Executing ground-up development for pure-play retail space — or retail product in mixed-use settings — in Houston is immensely challenging these days for a variety of reasons, despite the fact that the city has the underlying job and housing growth needed to justify a greater inventory of retail product.
While all retail developers in Houston face similar headwinds in terms of costs of capital and construction materials/labor, as well as elevated tenant improvement (TI) costs and hefty required return thresholds from investors, it’s difficult to single out any one of those factors as most responsible for the dearth of new retail development. Some issues will be felt more acutely in some submarkets than others. Certain companies may have better connections and capital situations such that they can circumvent some of the uncontrollables. But no matter the combination of barrier-to-entry factors, the net result is the same: a market that cannot adequately supply retail product to meet demand.
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At the inaugural InterFace Houston Retail & Mixed-Use conference that took place on Aug. 20 at The Briar Club, a group of Houston-based developers convened to share their stories on just what market forces were delaying or hurting their projects. The answers ran the gamut of real estate development woes, and the resounding takeaway was that the simple economics of supply and demand were not going to alleviate the situation. Shane Waddell, an attorney at The Porter Law Firm, served as the moderator of the development panel, which repeatedly emphasized the strong state of Houston’s underlying fundamentals while seeming to resign itself to the reality that new development was tough and getting tougher.
Nathaliah Naipaul, CEO of XAG Group, a developer primarily focused on retail projects within suburban mixed-use settings, opened the discussion with a take on how volatility in construction costs was making it more difficult to accurately underwrite new projects.
“They’re changing every day, so keeping those construction costs at a level in which our numbers pencil before [we break ground] has been challenging, she said. “Those costs are changing every day, which means that every day we’re running new numbers in our pro formas.”
Stephen Pheigaru, managing partner at Palo Duro Commercial Partners, then assessed the issue from the revenue side of the ledger. Pheigaru said that his company has struggled to readily show the tenant commitments and preleasing income that lenders — and perhaps equity sources too — require in order to provide construction financing.
Lacee Jacobs, founder and president of Rebel Retail Advisors and a former development executive at Houston-based Midway, expanded on both these notions.
“There’s still a big gap between the tenants’ expectations [on costs] and what’s being underwritten, and those numbers and expectations are changing all the time,” she said. “Trying to get both sides to be realistic and evolve every quarter based on what’s happening in the market can be a real challenge. So making that connection and getting that early commitment based on underwriting versus tenant demand is significantly difficult.”
Acho Azuike, COO of local developer DC Partners, agreed that the disconnect between the numbers that landlords need and tenants want has created a “chicken or egg” situation. Azuike said that in his experience with multi-tenant retail development, that dynamic has manifested itself in the form of tenants being reluctant to be the first to commit to a new project lest they overpay. That reluctance in turn breeds hesitation from lenders, who want to see upfront monetary commitments before releasing funds.
“Trying to determine the appropriate amount of leasing and how much equity you’re bringing into the project and overall just getting numbers to pencil — that’s the biggest challenge we’re seeing,” Azuike said.
Kevin Freels, executive vice president of investment and acquisitions at Midway, added a touch of optimism by pointing out that relative to industrial and multifamily, more capital is flowing into retail at the moment than in years past. However, he said, with that shift has come a realization that “the rents don’t justify the construction costs in many cases.”
Multiple panelists also invoked the role of infrastructure as a complicating factor. As part of their agreements with municipalities in which they do business, developers often pledge to undertake improvements to roads, sidewalks or other thoroughfares, as well as utility systems, in exchange for subsidies or tax breaks that help offset costs of new development. Hashing out these aspects of broader agreements in an environment in which both sides’ costs are rising only adds to delays and frustrations.
In concluding the opening segment of the panel, Guillo Machado, vice president of development at Houston-based Read King, surmised that only by getting more creative with leasing and tenancy could Houston developers overcome these obstacles. His analysis underscored the key, unspoken fact that some of these market conditions are far beyond the ability of developers to control.
“Mixed-use development is the most complex and challenging by nature; there are so many food groups seeking to use the same small space,” Machado said. “So we have to get creative with how we design and build to cut costs. Every year on social media, we see all the cool concepts all over the world, and we all want that in our backyards, from Katy to Conroe to Rosenberg. That’s accelerating every year, so trying to keep up with the expectations of users and tenants while also controlling costs — that’s the biggest challenge we see.”