The following is Part One of a two-part article. Check back Thursday for the second half.
In the past decade, a wave of high-density mixed-use development has swept the country. The activity was fueled by a demand for more housing, historically low interest rates and escalating land prices. Developers took action by building mixed-use projects and converting old apartment buildings, office buildings and hotels into predominately residential condominium developments. During the process of converting a building into individual residential condos, the evolution of the street-level portion of the development into a retail condominium was born. The retail condominium has become a phenomenon that has now emerged as a popular and alternative real estate investment platform to sell and acquire real estate.
Traditionally found predominately in major metropolitan cities, retail condominiums have now appeared in suburban markets throughout the country. In Scottsdale, Arizona, a former office building was recently converted to an adaptive re-use development known as The 4020 Building. The development incorporated 21 residential loft condominiums above a 7,080-square-foot ground-floor retail condominium.
Developers have mainly sought to profit from the sale of a project's residential component, but selling the retail space can result in the developer obtaining a higher cost per square foot for the individual residential condominiums. The sale of the retail condominium portion of the project has represented a substantial opportunity to add to the overall profit of the project from the development proceeds. At The 4020 Building, the residential sales prices in the building were in the mid- to low-$300 per square foot range. The retail condominium portion resulted in a sales price of nearly $575 per square foot.
Retail condominium sales are generally structured for sale in one of two formats. The first is a sale to an investor of retail space as a leased investment. The income stream is structured similar to a traditional retail building or shopping center. The second format is a sale to a single user. Due to the significant slowdown in leasing and attractive SBA financing for business owners, this has been a growing trend taken advantage of by an individual user or smaller entrepreneurial retailer. International Longshore & Warehouse Union Local 13 recently purchased the 18,864-square-foot ground-floor retail component of Centre Street Lofts, a 116-unit residential condominium building in downtown San Pedro, California. The retail portion was only 6 percent occupied at the time of the sale, allowing the buyer to occupy the building as its corporate headquarters.
For individual investors, retail condominiums have a tremendous advantage. The structure allows the buyer to purchase a stabilized investment typically in a prime location that may traditionally have been unavailable previously to private investors. Due to the location and component of other types of real estate uses in the development, this would have required an investment of tens of millions of dollars. Now it has opened it up to an investment market attractive to 1031 investors looking to acquire properties to satisfy a tax-deferred exchange.
The individual condominium sale to private users remains not only an alternative source of sale to developers, but also to potential tenants or purchasers. Due to the softening real estate market and the contraction of national and chain retailers in the current economic climate, the absorption period to lease retail space is now much longer. As a result of this longer time period, individual retailers can find more spaces in which to move their businesses and also may find the opportunity to acquire their own retail unit.
Additionally, due to the larger supply, downward pressures on pricing may allow an individual retailer a chance to negotiate a favorable price in purchasing their own individual condominium. From a financial markets perspective, while the credit markets may remain in a state of constriction in general toward lending for commercial real estate, many successful retailers have strong private banking relationships. These relationships often can open the door toward obtaining the financing to acquire real estate for their own use. Moreover, the SBA financing market remains healthy and also offers a source to finance and purchase an asset with minimal down payment, thus freeing up the working capital necessary to devote toward retail operations.
While many mom-and-pop retailers are more likely to purchase their commercial condominium, there have been instances when national chain retailers have acquired real estate for their own retail operations in retail condominiums. As an example, in 2006, Staples acquired an 18,873-square-foot retail condominium in downtown Chicago for $5.67 million. In areas that may have a predominately large Asian community, many Asian retail businesses have expressed a strong demand toward purchasing their own retail stores. While many individual attributes make the retail condominium an attractive investment and offer an attractive possibility to acquire commercial real estate in prime urban markets, investors need to be aware of certain considerations.
— Carlos J. Lopez is President of Hanley Investment Urban Retail Advisors based in Irvine, California.