices by shifting focus to safety with new signage and floor markings to promote social distancing and utilizing tech tools to help customers find merchandise.

POST-CORONAVIRUS SHOPPING HABITS PREDICTED BY EXPERTS:

6.0% 5.5%

Forced store closures cause uncertainty with investors, as consumers are spending less, and struggling tenants are filing for bankruptcies. Ten percent of acquisitions in April accounted for valueadd investments. Shops saw an 81 percent decline in volume, totaling $589 million, and shopping centers reached $308 million, an 87 percent decrease compared to the year prior. Both groceryanchored and drug store assets comprised 40 percent of transaction volume in April, indicating that investors are focused on retail catered to shoppers’ essential needs.

2015

75%

2016

2017

2018

2019

2020

A recent sale of a Houston shopping center, consisting of 75% of essential business, shows the investor appetite & hints at new buying requirements.

SOURCE: COWEN AND COMPANY RESEARCH

Contactless & Distant Shopping

Supporting Local Business

Decrease in NonEssential Spending

Increasing Use of E-commerce

Brand Loyalty

Conscious Consumers

MATTHEWS™ | 96

SHOPPING ACTIVITY CHANGE

Store

Online

Total Retail

SOURCE: NPD GROUP 140 130 120 110 100 90 80 70

Pre-Crisis Mar Baseline 7

Mar 14

Mar 21

Mar 28

Apr 4

Apr 11

Apr 18

Apr 25

May 2

May 9

May 16

May 23

May 30

June 6

June 13

June 20

ADAPTIVE REUSE

HEALTH & CLINIC OFFERINGS

The typical retail mall’s proximity to highways and residential areas position them as prime candidates for redevelopment and adaptive reuse. Often, this results in benefiting the community, socially and economically, as demonstrated in the case studies provided in NAIOP’s Repurposing report. Although neighborhoods initially have concerns, developers can closely collaborate with local officials and community members to address their needs in the project.

Another trend taking over brick-and-mortar retail is the adaptation of healthcare and medical services within stores and shopping centers. Going beyond the familiar optical and pharmaceutical services, customers can stop by for check-ups and vaccinations, among other services. Walgreens and CVS are the front runners of these trends, opening retail clinics operated by nurse practitioners and primary care centers with physicians.

ENTERTAINMENT The once Highland Mall in Austin, TX was home to 1.2 million square feet of retail but INEVITABLY CLOSED IN 2015 AFTER YEARS OF CONTINUAL DECLINE. In 2010, Austin Community College SLOWLY BEGAN ACQUIRING PIECES OF THE MALL and its surrounding area with plans to add to its education center.

IT IS NOW A MIXED-USE, TRANSIT-ORIENTED COMMUNITY, offering both office and residential space.

Shopping center landlords seeking the appeal of the new time-starved, tech-savvy demographic are open to adding experiential retail, including hotels and adult gaming, along with other non-traditional tenants, purposely designed for recreation and entertainment. These same centers evolve from simple retail properties into shopping, dining, and entertainment centers that fully complement the surrounding communities. With the introduction of COVID-19, experiential retail has faced its own set of difficulties with social distancing policies preventing large gatherings and shoppers’ growing concern for spreading and catching the virus.

$

American Dream, a three million square foot mall in New Jersey, opened in March 2020 at 90% leased, 45% of tenants consist of retail and 55% entertainment options.

THE DEVELOPER HAS MISSED RENT PAYMENTS IN APRIL AND MAY. SOURCE: AXIOS

97 | SPRING/ SUMMER 2020

FINANCE EVENT SPACES & RENTAL PROMOTIONS Savvy landlords can utilize their large shopping center spaces to contribute to cultural life by renting their public spaces with sponsor arrangements and limited use of the facility. This allows them to offset event-related costs through ticket sales or admission charges. To create a partnership with e-commerce players, shopping centers can offer promotions.

Companies that were on the brink of bankruptcy pre-COVID-19 are taking the biggest hit during the pandemic, while stores in high-income areas with low debt will likely survive and bounceback quickly. Mall operators are willing to work with tenants facing financial challenges to find a solution through payment plans. Shopping centers aren’t experiencing an apocalypse, rather a renaissance, where technological and societal changes are inspiring the direction of the industry.

FOR INFORMATION ON THE SHOPPING CENTER INDUSTRY’S STATE OF THE MARKET, CONTACT A MATTHEWS™ SPECIALIZED AGENT TODAY.

W W W. M AT T H E W S . C O M

™

The

Road Recovery to

A Recipe for Success

By Gary Chou

As COVID-19 quickly spread uncertainty among customers, a new era of restaurants was introduced. Restaurant operators faced sliding sales, shifts in operations, layoffs, closures, and more over the past few months. Quick to pivot, restaurants turned to takeout, delivery, and drive-thru order fulfillments. While the future of dining is still to be determined, one thing is certain – the behaviors both restaurants and customers adopt today will redefine the industry. In this report, Matthews™ will dive into the restaurant space’s reaction to the pandemic, new trends in the industry, and the future of dining.

Subtype Performance Consumers have a never-ending list of restaurant options, including quick-service, fast casual, and casual dining restaurants. After social distancing mandates were enacted nationwide, many restaurants, mostly casual dining, quickly shuttered without a response plan in place. According to Franchise Times, dine-in restaurants that pivoted to off-premise orders saw triple the number of sales as consumers migrated towards to-go orders. Quick-service concepts appear to be the darling of restaurants as they have already perfected off-premise practices. At the same time, fast casual brands have shifted practices exclusively to takeout and third-party delivery. Now that states are reopening, restaurants are welcoming back customers at a limited capacity.

Growth in Online Meal Delivery Services by Restaurant Type

Chains

Non-chains

Source: New York Times, M Science

$246.7 billion

in food and beverage sales was generated in 2019 by the counter-service industry.

Source: National Restaurant Association

During March and April, full-service restaurants saw major declines in transactions but saw a 106 percent increase in digital orders, which accounted for 20 percent of restaurant occasions in April. But as businesses opened back up in May and June, fast casual and full-service restaurants began to see improvements. Below is the latest data for June: U.S. restaurant chain transactions for the week of June 14th were down 12% YOY, a one-point decrease from the previous week.

Quick-service restaurants saw a 12% decline in transactions YOY for the week of June 14th, a 13% decline from the week before.

150% 100% 50% 0% February

March

National COVID-19 Impact on Restaurant Spending Source: Womply 0% to 25% -25% to 0% -50% to -25% -75% to -50% -75 to -100%

101 | SPRING/ SUMMER 2020

April

May

Full-service restaurants saw a 26% decline YOY, a 12% increase from the week before.

The NPD Group further shared that the rapid growth of technology used to engage with customers could create a digital divide that sets apart restaurants that successfully implement digital offerings, leaving those without to turn to third-party platforms.

Overall 2020 Restaurant Transactions Source: NPD Group 10%

YOY Change

0% -10% -20% -30% -40% -50%

3/15

3/29

4/12

4/26

5/10

5/24

6/7

6/21

Month/Date

However, tenants that were struggling before the pandemic, unable to keep up with the rapid changes, fell victim to the evolving economy, with 53 percent of U.S. restaurants closing, as indicated by Yelp data. According to the Bureau of Labor Statistics, of the 20.5 million jobs lost in the U.S. for April, restaurant industry jobs accounted for 5.5 million. As of May, over eight million restaurant employees were furloughed or laid off, and the industry lost $50 billion in sales. Yet, 1.5 million jobs in the food and drink industry were added in June, even though states like California and Texas have announced rollbacks on restaurant capacities, as COVID-19 cases begin to spike again.

Year-Over-Year Restaurant Sales Comparison Source: Womply

Max 51%

50%

0% Avg -37%

-50%

Min -85% -100%

Jan 2020

Feb 2020

Mar 2020

Apr 2020

May 2020

Jun 2020

After seeing significant drops in sales volume once suspending dinein services, investors paused on non-essential property categories, including sit-down restaurants seeking rent relief, according to CoStar.

However, Black Box Intelligence revealed that high-frequency spenders still exist and have not reduced their restaurant spend, with 39 percent ordering restaurant food at least five or more times in one week. Experts are monitoring restaurant performance, in-place rents, and sales during reopening stages.

MATTHEWS™ | 102

Dine-In Oriented Business Closures Source: Womply

0%

20%

40%

60%

Buffet

57% 36%

Bar & Grill Steakhouse

35% 33%

Cafe American

30% 28%

Breakfast/Brunch Diner

25%

Japanese

23%

Chinese

22%

Seafood

21%

Sushi

20%

Italian

19%

Indian

16%

Mexican

15%

Thai

12% Min 12%

Limited and quick-service restaurants with drive-thrus have been performing the best during the pandemic.

By optimizing off-premise business, drive-thrus offer convenience, comfort food, contactless transactions, and are in the best position to continue performing well post-coronavirus. Quick-service restaurants without drive-thrus that performed well before the outbreak will likely come back strong, but the same cannot be said for those already struggling.

Pizzerias and chicken-wing places saw activity up by 93 percent and 83 percent, respectively, and searches for dine-out options increased 300 times from March 1st to mid-April.

Source: Yelp

Surge in Delivery/Takeout Customers Source: Zagat

+19% 88% 69% Before COVID-19

103 | SPRING/ SUMMER 2020

During COVID-19

Avg 26%

Max 57%

As the remaining restaurants gradually recover, data shows that their recovery rate is influenced by location, despite the large presence of the country’s national brands. Depending on the restaurant’s location, if it’s in a reopening region, they will likely recover sooner, as demonstrated by Foursquare data. Limited and quickservice restaurants are seeing fewer visits on weekend days than on weekdays on a year-over-year basis. In contrast, full-service restaurants are seeing a lot of customers around dinnertime, according to Franchise Times. The largest uptick in foot traffic has been seen in casual dining restaurants in the South and Midwest, and more specifically, between 2 – 5 PM. Casual dining chains, like Hooters, Applebee’s, and Red Lobster that offer happy hour discounts or afternoon specials, will see faster recovery. Casual dining owners should consider the following when reopening: Promote loyalty and rewards programs that provide an incentive to returning customers.

Focus marketing efforts to retain loyal customers and increase visits.

Casual Dining Recovery Ranking Source: Foursquare

Rank

Brands

Relative Decline

Rate of Recovery

01

Waffle House

02

Hooters

03

Applebee’s

04

Chilli’s Grill & Bar

High

05

Red Lobster

06

Longhorn Steakhouse

Medium

07

Outback Steakhouse

08

Buffalo Wild Wings

09

IHOP

High

10

Denny’s

11

Cracker Barrel

Medium

12

Red Robin Gourmet Burgers

13

Olive Garden

14

T.G.I. Friday’s

15

BJ’s Restaurant and Brewhouse

Relative Decline

Low Rate of Recovery

Low

New Trends Ghost Kitchens

A concept accelerated by the arrival of COVID-19 is ghost kitchens, which started as a trend in 2019.

Ghost kitchens entail the space and equipment for a restaurant kitchen operation, but without the customer interaction, and focuses on takeout services only. Offering low cost and faster time to market, this model appeals to new entrepreneurs and established brands wanting to test new concepts or expansions to new markets, while supporting social distancing. As struggling tenants continue to close permanently, the increased available supply will result in more opportunities for ghost kitchen concepts and less competition for the remaining restaurants. In the future, we could see more hybrid operation models as full-service restaurants seek to partner with ghost kitchens to continue their carry out business, and others could offer their kitchens.

COVID-19 Surcharge

With the temporary closures of meat-processing plants during the peak of COVID-19, the nation experienced a shortage in the supply chain. In response, some restaurants are adding a COVID-19 surcharge to carry out orders. After hearing uproars from customers, restaurants have revealed that seafood and other ingredients have significantly surged in cost. A barbecue restaurant in Missouri cited double ground beef prices, an eight percent increase in chicken and turkey, and a 15 percent increase for pork.

Meat industry experts, analytics, and a meatpacking plant union expect the country’s meat supply chain issues to continue for the duration of the pandemic.

Source: Deslish

MATTHEWS™ | 104

Pantry Kits

When supermarkets were quickly selling out of items, including food, fast casual and casual restaurants converted their unused dining space into a make-shift “groceraunt.” Here, operators leveraged their relationship with vendors and farmers to sell an assortment of ingredients and produce ranging from seasoning mixes to fresh vegetables. Taking it a step further, some are even delivering groceries or offer contactless pickup. Other restaurants are also maximizing the output of their existing facilities by offering “pantry kits,” which entails an assembly of ingredients for meals, and many plan to continue selling these kits after seeing tripled sales.

Heightened Safety Protocols

Operators will continue to follow the County Health Department and CDC guidelines to create and establish a safe and healthy environment while providing customers with a five-star dining experience. In response to customers’ lack of confidence in dining out, restaurants are trying to achieve a safe and sanitary experience, such as using biodegradable materials, serving customers at adjacent sidewalks or parking lots, and using physical barriers between tables. According to Franchise Times, some operators have noticed customers migrating towards deliveryfriendly meals, emphasizing elaborate meals, which could remove or add new menu items.

Diner Behavior March - April 2020 Source: OpenTable

Takeout is up - way up

Up 72%

Compared to pre-COVID for those ordering takeout once a week in the U.S. (59% globally)

And delivery isn’t far behind

Up 62%

Compared to pre-COVID for those ordering takeout once a week in the U.S. (52% globally)

Restaurant Behavior March - April 2020 Source: OpenTable

7%

24%

31%

of U.S. restaurants chose to become delivery-only during COVID-19

of U.S. restaurants are offering only-takeout during COVID-19

of U.S. restaurants are open for both delivery and takeout during COVID-19

(6% globally)

105 | SPRING/ SUMMER 2020

(18% globally)

(20% globally)

Contact-Free Technology

Further, extra-precautious restaurant owners are installing technology to help navigate these unprecedented times. Operators looking to keep customer confidence and cut costs beyond reducing hours and staff should consider the following:

OneDine is an excellent example of the innovative technology that restaurants are utilizing during this time. It offers a contact-free experience where customers can view the menu and pay by tapping their phone to the table. One operator told Franchise Times that they saw customers adopting their new card-free payment system by 50 percent within days of implementation, indicating that customers are willing to adopt new practices.

Reduce Menu Refer to the restaurant’s POS data to determine which food and supplies to reorder and temporarily eliminate less popular menu items.

Consumer’s Future Dining Preferences Source: Technomic

Address Consumer Concerns

9%

3 Feet

50%

6 Feet 9 Feet

15 Feet

Act on Promises

20%

12 Feet

Communicate and implement sanitation procedures to regain customer and employee confidence.

5% 2%

Prefers not dining out

Make sanitation a top priority to help diners feel more confident and safer.

15%

Improve Operations Find new strategies to keep operations efficient, given reduced staff and customer count.

Factors Influencing Immediate Restaurant Visits Source: Technomic

Temperature Checks

Outdoor Seating

77%

Reduced Seating at Indoor Restaurants

5% 18%

67%

Restaurants at 5% Full Capacity No Vaccine 10% Available Yet 0%

11% 84%

46% 25% More Likey

50% Less Likely

Source: Datassential

48%

Order Delivery

78%

Order To-Go or Drive-Thru

Order in Restaurant

11% 44%

Consumer Dining Preferences

64%

22%

75%

100%

Not Sure

Require staff to take their temperature before entering the premises and send home employees with fevers.

Health Questionnaire Ask employees a series of questions related to their health.

Contactless Payment Encourage the use of contactless payment through electronic payments.

Single-Use Menus Utilize temporary menus to reduce the risk of spread.

Employees Use PPE Enforce employees to wear masks and other personal protective equipment to increase customer confidence.

MATTHEWS™ | 106

The Future of Dining In a survey conducted by Datassential, 45 percent of respondents claimed dining at their favorite restaurant will be their most exciting post-lockdown activity.

As states began reopening, restaurants saw high volumes from pent-up demand with excited customers returning to a resemblance of normal life. When Texas officially opened in early May, restaurants saw 70 percent of pre-pandemic sales even though they were restricted to operate at 25 percent. The pandemic has fueled widespread changes in dining and alcohol laws, such as Michigan, along with 30 other states, where legislation was recently passed to allow restaurants and bars to sell alcoholic drinks to-go until 2025. This provides a much-needed lifeline for these venues as they provide an essential revenue boost.

Dining out Frequency Pre- and Post-COVID-19 Source: Zagat 40% 30% 20% 10% 0%

1x/ Week

2x/ Week

3x/ Week

Pre-COVID

4x/ Week

5x/ Week

Post-COVID

As for employee retention, operators are experiencing a plethora of issues. The first being that minimum wage employees are earning less than those receiving unemployment checks and the second being employees with children. Although operators

are seeing growing frustrations, unemployment benefits are to expire at the end of July. With the concern of bringing the virus home, some employees are apprehensive about returning, especially if they lack childcare. On the other hand, some employees are itching to get back to work with the lack of entertainment at home.

In places like Chicago, fast-food employees are protesting in front of food establishments to draw public attention toward unsafe working conditions.

Source: Eater

Restaurants that only offered dine-in seating and sales before the pandemic will continue to feel the effects of the outbreak. However, those that utilized to-go and delivery will continue to see activity beyond COVID-19. For the remainder of 2020, restaurants will need to successfully implement and survive through the various new restrictions placed on dining to appeal to investors, and pivot to business initiatives and strategies that address customer concerns and enhance future benefits.

With the disruption and turmoil in the restaurant space, experts are seeing more challenges in financing business and properties. As lenders begin to reengage in lending, underwriting standards will become more stringent, and many deals may require more equity than in the past. Conversely, this disruption has allowed operators to negotiate better deals to reduce operating costs at both existing space and new space.

For more information, contact a Matthews™ specialized agent today.

Gary Chou

gary.chou@matthews.com (310) 919-5827

107 | SPRING/ SUMMER 2020

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Landlord + Tenant Leverage How to Enhance Property Value

By Mi ch ael Pakr avan & Chad Kur z

109 | SPRING/ SUMMER 2020

The COVID-19 pandemic forced tenants and landlords to seek creative solutions that allow both parties to remain viable. Landlords faced pressures from tenants to renegotiate leases and now face potential pandemic escape clause additions, and tenants looked for additional forms of relief. As states begin lifting mandates, retailers are itching to reopen while others are now welcoming back customers under particular capacity guidelines. These capacity levels, however, eliminate retailers from going back to pre-coronavirus businesses, and retailers must adapt to new shopping behaviors. Those who adjust and adapt to this new reality will succeed and shift the industry to a brighter future, ultimately weeding out tenants unable to keep up with changing consumer times.

This article will help landlords and tenants navigate and plan for the next generation of complexities that will be necessary to address in the new retail market.

The Biggest Challenge Since the Great Recession The widespread economic shutdown disrupted relationships between landlords and tenants, with the outcome poised to change the commercial real estate industry. As non-essential businesses closed in most states, unemployment applications soared, and tenants began to see cash flow problems. This unique economic situation has brought tenants and landlords together to discuss viable, legal solutions.

Retail landlords in the U.S. typically collect more than $20 billion per month in rent.

But in April, landlords only collected between 15 to 30%.

The truth of the matter is that many cities do not provide self-help relief to landlords. Some cities have issued a moratorium on evictions, but limit eviction actions for the non-payment of rent based on a tenant’s inability to pay rent caused by COVID-19 or local, state, or federal government responses to the pandemic. In some cases, the local ordinances also restrict a landlord’s ability to pursue no-fault evictions.

However, it appears that landlords do retain eviction rights for other breaches of the lease. Further, some ordinances limit eviction moratorium protections to small and mid-sized businesses. For instance, the City of San Francisco limits protections to businesses with less than $25 million in annual gross receipts. The ordinances do not relieve a tenant, who may otherwise

A pandemic clause does not come standard in most commercial lease agreements, unless the lease explicitly states an epidemic or pandemic as a possible force majeure event. Generally, though, there is no obligation to the landlord to provide any rent concession. With this precedent lacking, landlords and tenants have found themselves in unchartered waters. They have been working together to reach an agreement, thereby avoiding legalities where neither party has taken any adverse action to put themselves in that position.

be prohibited from being evicted, of its obligation to pay rent.

If a tenant does not pay rent, a considerable amount of time may pass before a landlord can collect rent, thus encouraging landlords to look for other, more cost-effective solutions, including some sort of deference or even abatement. In the long run, tenants should pay the rent they can now, not only because it is their obligation and a matter of fiscal discipline, but tenants who do not pay may end up with

By mid-June, 61% of tenants had completed June payment, up 15% compared with May, but down 30% from mid-March.

a massive rent bill. Non-payment of rent also places financial pressure on the landlord who has a mortgage payment, taxes, and employees to pay. Sometimes, the non-payment of rent puts the landlord in jeopardy of mortgage foreclosure.

MATTHEWS™ | 110

How Landlords Can Respond: Rent Reduction - The landlord reduces the tenant’s rent for a portion or all of the term left on the lease. Usually, it is a rent reduction to the base rent, operating expenses, or both.

Rent Deferral - Particularly for hard-hit restaurants and retail properties, rent deferral allows the landlord to defer a portion or all of the tenant’s rent but requires them to repay the rent deferred at a later time, either in a lump sum or by increasing subsequent payments. Often, it is a three-month deferral with the payments either tacked on to the end of the current lease term or amortized over the balance or a portion of the remaining term.

Rent Abatement - The landlord forgives a portion of the rent. This is rarely accruing, and for

the most part, landlords typically want something in return for pure abatement. This could include the tenant agreeing to extend their term in exchange for rent abatement.

Partial Rent Abatement - The landlord forgives part of the rent, say 50%, but usually, this is tied to the responsibility of paying the remaining 50% in a timely manner.

Loan Conversion - A landlord converts the past due rent into a loan payable over time. The tenant would continue to pay rent, but the loan is essentially a promissory note that is cross-defaulted with the lease.

Application of Deposit - If the landlord holds a deposit, this amount is credited against the tenant’s current rent.

Sublease - Allows the tenant to bring in a new tenant to reduce or eliminate rent obligations while replacing revenue for the landlord.

Percentage Lease Clause - The tenant pays a reduced rent, but a percentage of the tenant’s monthly sales volume goes to the landlord to complete the base rent.

Renegotiation of Lease Term - For successful long-term tenants, lease terms can be renegotiated and extended. This structure would give tenants a break over a few months and then normalize over time.

111 | SPRING/ SUMMER 2020

Ultimately, landlords are in the business to lease space. If there are increases in the number of defaults or tenants increasingly going out of business, then the prospects of relating the tenant are diminished.

For landlords, some lenders are offering 90 days of interest-only payments, and franchisors are reducing or eliminating franchise fees. There is a lot of flexibility with regional banks that are offering certain fee waivers and payment deferrals. At the same time, there’s less flexibility from Wall Street commercial mortgage-backed securities (CMBS) funds and large institutional lenders.

The health threat adds up to several hurricanes’ worth of local economic upheaval across the U.S. From a purely economic perspective, it is based on consumer interest in local businesses:

This widespread economic shutdown will bring landlords and tenants to revisit the terms of their lease, restructuring to give landlords a greater sense of certainty of tenure and cash flow in exchange for sustainable rental structures and capital relief for tenants. Landlords should understand that whatever the new consumer norm will look like, it will come after a great deal of reevaluation by tenants. The outcome of challenging conversations with landlords and tenants is poised to change the commercial real estate outlook.

New Orleans experienced the equivalent of 4 Hurricane Isaac’s

The Disrupter & It’s Imprint on Retail

Overnight, businesses overhauled their operational models and workers, and consumers changed lifelong habits. How COVID-19 will impact the world of retail is just beginning to be experienced. As long-term social distancing, occupancy restrictions, and less comfortable shopping environments are introduced, the adoption of e-commerce will hasten. The pandemic has compounded the existing challenges faced by already struggling retailers with the competition from e-commerce, softening asset values, and the business model being challenged.

More than a third of local retailers have seen sales dry up entirely. Data found that 21% of small-business owners could only survive 30 days under these conditions, and 55% had fewer than 90 days.

New York experienced the equivalent of 8 Hurricane Sandy’s Houston experienced the equivalent of 4 Hurricane Harvey’s Miami experienced the equivalent of 4 Hurricane Irma’s

Prior to the pandemic hitting the U.S., plenty of small businesses were already struggling. Many needed cash to sustain operations or didn’t want to take out additional debt. This toll is likely to grow as business owners now see dwindling cash reserves and uncertainty as to when business will return to normal.

As a result, many see more available square footage towards the end of 2020.

Overall Retail Sales Grew 17.7% in May 2020 Source: Yahoo Finance

Clothing Stores Furniture Sporting Goods, Hobbies Electronics Department Stores Restaurants, Bars Gasoline Stations Non-store (Online) Grocery Stores 0%

40%

80%

120%

160%

The situation, however, is sparing a few retailers, from national chains to discounters. How companies are set up financially determine if they will be able to pick back up once daily routines return to normalcy. It has become essential for retailers to consider longer-term strategies that prioritize the needs of consumers in a post-COVID-19 world. The prioritization of consumer value now revolves around safety, accessibility, reliability, and transparency. Of course, consumer confidence will take some time to return, but this will drive the economy back to a healthy place.

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Retail Pivots Value-Offering The pandemic has accelerated the digital revolution, introducing the future store model sooner than initially anticipated. The renewed focus on cooperation, between landlords and tenants, will be paramount to ensure that buildings are safe and accessible to workers, and prioritize consumer confidence.

01

New Grocery Layout

02 Updated Mixed-Use

In 2018, Forbes stated that grocery is one of the leastpenetrated retail sectors for online shopping, but since the introduction of social-distancing, some grocers have technology and systems in place to better offer fresh produce to consumers. As consumers transition to online shopping for groceries, less retail space will be needed for future grocery stores. In 2019, smaller urban grocery stores were on the rise, they are often as small as 25,000 square feet, much smaller than traditional supermarkets So, how will retailers maintain this positive trend and ensure their shoppers feel comfortable inside a store?

In 2019 and early 2020, there was an increase in mixed-use projects as existing retail-only developments converted to include retail, office, and residential. These developments were part of enhanced live-work-play neighborhoods that curate a tenant mix to attract a broad range of customers. They include retailers that were previously not thought of as belonging in malls like grocery stores, movie theaters, and gyms. Landlords would find tenants that would bring more people to their property, but COVID-19 threatens to change the equation.

In 2018, new grocery store openings in the U.S. increased by nearly 30 percent, adding more than 17 million square feet of retail space, according to Winsight Grocery Business. In 2020, it’s possible retail floor space may reduce in exchange for backroom space for storage and staging to accommodate e-commerce. While grocery stores have remained open and fared better than other retail segments, e-commerce grocery sales have accelerated at an unprecedented level. For many customers, it has become more comfortable and safer to purchase online for delivery or contactless pick-up. These gains may return to normalcy, but it is also likely that this new normal will feature a much higher e-commerce penetration rate and continued growth.

During the peak of the pandemic, 48,000 shopping establishments, 30,000 restaurants, & 24,000 spas and other beauty establishments were marked as closed.

Online grocery sales surged 49% in April following nationwide lockdowns in response to the virus outbreak.

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Short-term, where gyms are closed, grocery shopping is handled by delivery services, and restaurants are struggling to stay afloat, operators are disincentivized to go the mixed-use route. In the mid-term, mixed-use properties will serve as a safe space for those who don’t want to stray too far and who strive for a sense of community. Long-term, the mixed-use properties that will fare the best are those heavily weighted towards multifamily, are in strong locations with walkability for residents, and have cultivated a sense of community.

03

Re-Focus on Health and Lifestyle Concepts

Landlords are exploring uses of retail space for health and lifestyle concepts like medical care, health, beauty, and even marijuana dispensaries and breweries.

Certainty during a pandemic, people prioritize health over every aspect of their lives, and that’s true for the role that CRE plays in creating a healthier environment that caters to this new lifestyle. People have realized how much they rely on salons as a comforting source of self-care and community. However, salons won’t be operating at full capacity for quite some time.

Appointments are limited and spread apart, and salons have learned how to harness technology better through virtual consultations and at-home coloring kits. According to the beauty-trend forecaster, Clara Varga, the industry seems on the verge of hitting the reset button in terms of what consumers need to feel “pretty.” The pandemic has accelerated this irreversible health and lifestyle trend.

Further, breweries have increasingly become more popular with the growth of microbreweries. These tenants draw in consumers who favor the lifestyle component and who may shop in other surrounding stores on the same visit. As a result, landlords are finding ways to allow these certain kinds of tenants.

Online sales of hair coloring have more than doubled to $128 million vs. $50 million during the same period in 2019.

Likewise, online nail polish sales have more than doubled to $35 million from $14 million in the same timeframe last year.

04

Restaurants of the Future

The restaurant industry is preparing for a long, uphill battle predicted to last 12 to 18 months before restaurant demand returns. With takeout and delivery services not providing sustainable revenue, industry leaders expect permanent closure of a large number of restaurants. These closures will come from those that are unable to reopen or are unable to turn a profit once business resumes. With this wave of closings,

there will be an increase in the retail vacancy rate and a dynamic shift to favor tenants. However, this will create opportunities for well-positioned restaurants to expand and create less competition.

With human behavior and work culture shifting rapidly, some restaurant locations will be more desirable moving forward. Downtown locations, for example, have traditionally been hot spots for restaurants as there’s an abundant number of office workers nearby looking for a quick lunch or happy hour spot.

However, with more people telecommuting, there is an open question as to whether people will return to the workplace, which will change the calculus around which restaurant locations to open moving forward.

There will most likely be a renewed appreciation for restaurants and increased demand for transparency.

Restaurant Trends Source: Yahoo Finance

Reduced occupancy to accommodate the distance between customers More outdoor seating Adoption of delivery, takeout, or online ordering The rise in ghost restaurants Diversification of offerings More zero-waste kitchens and local sourcing Some businesses were well-suited to meet the needs of customers stuck at home, as they adopted virtual services, delivery, and even shifts to their business: Restaurants with grocery services Instagram live sessions/ virtual workouts Portable cocktail service

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05

Fitness Moves Online

The pandemic locked up gyms and fitness studios and inspired coaches, trainers, and teachers everywhere to take their livelihood online, many for the first time. Clients abruptly altered schedules and budgets and found themselves making adaptations online. Centralized gym-focused digital platforms have boomed, and are likely to settle into something different from what it is expected.

Gyms across the nation have all been affected. Gold’s Gym is restructuring under bankruptcy, 24 Hour Fitness is said to be doing the same, Planet Fitness is softening its growth forecast, and Equinox isn’t paying rent. The future of gyms will be cleaner, quieter, and less crowded in terms of capacity.

COVID-19 might bring the end of gym cancellation policies.

06

Short-Term Lease Tenants

In the past, pop-up shops were retailers like Halloween costume stores and were thought of as undesirable by landlords, according to Forbes. Now, they draw more interest because they are often incubator spaces for launching new businesses or foreign brands venturing into the U.S. market. They also offer something new and different and can help drive traffic. As pop-ups proliferate, landlords have to accommodate the shorter-term leases those stores need. Further, popups will aid in providing short-term rent allowing a landlord time to secure a longer-term tenant.

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The Outcome

Naturally, as the needs of consumers change, leases between landlords and tenants will change. As of late, there have been increased discussions of turnover rents, where all or a portion of the rent is based on the gross income generated by the tenant at the premise. Percentage rent, where a retailer’s rent is based on the percentage of in-store sales, has also increased. These rent structures help align landlords’ and tenants’ interests so that each can proportionately share the peaks and troughs of the broader economy.

The challenge, though, comes with the growth of online retail sales. Stores are often used as a place for consumers to look at products, but the actual purchase is made online, making the attribution of a sale to a particular store more complicated. Also, physical stores have become important for consumers to return or exchange products purchased online. Returns add value to a store but don’t figure into percentage rent deals, except perhaps as a deduction.

Architects will also need to understand and address how to make spaces and places healthier and safer.

The introduction of outside air into a shopping center, multifamily, or retail space will become a greater part of new-builds as fresh, clean air not only helps maintain healthier environments but can also help dilute the human-to-human passage of airborne elements.

The U.S. has almost four to five times the amount of retail square footage compared to Europe, and over the next 10, 15, or 20 years the square footage in the U.S. is going to be similar to Europe.

Landlord & Tenant Actions for Today The changes in consumer shopping behavior continue to create upheaval in the business of retail real estate. As certain kinds of space become less valuable or obsolete, landlords and tenants have to adapt and make arrangements. With that in mind, what can landlords and tenants do today to survive the challenging third quarter, prepare for reopening and emerge stronger for the rest of 2020?

A New Beginning for Retail

Like so much of retail, being flexible is the best strategy and the landlords and tenants who can adapt the fastest will succeed. The lessons learned from COVID-19 are likely to transform the terms of future leases and shift the dynamics of commercial real estate partnerships.

The lasting impact could come from tenants reassessing their space needs and the flexibility of their lease agreements.

Landlords

It’s not uncommon for a significant disrupter to appear every ten years, but how retailers react is going to pave the way for the future.

Maintain safe buildings for tenants and customers: Implement recommended best practices for cleaning, access, use of common areas, social distancing, etc.

Analyze your lease/be aware of current legislation: Evaluate your lease for provisions involving force majeure, health emergency, access, provision of essential services, rules and regulations, ability to charge tenants for COVID-19 related costs, whether or not COVID costs are controllable expenses, cotenancy obligations, etc.

Devise a long term plan to weather the storm: Be prepared for increased audits of 2020 operating expenses & find creative ways to attract new tenants, if necessary.

Discuss lease amendments/modifications with your lender.

Tenants Prepare & update your business plan, reevaluate regularly: Evaluate financials and space needs.

Consider available options for support or relief: Stay updated on legislations in your state, the Paycheck Protection Program, read insurance policy, discuss/request lease modifications with your landlord.

It is already being suggested that the future lease documents won’t leave anything open to interpretation. Lease terms may be very different moving forward - it is expected to see changes in rent, lease durations, and perhaps even the level of security required by a landlord under the lease. Likewise, at least in the immediate future, expect there to be more security over legal drafting to specifically deal with rent abatement, rent deferrals, or the specific exclusions.

The COVID-19 pandemic has accelerated the inevitable digital distribution of e-commerce and has caused a significant consolidation of retailers, fundamentally altering the competitive and partner landscape. For more information on the current tenant and landlord environment, please contact a specialized agent.

Michael Pakravan

michael.pakravan@matthews.com (310) 919-5737

Chad Kurz

chad.kurz@matthews.com (214) 692-2927

Read your lease and evaluate existing options.

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W H AT I S A N

UPREIT? Monetizing Healthcare Real Estate Through a Unique REIT Structure

BY RAHUL CHHA JED & MICHAEL MORENO

N E E D S T O B E U P D AT E D

In a market where the demand for healthcare real estate is at an all-time high, many physician groups are being asked the question: Have you considered monetizing your real estate through a sale leaseback?

With more private and institutional capital flooding into the healthcare space than ever before, the industry has seen a significant increase in value and growth, and even more so, given the low interest-rate climate. An additional question comes to light after physicians are faced with the opportunity to monetize their assets through a sale leaseback: Although your building is worth a significant amount of money in today’s market, why would you pay capital gains taxes? Is there any way to minimize your tax burden without having to go through a 1031 Exchange?

IN THE FOLLOWING ARTICLE, MATTHEWS™ DIVES INTO THE GROWING TAX-DEFERRAL STRATEGIES IN THE HEALTHCARE SPACE. 119 | SPRING/ SUMMER 2020

THE CURRENT HEALTHCARE REAL ESTATE MARKET Medical Office sales topped $11 billion for five years straight, and retention rates trended between 75 and 83 percent for the last 11 years. With nearly 50 million Americans over the age of 65 as of 2016, healthcare services were already in high demand. Now, medical office buildings are faced with challenges due to longterm closures and cancellation or postponement of appointments due to COVID-19.

The medical office space has proven to be recessionresilient, as it is a robust property type poised for a quick recovery. Physicians have pivoted to introduce non-contact methods, including drive-through services and telehealth. Though the closure of medical offices has impacted physician’s bottom lines, this idle period shouldn’t have any long-term damage as visits will eventually return to normal or even exceed routine schedules once events have settled.

SHORT-TERM CHALLENGES Patients canceling or rescheduling appointments Patients foregoing elective surgeries and non-essential surgical or dental procedures Generating little to no revenue due to partial or full closures

For well-located assets, medical office building acquisitions are considered a defensive play and a safe bet in an uncertain environment. This niche market has limited supply and significant demand from investors as there is an ongoing trend to performing medical procedures at outpatient facilities rather than hospitals, and overall growth in healthcare spending contributes to this demand.

THE RISE OF SALE LEASEBACKS As the realities of COVID-19’s economic impact become more evident, businesses are looking to strengthen their capital reserves for immediate needs and other core activities. A growing number of owners are using sale leasebacks to sell their assets for an influx of cash but retain possession of their facilities. During a recordlow interest rate environment, a sale leaseback proves to be advantageous as it provides the tenant with more favorable rent terms.

Currently, there are a lot of places where sellers can put capital, including paying down debt, making acquisitions, or investing in technology or people. A traditional sale leaseback is when an owner sells the property to third party buyers. Still, buyers can range from private equity groups, institutional funds, and even real estate investment trusts (REITs), despite the increasing cost of capital and stock prices, placing downward pressure on acquisition abilities.

LONG-TERM CHALLENGES Prior solid fundamentals allow for a relatively rapid rebound when the economy bounces back Data in 2019 showed low vacancy rates for medical office buildings and six million square feet absorbed

Given today’s market conditions, a tax-deferral strategy that is rapidly growing in popularity amongst physician groups is a 721 Exchange, or more commonly know as, an UPREIT transaction.

Aging population combined with expanding medical insurance coverage and new treatment options equate to a growing demand for medical office space The backlog of rescheduled or canceled appointments due to closed offices brings an influx of patients and work for medical staff boosting long-term financial stability MATTHEWS™ | 120

WHAT IS AN UPREIT? The term UPREIT, short for Umbrella Partnership Real Estate Investment Trust, is a unique corporate structure that allows real estate owners the opportunity to defer capital gains taxes by selling their building(s) to real estate investment trusts (REIT) in exchange for operating partnership (OP) units instead of cash. With an UPREIT, a REIT will acquire the property as an OP with shares allocated to the seller of the property, rather than as a standard real estate transaction. For this reason, an owner’s real estate contribution to the partnership isn’t considered a sale; and therefore, capital gains taxes are deferred. OP units are similar to common shares in the sense that they are equal in value to REIT shares, mirror performance of REIT shares, and provide owners with monthly or quarterly distributions. However, unlike shareholders, OP unitholders don’t hold voting rights.

BENEFITS OF AN UPREIT Moreover, to avoid capital gains taxes, an UPREIT transaction provides physicians with the opportunity to diversify as they near retirement to step away from the daily management requirements of owning property, and to ultimately benefit from the recurring income and flexibility associated with the liquidation of OP units.

DIVERSIFICATION Owners that exchange into an UPREIT for operating partnership units possess interest in a portfolio comprised of multiple assets rather than one. REITs that are structuring an UPREIT are professional investment companies with billions of dollars of real estate in their portfolio. An OP unit holder can have confidence in the company’s ability to acquire quality assets.

CONVERT OP UNITS INTO COMMON SHARES OF REIT & SELL FOR CASH OP unitholds can unlock value and access capital as they deem necessary by converting OP units into common shares. These OP units are convertible on a one-for-one basis with shares in the REIT. These shares received after conversions from OP units can be sold for cash on an as-needed basis. However, owners should be mindful that doing so can result in a taxable gain.

EASE OF OWNERSHIP OP unitholders can enjoy passive ownership with zero management responsibilities as REITs take control of operating and managing all properties.

STEADY STREAM OF CASH FLOW OP unitholders will have the advantage to receive recurring cashflow through monthly or quarterly distributions up until they elect to sell or the property is sold off by the OP. UPREIT transactions should be considered by all physicians that are looking to potentially monetize their medical office building, in addition to other opportunities such as 1031 Exchanges into real property, Delaware Statutory Trust (DST), etc. Although they aren’t as common as a 1031 Exchange, the Matthews™ Healthcare Division sees a considerable uptick in chatter and consideration of this particular tax-deferral strategy, especially with more physicians seeing increased values as well as more planning on setting themselves up for retirement.

RAHUL CHHAJED

rahul.chhajed@matthews.com (949) 432-4513 121 | SPRING/ SUMMER 2020

MICHAEL MORENO

michael.moreno@matthews.com (949) 432-4511

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