What WeWorks Acquisition of Lord & Taylor Tells Us About the Future of Retail Real Estate

 

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Today I am conducting a podcast on distressed U.S. retail real estate for Gerson Lehrman Group, a professional learning firm that connects its clients to industry experts to inform business decisions. One of the most relevant (to New York City) and fascinating events in this sector was the recent announcement that WeWork was acquiring from Hudson’s Bay Company the Lord & Taylor Fifth Avenue flagship store for $850 million and that Lord & Taylor will be leasing back only the bottom three floors of this 12-story, 670,000-square-foot landmark for a condensed department store. WeWork will establish its new global headquarters throughout the balance of the building.

Hudson’s Bay, like other legacy department store retailers, has been under investment pressure to monetize its real estate holdings at a time when department store sales are battered by the shift in shopper preferences to discounters, ”fast fashion retailers” like Zara and Uniqlo and e-commerce purchases. Macy’s has already sold its Chicago flagship and leased back a portion of the building for its store. Activist investors have been pressuring Hudson’s Bay to sell its Saks Fifth Avenue New York City flagship, which is almost exactly the same size as the Lord & Taylor flagship – and was recently valued at $3.7 billion. The Saks Fifth Avenue flagship store is indeed located in a more celebrated portion of Fifth Avenue, ten blocks north of Lord & Taylor, but the WeWork acquisition points to a dramatic repricing in the value of New York department stores.

Retail properties in New York City generally deliver no more than a 4% cap rate – which means they trade at pricing at least 25 times their net operating income (NOI), reflecting actual or potential lease rent net property taxes and operating expenses. If the ground floor of the Lord & Taylor store is attributed a conservative potential NOI of $400 per square foot and the eleven floors above accorded an NOI of only $40 per square foot (attributed to office use and not to retail), the building should be valued at about $1.2 billion, assuming a 4% cap rate. By this calculation WeWork definitely made an under-market purchase and the Saks Fifth Avenue flagship store, even if its superior location justifies an NOI for its ground floor of $1,200 per square foot, is worth perhaps $1 billion less than its recent appraisal.

Footprinting Luxury

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I just participated in a panel at the 2017 Luxury Interactive conference with the young founders of two luxury, multi-brand e-commerce websites who both have dipped their toes into (pop-up) retail. Physical stores, even short-term occupancies, are expensive for young companies, but once a nascent e-tailer attracts private equity capital (Warby Parker or UNTUCKit, for example), the reality that nearly 88% of all retail sales were still store-based in 2016 typically drives the retail footprinting of the brand.

Most of the growth in e-commerce, which is forecast to rise to 17% of all retail sales by 2022, will be driven by Amazon. But in the luxury brand category, as we’re not talking about buying paper towels or other necessities, the impact of e-commerce is much more nuanced and not necessarily a threat. Mobile phones will soon be the primary way we access the Internet (outside of work). Apps now dominate mobile phone usage with browser activity only representing 8% of time spent on the phone and lifestyle/shopping apps only accorded 5% of our attention. Messaging, chatting and following our friends’ activities through Facebook, Snapchat and Instagram now represent nearly 35% of our growing time commitment focused on our phones. This is fascinating, in that what attracts us most to this addictive technology is how it allows us to communicate with each other and express ourselves or appreciate the expressions of our friends and peers.

The luxury category of purchasing is about communicating our recognition of quality and demonstrating our status to others. A store like Canada’s luxury department store chain Holt Renfrew, that treats its customers as “omni-channel” purchasers and doesn’t differentiate between in-store and e-commerce shoppers, can generate 60-70% higher customer spending. The key to this customer approach is personal relationship and engagement realized (at least initially) only by face to face interaction with in-store salespeople. These relationships can become almost completely “virtual” because of the appeal and effectiveness of chat-based communication. A customer may only visit a physical store once a year, but would have never developed this a personal relationship without meeting a sales person face to face. If a sales person is enabled to know a customer’s buying history (and tastes) and creatively integrate both in-store and e-commerce offerings with a customer’s profile, messaging technology becomes a powerful tool to expand sales. None of this is possible if there’s no physical store.

WeWork, Coworking and the Disruption of Office Real Estate

wework

Last week, I conducted a national web conference sponsored by Gerson Lehrman Group (GLG.it) to advise investors on how WeWork and other coworking firms are disrupting office real estate.  Between August 2016 and July 2017, only Amazon has leased more office space than WeWork in the United States. Though shared office spaces (office environments in which multiple firms sublet places to work within a single demised office space) still occupy less than 1% of all office space in the United States, coworking (like other disrupters AirBnB and Uber) is having an outsized impact – specifically on where and how freelancers, entrepreneurs and established corporations inhabit office space.

Together WeWork  and the executive suite firm Regus lease nearly 80% of shared workspaces in the United States, totaling about 30 million square feet.  But there are now hundreds of independent coworking operators in spaces of typically less than 15,000 square feet – much smaller than the typical WeWork location.
What explains the explosive growth of WeWork, founded only in 2010 and now operating 216 locations in 53 cities, 19 countries and with more than 100,000 members, as well as the rapid expansion of its smaller peers?
  • The near universality of handheld mobile devices that allow “office” work traditionally bound to an immobile desktop computer to be performed anywhere has transformed the traditional rationale for “going to work.”
  • The rise of the freelance economy, estimated to grow to 40% of the workforce by 2021, and the demand from this segment for workspaces that foster community, collaboration and flexibility.
  • Millennials’ importance in today’s workforce – 63% of whom are as comfortable working from a mobile device as from a desktop.
  • The appeal of coworking workspaces, in terms of their cool, organic design aesthetic and the opportunities they create for business owners and their employees or contractors to benefit from proximity to other firms and their talent and business offerings.
  • Unlike traditional office space leases of 5 or 10 years in term, coworking occupancy obligations can be as short as 1 month and may allow for rapid growth or retraction of seats and offices. Individuals and companies taking coworking space do not have to invest capital in furniture, space build-out or technology. As demonstrated by WeWork‘s “client savings” presentation, particularly for firms that occupy 3,000 square feet or less, the higher density of coworking occupancy and the fact that tenants do not have to pay for square footage devoted to reception, conference rooms and amenity space like pantries generates occupancy and operational savings. This translates to potential occupancy savings per employee even though coworking space can be substantially more expensive per square foot than regular office space.
Even large corporations that want to give their employees flexibility and avoid or delay expensive capital investment in new office space are committing to significant coworking occupancies. For example, IBM recently leased an entire WeWork location of 70,000 square feet to serve 600 employees on University Place. Additionally, Microsoft just bought 300 WeWork memberships for its New York-based sales team that allows them to work in any WeWork location globally.
How is traditional office space disrupted?  Below are three examples:
  • previously wrote about professional service companies de-emphasizing fixed work spaces in favor of decentralization. This trend will reduce overall demand for traditional leased office space and extends to the sales and client-oriented oriented functions of TAMI firms that otherwise want to focus and consolidate their occupancies in campus settings as Amazon plans to do with its new second headquarters facility.
  • Outside of the realm of the top tier Class A office building, where owners often pre-build smaller spaces (less than 10,000 square feet) to appeal to boutique financial tenants like hedge funds and private equity firms, fewer landlords will demise and build small offices spaces because they cannot compete with coworking efficiencies and appeal.
  • To compete with the flexibility of coworking space, landlords must offer tenants shorter lease obligations, even though this presents a challenge financially for them to amortize capital investments and transactional costs and incentives over shorter term leases.

The Real Disruption

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Business analysts (and commentators in general) harp on our current environment of disruption, in which entrepreneurs are harnessing unprecedented breakthroughs in technology and ubiquitous connectivity to build alternative means of consumption. Many of these ventures (Airbnb, Uber, Breather, Rover, etc.) are tied to growing consumer acceptance and preference for sharing resources, fueled by the capacity of mobile devices and their addictive impact on our behavior.
In this milieu, it it simplistic to implicate retail’s current challenges, particularly the struggles of department stores, shopping centers and certain fashion brands just to the “disruption” caused by e-commerce and related trends. Clearly, tastes and shopping habits have changed rapidly and dramatically. Discount retailers are performing quite well as are the “fast fashion” category of Zara, Uniqlo and Forever 21. Certain luxury brands’ “brick and mortar” (Gucci, Goyard, Hublot, etc.) are thriving, even as internet sales continue to rise. But department stores with a lackluster, uncurated assortment of brands and merchandise are suffering, just as historically strong fashion brands that failed to update their perennially consistent style (Ralph Lauren, Ann Taylor, MaxMara, etc.) are compelled to close poorly performing stores.

While activist investors are pushing Saks Fifth Avenue’s parent company, Hudson’s Bay, to sell the Fifth Avenue flagship store, so that upper floors might be possibly converted to luxury apartments, the department store is all over the place trying to boost lagging sales. Saks is shifting its traditional make-up floor upstairs, moving leather goods to the ground floor, installing a temporary “wellery” on the 2nd floor with pop-up cross-fit classes, spa services and athleisure displays. Meanwhile, just down the street, Adidas may have hit the mark with its year-old, engaging global flagship. The store is designed to mimic a high school sports stadium interior with professional sports trainers providing free advice, plus a floor dedicated to New York sports teams targeting tourists, who don’t appear to have stopped shopping!

No Need to Wait for Driverless Cars

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In less than five years, Uber and its competitors transformed the way many of us choose to get around New York City. Likewise, they disrupted the business and leisure traveler’s attachment to rental cars. Now much attention is focused on how driverless cars will inevitably transform urban and suburban life. But whether A.I.-equipped cars become widespread in five years or 20 years, the continued explosion of ride-sharing (with or without drivers) will rapidly reorder the place of the automobile in our lives. What will be the impact of this mobility revolution on how our region’s real estate is valued? What opportunities and challenges does it present?

BMW recognizes that its future is not primarily as a seller of cars but as a ride-sharing company (www.reachnow.com). ReachNow is available in Brooklyn and many European cities. The economic and flexibility rationale for paying for a shared vehicle by the minute, hour, mile or day with no need to park, insure or maintain the car will probably be too strong for all but the most enamored urban car-owning residents, commuters or visitors to withstand. In light of the fact that the average vehicle in the United States is parked 95% of the time, ride-sharing obviously reduces the need for parking and will continue to reduce traffic and congestion.

Ride-sharing and the City
Before the popularization of the automobile, cities like New York didn’t look significantly different. Buildings were not as tall and there was not as much segregation of uses on the street as there is today. I don’t think cities will change physically as personal car use declines.

However, the long-term outlook for Manhattan parking garage owners and operators, who have enjoyed one of the most lucrative businesses in real estate history, is not positive as car sharing displaces car ownership and the demand for parking. Corporately-owned ride sharing vehicles will require storage and servicing centers during lower demand periods, but in all likelihood, these will be located where real estate is not as expensive.

The Red Hook Effect
In New York City, in neighborhoods like Red Hook that are generally inaccessible by public transit, historically residential real estate has been priced to reflect this limitation. But with attractive housing options and amenities like waterfront parks, real estate should appreciate in value at a faster rate than other areas, as ride-sharing overcomes inconvenience.

The Suburbs
The earliest suburbs (like Bronxville, New York) developed as “railroad suburbs” before the popularization of the car. These appealed to residents with professional and commercial ties to the city, but with a preference for and ability to live in a private home that had a train station as well as neighborhood retail and services within walking distance. It was the automobile that helped spawn the post-war explosion of sprawling suburbs in which all activity outside the home is car-dependent. These communities now face the greatest planning and development challenges. For example, a suburban big box shopping mall can devote 75% of its land to parking – most of which may become superfluous as driving habits change.

While urban living has gained popularity among baby boomers and millennials at the expense of the suburbs, I don’t expect ride-sharing to dramatically change individuals’ or families’ preferences for one lifestyle over the other. But our already overstretched railroad infrastructure will be burdened severely as ride-sharing eliminates the expense and annoyance of train station parking. Train ridership from the suburbs into and out of New York City will inevitably increase

Retail Destinations
The current struggles of retail are well-publicized. The growth of ride-sharing may offer an opportunity for some retail to prosper and retail real estate to appreciate. Ride-sharing should make unique retail destinations with an experiential quality more attractive. For example, I foresee growth in customers (and sales) at the Woodbury Premium Outlets, which is unmatched among outlet centers nationally for its inclusion of luxury brands. Woodbury Commons is located 50 miles north of Manhattan, but ride-sharing will make this destination more accessible from throughout the metropolitan area and perhaps more attractive as an alternative to clicking on Gilt.com.

Location Intelligence and the Future of Real Estate

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The explosion of data collection from many newer sources, including mobile devices, car sensors, wearables, smart power grids, and drones has not yet fully infiltrated the real estate investment and location decision making process. But technology companies like Brooklyn-based CARTO are starting to usher in change. Founded in 2012 by a team of experts in geospatial development, big data analytics and visualization, CARTO organizes and maps data from multiple sources and allows its software users to access and capitalize on this information. For instance, in London, CARTO developed a live interactive mapping application of London’s residential markets overlaying annual home price changes, population growth, transit connectivity, active and future residential and commercial development and infrastructure projects and other datasets. To be able to visualize integrated data sets is what provides users a way to analyze trends and forecast (and map) growth in property values and other key indicators.

As retailers face the headwinds of internet sales and changing tastes, the ability to target prospective store shoppers with the merchandise they are most likely to purchase becomes critical. Socio-demographic profiling and segmentation of population  by housing, age, income and lifestyle by data aggregators, like Claritas, has been around for decades. But CARTO has taken population segmentation data to the next level in terms of visualization and analysis. The firm worked with the 95-year-old French home improvements retailer, Leroy Merlin to integrate and map live sales information and customer demographic data to not only analyze competitors and where Leroy Merlin’s customers come from, but to continually update on a store-by-store basis exactly the households the chain should send marketing collateral. One can imagine that this mapping database will become the most crucial tool the company uses as its grows its 300 location across France and 12 other countries.

Short Term Investment Strategies

fix and flips

With housing prices rising even in unlikely markets like Las Vegas and Detroit, the “fix and flip” phenomenon appears once again to be gaining in popularity. While the opportunity to achieve a quick profit in a rising home market from buying a property in need of a makeover and quickly selling it at a significantly higher price may appear enticing, there are significant risks associated with house flipping, in common with other short-term investment strategies.

The Risks
The renovation required to improve a property to appeal to a higher demographic of buyer may cost more than anticipated. A “fixed” house may face significant competition from newly constructed properties delaying a successful sale and adding to carrying costs or generate significantly less profit than anticipated upon sale. A renovation may also quickly increase property taxes. Finally if the property is resold within a year, there is no opportunity to defer capital gains taxes through a 1031 “like-kind” property exchange.
An Alternative Paradigm 
I’ve previously written about the demographic and housing supply trends that make carefully researched millennial-oriented real estate investments promising, both from an income and an appreciation perspective. The objective is not to hold a property indefinitely, but rather to capitalize on appreciation over time and trade up to a more valuable property, after earning sufficient rent to at least cover carrying costs and financing. With financing, levered appreciation can be particularly dramatic. If a property is purchased for $200,000 with $50,000 in equity and a mortgage of $150,000 and later sold to net $240,000, after transactions costs (brokerage, transfer taxes and closing costs), the initial investment of $50,000 has grown by 80% (to $90,000). If the property is held at least a year and a new real estate purchase meets the 1031 guidelines, taxes on this gain are deferred.