Inflation’s Impact on Retail Leasing

Back in March of 2022, the Federal Reserve approved its first interest rate increase in more than three years to combat the fastest pace of inflation seen in more than four decades. With that announcement, the Fed also hinted at additional rate hikes in the coming months, should they be unable to quickly fend off rampant CPI increases. The move, aimed at reducing long-term inflation to approximately 2% per year, had landlords and tenants alike battening down the hatches while they evaluated emergency plans to ensure long-term staying power within the marketplace.

Since that initial rate hike in March 2022, the Fed has implemented nine additional rate hikes totaling a full 500 bps increase in just fourteen months. Most assured that such an aggressive change in monetary policy would send retail leasing activity into a spiral, right?

Let’s start by comparing the current health of Los Angeles’ retail tenancy against the other major asset types. For starters, every sector experienced some level of negative impact as it relates to vacancy rates on a rolling 12-month average. According to CoStar, LA’s retail sector has fared rather well, with overall vacancy dropping from its Q1-22 5.1% vacancy rate to less than 5%, before increasing modestly to 5.3% as of the date of this article. That said, the market’s negative net absorption of 486,000 SF, combined with stagnant population growth, has left LA’s retail market trailing behind the national vacancy average of 4.2%. LA’s Industrial vacancy rose modestly from sub-2% vacancy rates in Q1-22 to 3.4%, trending below the national average of 4.5%. Similarly, multifamily has remained rather strong compared to the national average, ranging from a Q1-22 low of 3.7% to today’s 4.5% (compared to national averages of 5% and 6.8%, respectively). Office, still reeling from the effects of the initial COVID-19 lockdowns, has yet to see a positive net-absorption quarter since the beginning of the pandemic. Despite leveling off for a short time in 2021, vacancy rates since the first implementation of rate hikes have increased from 13.5% to 14.9%; a record since CoStar started tracking said data in 1996.

On the flip side, rent growth in LA has been more heavily impacted by the multitude of rate hikes. After a sizeable 4% rent increase during 2021, as the pandemic-related uncertainty eased, LA’s retail market recorded a modest Y-O-Y year growth of just 1.2% as of May 2023, with rents projected to remain stagnant through 2024. This performance is on par with that of NYC with 0.7% Y-O-Y growth. Conversely, the San Diego market has boasted a 4% Y-O-Y rent increase and a positive net absorption of more than 325,000 square feet during that same time. In a similar fashion, the Phoenix MSA recorded 8% rent growth, with almost 90% of the current construction pipeline already having tenancy in place as incoming residents bolster a strong need for additional retail offerings.

So what’s on the horizon for LA’s retail market? According to Oxford Economics’ latest report, experts project a mild recession to occur in Q3-23 with a slow subsequent rebound, as the Fed will be cautious to prematurely loosen monetary policy for fear of returning inflation. This means that certain submarkets within LA that rely more heavily on tourism dollars such as Santa Monica and Hollywood will experience larger decreases in foot traffic and leasing activity compared to those that cater to residents and their daily needs. This is similar to NYC, whose notable leases in the last year include several luxury goods and tourism-driven concepts.  Markets like these are at increased risk of being negatively impacted in the event of a recession where discretionary spending will decrease before many other forms of consumer spending. On the contrary, markets such as Phoenix have experienced robust population growth in recent months and continue to provide attractive investment yields for retail properties despite high interest rates.

The office sector’s slump, exacerbated in certain tech-heavy markets such as San Francisco and Seattle, will undoubtedly continue to hinder retail recovery in core business districts that rely on daytime population. That said, daily service-oriented neighborhood and strip centers whose tenants have historically been somewhat insulated from recessionary and e-commerce threats, have shown resiliency that is anticipated to continue for the foreseeable future. Additionally, tenant closures such as Tuesday Morning and Bed Bath & Beyond (the latter closing 16 California locations in 2022 with another 11 slated for 2023) are not truly indicative of today’s current inflationary cycle. These concepts have struggled on many fronts, including a years’ long fight to stay current amid a myriad of e-commerce competition and poor fiscal management by the company’s leadership. Once the above-referenced tenants are removed from the overall statistics, retail’s market-driven performance in the SoCal market has fared relatively well despite measures designed to curb inflation and slow consumer spending. The QSR segment also has continued strong performance with dine-in, takeout, and delivery all posting double-digit revenue gains Y-O-Y according to Revenue Management Solution’s annual report from February 2023. The only QSR sales that have decreased belong to the drive-thru lane, whose numbers remained inflated throughout the course of the pandemic, and to which a correction is a positive sign of the public’s willingness to venture out into the world.

The Los Angeles retail leasing sector has taken a hit, though not to the extent that many initially forecasted. Despite the current economic policy, we do not anticipate the same widespread retail fallout that plagued retail landlords following 2008’s collapse. Instead, we anticipate a market correction that will create short-term challenges offset by stabilized, long-term growth thereafter. Consumer credit card debt remains to be a potential additional challenge for retail tenants, with a record $930 billion in total credit card debt and a whopping 49% of Americans using cards to cover essential living expenses. As a result, tenants and landlords relying on discretionary spending will likely experience the greatest impact as consumers shift their focus from “wants” to “needs”. Alternatively, projects with daily needs and recession-resistant tenancy (think grocers, auto parts, service, and medical to name a few) will generally find themselves somewhat insulated compared to other asset classes within the sector.

We at Quantum Real Estate Advisors are well poised to help our clients identify potential challenges and address how to best position themselves to be better prepared for uncertainty in the months to come. Let us show how we can help you too.

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