Watch Rents Rise

Our firm recently completed a Q2 survey of the region’s 25 flagship Power Centers, in which we reported that occupancy levels across the Northern California region reached their highest levels in 4+ years.

Across a 13 million square foot cross section of the region’s top retail assets, occupancy clocked in at 94.05%.  This total included seven assets with occupancy levels above 99.40%. Vacancy rates are down to pre-Covid levels, and rents across the region have moved to all-time highs.  And while the heady occupancy and rental rate data suggests that the market may be approaching a peak, our view is that we are only in the third or fourth inning of the game in a major upward recalibration of rents among best-in-class assets.

Market participants realize that rents are driven by supply and demand.  But another factor is at work in the current environment that will virtually assure further constriction of supply, thus driving rents still higher.  The combination of stubbornly high interest rates and historically high construction costs have destroyed the cost side of the equation in bringing new regional retail assets (Power Centers) to market.  Fueled by the explosion of data centers, semiconductor fabrication facilities, and large power-grid infrastructure projects, construction costs are moving aggressively higher with no near-term sunset in view.  Add to this the tariff pressures on goods and raw materials that will only continue to move costs higher.

Absent the introduction of additional new supply to the current inventory of regional retail shopping centers, the already shrinking supply of remaining vacant spaces will relentlessly be absorbed, causing demand to swamp supply, thus driving rents still higher.

When the Fed announced on July 29, that it had voted to keep interest rates unchanged, they also reported that 3 of the regional Fed presidents had voted to raise interest rates still higher.  Translation: It will be a very long time before interest rates drop meaningfully, which is a necessary condition for the developers of high-quality regional centers to build additional competing assets.

Of course, in outlying, tertiary markets where the availability of land sites and lower land values improves the developer’s math, occasional projects may come to market.  But in the core metropolitan areas where the bulk of our population lives, where the majority of our retail assets are located, and where the vast majority of retail sales take place, the barriers to new development are only growing higher.

Yet another hurdle to the creation of greater inventory is the scarcity of large format development sites in core metropolitan areas.  Power Centers exist on sites that typically range from 20 to 40 acres, more or less.  In locations where these sites rarely exist in core markets, they consistently optimize value either when densified into vertical assets like residential or office buildings, or when carved into much small parcels that drive the price per foot higher.  Indeed, in numerous submarkets such as the San Francisco Peninsula and West Los Angeles, single-level retail assets on medium to large sized parcels are increasingly being acquired by residential and mixed-use developers, who create value through the vertical densification of these strategic locations.  Homelessness, whatever its root causes, has created an environment where the political will has shifted in favor of razing retail centers to address the politically popular goal of creating more housing inventory.  Consequently, the supply of retail inventory is in fact shrinking, putting still more upward pressure on rents in the flagship retail centers.

These barriers to new regional shopping center development; prohibitively high interest rates, soaring construction costs, and the lack of sites of scale in core markets, are creating a fortress effect on the existing inventory of flagship assets in this market and others.  In any fortress, the golden rule applies:  “He who has the gold, makes the rules.”  And increasingly, the gold in commercial/retail real estate is the limited supply of best in class regional retail assets. Count on owners to leverage these evolving supply/demand dynamics to turbocharge returns on their assets.