The Interest Rate Environment Makes Nashville Even More… Interesting

BY Arthur Perlen, CCIM

As an experienced, 30-year career tenant representation broker, I am seeing the current realities of the interest rate environment lead to unprecedented challenges in the local commercial real estate market. How these issues impact developers and tenants warrants an in-depth exploration and presentation of some of the solutions we have observed in the Nashville and Middle Tennessee market.

Challenges Impacting Developers

Both investment real estate and build-to-suit projects are heavily impacted in every stage of the deal cycle. Developers face an uphill battle to get a deal funded.

  • Land costs are high. Land prices go up quickly in boom markets and go down at a very slow rate. They have not adjusted to market realities, yet.
  • Construction costs are high. Demand has slowed, and we’ve seen new construction in office, multi-family, retail, and industrial areas decline precipitously. COVID challenges related to the supply of building materials and labor shortages created increased expense in this arena.
  • The intersection of high interest rates and banks more cautious loan underwriting in commercial real estate creates a dearth of financing options. The cost of equity is increasing. Moreover, there is increased scrutiny for bank real estate loan portfolios at the federal and branch level.
  • Cap rates for property sales are going up. This decreases the spread between development costs and profit upon exit, pushing developers toward an untenable risk-reward ratio. This pushes rental rates, and the rates required to support an appropriate profit margin become impossible for tenants.

 

Challenges Impacting Tenants

When the rental rates increase – or even stay the same as underwritten initially but the associated build-out costs and the dollars needed to establish a business increase – the projected or actual sales of a tenant cannot support the rental rate. It’s simply more than the retailer can pay.

High rental rates also impact the financing of tenant businesses. Lenders underwrite businesses carefully and determine funding based on the comparison of sales and occupancy costs. Whether a tenant is looking for a build-to-suit or shop space, they face the same lending challenges. We have seen multi-tenant shopping center developments die because of changing market conditions.

Solving for X

All parties to a deal, including the retailer, need to get involved to reduce the cost of development. Creative options we have seen include the tenant building out their own space to reduce the amount of requested TI or even contributing equity to the deal. Because TI allowance is amortized as increased rent over the term of the lease, and the new goal is to keep the rent low, tenants may accept a cold dark shell and use their own equity or leverage instead of relying on the developer’s. Tenants with the ability to negotiate leases without forcing landlords to infuse cash into the space are going to prosper. Another option for retailers with ample capital is to modify their deal structure to a ground lease and self-develop the property.

Right-sized expectations for the number of stores that will open are crucial. Projections and reporting to Wall Street or to franchisors should be reflective of current real estate realities to prepare stakeholders for the creative structuring that may be required to achieve all or part of an expansion plan.

Cultivating multiple lender relationships has never been more important. Neither a tenant nor a developer can assume they will walk into a bank and receive funding.

What is Different About this Market

I’ve seen high interest rates – certainly much higher than they are today – throughout my career. Historically, however, those high interest rates were coupled with low prices. But we have not seen increased supply in Nashville over the past 10-15 years, with very little development in the city during this timeframe. We have also seen dramatic population increases. There has not been enough development to accommodate the market growth, which keeps the commercial real estate market inventory tight, and the demand inflates prices. It has never been painful to do development at 6-7% interest rate, but it seems to be that way now. Never have we seen an environment where retailers want to expand, consumers are still spending, and yet they do not have enough space to accommodate the tenant growth.

Advising Clients in Times of Uncertainty

Retailers coming to Nashville and Middle Tennessee rely on our boots-on-the-ground knowledge of the market to recommend creative solutions. Especially when pricing excludes so many opportunities, we identify alternate locations and market entry points where our clients can be successful.

There are markets outside of where franchisors tell their franchisees to be. While they rely on technology platforms and data that are useful, those numbers rarely tell the whole story. The physical market knowledge of a local broker is irreplaceable (Read more). We tell our clients where they should be, and why.

At times, we have to say no. There are opportunities that we sadly must refuse. Not every retailer is ready or able to come to Nashville. Especially if their parameters are unrealistic and inflexible, we care enough about their business to prevent expensive, arduous searches that result only in frustration.

At other times, we get involved in conversations with the developer to advise on the build-to-suit for a client. It is important to advocate for our clients and provide creative solutions for the issues that developers face.

We don’t know what the future holds, but I am still betting on the U.S. consumer. Market conditions are impacted by macroeconomic factors that we don’t control. But what we do control – decades of experience, real-time market knowledge, and creative structuring – enables Centennial to create success for our clients in a geographic area that will continue only to get better.

To learn more about the Centennial approach to site selection and tenant representation, contact Arthur Perlen at aperlen@centenretail.com.

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