It was a year ago, this month, that life came to a screeching halt, like crash test dummies hitting the wall…we hit the COVID wall. Most of us watched as many retail stores struggled to keep their doors open. If they weren’t a food and drug chain, chances are they took a hit. As many small retail businesses saw the loss in foot traffic, some opted to take advantage of the internet and promoted more online shopping and even drive up / pick up service. Most fitness centers offered online classes to those who wanted to keep up with their healthy lifestyle. By 20Q4, stores had opened back up, but some consumers remained hesitant to venture back into the world they once viewed as safe and routine. Maybe now that Arizona businesses can operate at full capacity, we will find our way to break through that tough COVID wall.
Before the global pandemic, Phoenix’s retail market was already facing challenges due to the rising competition between e-commerce and brick-and-mortar sales. Over the past decade, positive demand drivers and a conservative supply pipeline had supported fundamentals. However, the economic disruption caused by the coronavirus has created significant headwinds that are weighing on the market.
There are many uncertainties about the length and depth of the disruption caused by the coronavirus. The recovery depends on an improving health situation and when people will feel comfortable revisiting crowded retail locations. Fortunately, the Phoenix retail market is in a better position than in years past, thanks to a slowdown in development. New supply has been limited to build-to-suits, mitigating supply-side risks in the near term.
The Phoenix retail market was fairly resilient amidst the challenges in the evolving retail landscape before the coronavirus. Despite the ongoing battle between online sales and brick-and-mortar retailers, steady leasing and limited new supply had supported fundamentals. But the pandemic and policies adopted to reduce the spread of the virus wreaked havoc on retailers. A curtailment in consumer spending on discretionary goods, social distancing, and reduced travel decreased foot traffic in physical retail stores and strained retail revenues. Many businesses have not been able to weather the storm, and the recent rise in COVID-19 cases will force more retailers to shutter for good.
The near-term outlook is mixed for the sector. Discount, grocery, drive-thru, and necessity service retailers will continue to expand, while some other non-necessity retailers will continue to battle with e-commerce. In the Base Case scenario, demand will improve but it will be nominal over the next two years.
Rent growth has slowed since the onset of the pandemic, following a long stretch of gains. In 20Q2, daily asking rents tumbled due to the disruption caused by the pandemic. In the months after, asking rents started to rise again and then stabilized. Asking rents returned to pre-pandemic levels in January, though the daily rent series is volatile. Over the past 12 months, rents changed by 0.6%, which is better than the national average.
Even before the pandemic, average asking rents were still below the previous peak due to the losses incurred during the global financial crisis. At the end of 2019, average rents in the metro were about 20% below the previous high. Looking further ahead, rent growth is expected to decelerate and turn negative as store closures mount and vacancies rise.
Most retail construction is attributed to build-to-suits for gyms, fast food, and grocery-anchored shopping centers. About 470,000 SF of retail space is under construction, which accounts for about 0.2% of the existing inventory, a small share by historical standards. Less than 15% of the space under construction is available for lease.
Looking ahead, a conservative construction pipeline will limit supply pressures in the Phoenix retail market, which has been the case in years past. Construction starts have tumbled over the past few quarters, and development is expected to remain modest in the near term.
While the pandemic caused investors to press pause in 20Q2, activity picked up in the second half of the year. Despite the increase, sales volume in 2020 was still one of the lowest years for investment in a decade, totaling around $1.5 billion.
Investors have heavily targeted properties in fast-growth suburbs, such as Gilbert, Red Mountain/Mesa, and Chandler. In November, Oversteet Project, LLC, a Nevada LLC, acquired a mixed-use retail center in Downtown Chandler for $12.3 million ($387/SF) from the developer. The property was built in 2018 and consists of 31,800-SF of retail and includes office space on the second level. The property is fully leased to high-credit food and beverage tenants and an industry leader in healthcare reimbursement on the second floor.
Before the spread of the virus, competition for well-located and quality assets bolstered transaction pricing to an average of $210/SF. Yet, values had not returned to the previous peak. Despite price growth, Phoenix’s average cap rate has hovered near 7% since 2015, mirroring the National Index. Higher yields than pricey coastal markets have attracted buyers’ attention, especially from California, where the average cap rate is roughly 250 basis points lower than in Phoenix.
The competitive advantage and growth drivers that were stimulating growth in the Valley of the Sun may be stronger than ever. People living in dense and expensive cities have always looked to Phoenix for job opportunities and affordable living. But a rise in remote work will entice more people to move to Phoenix as an affordable option to California or East Coast markets. The market is better positioned than it was a decade ago. Once known for cheap labor and land and identified as a retirement community, Phoenix has become a dynamic and vibrant market. Population growth, a diversifying economy, relative affordability, and business-friendly regulation have strengthened the Phoenix value proposition. These characteristics are attracting more than 200 people to Phoenix each day.
As the retail market struggles to regain its strength, the Phoenix economy remains strong. Companies have learned to adapt to the changes around us and many are thriving as we move from in-person shopping experiences to the online sector of the retail world. If you have any questions regarding the retail or any other commercial market, please feel free to contact me.