Commercial Real Estate: The King Kong Of Category Killers by Danielle DiMartino Booth, Fed Up: An Insider’s Take on the Willful Ignorance and Elitism At the Federal Reserve
Kings are threaded through time, from all incarnations, realms, and mediums. Some are real, others imagined. There are great ones from literature, such as the tragic Lear and the legendary Arthur, to name but two of a multitude. The great, or not so great, of recorded history may inspire or fascinate as does King Henry VIII with his notoriously insatiable appetites. In Egypt the king was pharaoh with the most famous of these, Tutankhamun, discovered in 1922, and very unroyally immortalized in pop culture by one of comedy’s most irreverent kings, Steve Martin.
The silver screen too has its kings, and one of those is surely that enormous silver back, regally sporting a remake crown on his massive head. Debuting in 1933, King Kong featured primitive animation and an ape doomed to never get the girl. The public was hooked, and with ever more sophisticated technology, Hollywood would remake this winner six more times. Borrowing from modern vernacular, you might call Kong what he is, a colossal cinematographic category killer.
Commercial Real Estate
Sadly, Kong couldn’t win, but he did make scaling the Empire State Building look like child’s play, as he battled annoying aircraft and tenaciously guarded his shrieking starlet prize. Some might even say the ill-fated ape was Amazonian in his feats.
Few would dare dispute that a different kind of Amazon reigns supreme, lording over the retail realm, growing its kingdom by killing one category after another. In the event you are unfamiliar with the term, ‘category killer,’ it refers to a company, service or brand that has such a unique advantage that it makes it nearly impossible for competitors to operate profitably.
Amazon long ago killed off legions of book vendors and electronics retailers. Most recently, though, it’s left the entire commercial real estate (CRE) sector feeling as if it too is under siege. Such is the depth of the carnage in retail and its potential to spread to other areas of the commercial landscape.
Think of the burgeoning situation of the sum of the parts overwhelming the system. For a time, the notion of malls crushing the CRE space was unfathomable. The initial debate centered around which malls would emerge as ‘winners,’ and which would be retrofitted, and into what would they be reincarnated.
Followers of CRE quickly learned to distinguish between the top ‘A’, middle ‘B’ and bottom tier ‘C’ malls. There was also a ‘D’ category, which gallows humor quickly branded ‘death malls.’ The Reader’s Digest version of what was to come consisted of predictions that a choice few of the swankiest outfits surviving while the rest were left to rot and eventually die off, or as mentioned, come back in another form.
Innovative incarnation ideas include indoor sports venues, charter schools, residential communities, movie production studios, and the king of irony, fulfillment centers for online vendors. (What better way to be closer to city centers at deeply discounted rates after you’ve killed off the occupants?)
In mid-May, Morgan Stanley’s Richard Hill initiated coverage of the retail REIT sector, as in real estate investment trusts, companies that own and operate income producing commercial properties. He titled the piece, ‘Malls Aren’t Dying (Just Some of Them).’ Devising the dividing line involved simple and elegant analysis – if a property generated north of $400 per square foot in sales and was located in a major market, it was apt to survive. The ‘major’ aspect assured sufficient population density and a high enough median income to support minimum sales thresholds.
To take the sales argument to the extreme, Apple stores generate $5,000 per square foot. Throw in a few luxury anchors and a Microsoft store to keep things honest and you’ve got the mall of the future.
To place the ultra-high end into context, the average mall in America last year generated $165 per square foot, a 24 percent decline over the past decade. According to the latest data available from Cushman and Wakefield, this dramatic sales decline stems from a cratering of mall traffic: In 2010, there were 35 million visits to malls; by 2013, that number had halved to 17 million.
A landmark study by Green Street Advisors released earlier this year estimated that one-in-five anchor department stores would have to be shuttered to return many struggling chains to the same levels of productivity they enjoyed 10 years ago. Big department stores, such as J.C. Penney, Sears and Macy’s, occupy some two-thirds of anchor space.
Without a doubt, the hatchets are in full swing. In April, Sears announced it was closing 78 stores, including 68 Kmart stores. You might be saying, ‘No surprise on that one,’ — few of us even claim to know someone who has frequented these stores of late.
But the Macy’s announcement from a few weeks back, that was anything but fully priced into market expectations. In January 2014, the retailer said it would shutter 14 stores followed this January with the news another 15 were on the chopping block. Hence investors’ surprise when the company revealed it would close 100 more stores by early next year.
Anchor closings have a contagion effect; they weigh heavily on the smaller retailers that depend on the draw of the big boys.
“Retail bankruptcies and store closures have thus far represented the greatest risk for mall operators, but also a potential opportunity if they can be replaced by higher-quality tenants” wrote Hill in the wake of Macy’s news. “Further store closure announcements by department stores would be an incremental headwind for Mall REITS.”
If only it was as simple as a pure mall story. Retailers from the mammoth Walmart to the luxurious Ralph Lauren have also announced they will close stores this year to the tune of 154 and 50 locations, respectively. They too will be laying off thousands of employees nationwide.
Moreover, there’s no magical macroeconomic expectation of a dollar-for-dollar shift from bricks-and-mortar to eCommerce sales. Recall what set the train in motion in the first place — finding the cheapest price online with the added convenience of shopping basically anywhere, an increasingly important driver of shopper behavior.
As for households’ continued laser focus on prices, stretching your paycheck is pretty important when it refuses to keep up with the growth in the cost of living. Wage inflation has picked up a bit, to an annual 2.4-percent rate in August from the 2-percent pace that characterized much of the ‘recovery’ years. And while food inflation has cooled to a flat reading over last year, an immense relief for families coast to coast, wage growth is still running far behind that for rents, at 3.8 percent, and that of healthcare, at 4.0 percent.
That gets us back to commercial real estate and the odd prospect that retail stresses could eventually spill over into other sectors of a market that is, by any measure, riding a runaway train of heated valuations. It will not surprise you that for years now the engine driving that loco locomotive has been luxury apartments.
While it had looked as if CRE was off to