By Taylor Williams
For the past several years, including during the height of the pandemic, the Boston retail market has performed well, if unspectacularly. Defined and driven by stable fundamentals in terms of job growth and tenant demand, the state capital’s retail sector has proven itself a reliable environment in which to expand store counts and park long-term money.
But few, if any commercial markets and asset classes are wholly immune to the effects of sluggish and disruptive macroeconomic activity. Through no fault of its own, the Boston retail market is seeing its paces of growth slow across the key verticals that are development, leasing and investment sales.
That said, seasoned players in this space know better than to panic. Boston remains a dynamic market, despite data from the U.S. Census Bureau showing that the city’s total population shrunk by about 25,000 people, or 3.7 percent, between April 2020 and April 2022.
In addition, even in an inflationary economy, Boston consumers tend to retain healthy disposable income levels. A burgeoning life sciences sector that is bringing thousands of well-paying jobs to the city and a steady flow of students and young professionals across its 25-plus colleges and universities lie at the heart of these trends.
By The Numbers
According to data from CoStar Group, as of the end of the second quarter, the marketwide retail vacancy rate in Boston was just 2.6 percent. That is just 20 basis points below the historical record of 2.4 percent that was achieved in the third quarter of 2017.
Leasing activity has therefore been muted as well. Per CoStar, there has been 355,000 square feet of positive net absorption over the last 12 months, as opposed to an annual average of about 670,000 over the last three years.
As is often the case in the capitalist system, the origin of the slowdown in new projects and dealmaking can largely be traced to the top of the food chain: the lending community. Sources say that some lenders are actually truly open to financing deals for select retail assets, but those deals that are approved are subject to stringent terms in this interest-rate environment.
“Over the last several years, you had a lineup of banks ready and willing to provide term sheets and look at refinance opportunities,” says Jeremy Grossman, principal at locally based investment and development firm Grossman Development Group. “Today, there are fewer banks lending, and those that are interested in retail are requiring much tighter terms. That’s squeezing us as landlords. Fortunately, we have strong market fundamentals in New England, which banks take note of, but it’s a much tougher financing market.”
“When debt is cheap, it gives investors more flexibility on acceptable yields or cap rates to buy on,” concurs Evan Eisenhardt, senior vice president and head of leasing at Linear Retail, a retail real estate owner-operator based in Burlington. “But right now, we don’t know where pricing is going to land. Interest rates are so high; they’re exceeding some of the cap rates that are being offered in the market, so the upside on the investment isn’t there.”
More specifically, sources say that banks with retail buckets to deploy are focusing on grocery-anchored assets, outdoor lifestyle centers and value-add plays. But capital flows are similarly stunted for acquisitions, he says. In the case of Grossman’s recent acquisition of Bay State Commons, a 261,672-square-foot center in Westborough, Grossman’s plan to upgrade the property’s landscaping, signage and sidewalks played into the capital partners’ willingness to do the deal.
Fundamentals are always important in facilitating new construction, sales and leasing. But when it comes to growing the raw supply of quality retail space in the face of high interest rates and construction costs — as well as general trepidation from regional lenders ¬— they’re simply insufficient. As such, Boston continues to suffer a lack of quality retail space to meet tenant demand.
“For quality real estate, demand far outpaces supply,” says Jonathan Martin, managing director at Newmark’s Boston office. “We have been demolishing retail for years now, and we are starting to see developers look at new construction to meet demand. Sales volumes coming from retailers and restaurants continues to grow and have in many cases eclipsed pre-pandemic levels. There are also many quality operators looking to expand to Boston from other markets.”
According to CoStar, across all subcategories of retail real estate, there is approximately 720,000 square feet of space under construction in greater Boston. That figure represents just 0.3 percent of the total inventory
These numbers speak to the basic truth that in this financial climate, the underwriting process for new projects is fraught with pitfalls that can kill deals. Higher interest rates translate to lower leverage ratios, meaning developers need more equity in their capital stacks. And those capital sources are being equally cautious at present.
“To underwrite a development, certain levels of returns are required to make the deal pencil,” says Grossman. “Costs to develop retail product are at historic highs, but the income side is not moving at the same pace. So retail development is facing underwriting challenges and lack of product, both in terms of land as well as existing centers.”
Outside Competition
In a market like Boston that is exceptionally dense and compact, when rare infill parcels of developable land become available, pure-play retail projects aren’t exactly the community’s first thought in terms of usage.
Like most major cities, Boston faces an acute shortage of affordable housing. Municipal leaders, who are often judged by the levels of economic growth they generate, generally see more value in logistics or life sciences projects that can anchor larger employment clusters and create wealth-building mechanisms over the long run. Consequently, retail supply growth tends to hit the market in ancillary, nickel-and-dime manners, with little chunks of space added as attachments to larger residential, life sciences or mixed-use developments.
“Life sciences has been somewhat responsible for the lack of supply growth by taking out theater spaces in Cambridge and developable areas of Boston like the Seaport District,” says Don Mace, vice president of retail brokerage at local advisory firm KeyPoint Partners. “So there’s really not a ton of growth on the supply side — movement in interest rates has obviously made that even tougher — and what’s come out of the ground has mostly been small-shop space.”
“Rarely does it make sense to develop horizontal retail product when you’re competing for land with multi-housing, mixed-use, life sciences and logistics developers,” adds Chris Angelone, senior managing director and retail group leader at JLL’s Boston office. “So there isn’t a lot of net new retail development because the numbers don’t make sense. Every piece of retail real estate that sells does so at below replacement cost. That’s not even a factor of rising interest rates, though that has made it harder to solve for a yield on cost.”
As a testament to how much Boston needs more quality space, Mace says that the retail community is actively monitoring the soon-to-be-vacated boxes of Bed Bath & Beyond, which previously operated five stores in the metro area.
“We don’t see much in the way of big box space available inside Route 128 all the way up to the North Shore,” he says. “The stores of Bed Bath & Beyond and maybe even Christmas Tree Shops and David’s Bridal are linchpins for well-located real estate in those submarkets. There is very strong demand for those spaces, which are being pursued by the likes of TJX Cos. and Burlington, and it reflects the supply-demand imbalance we have here.”
Angelone, who specializes in the capital markets side of the sector, says that while deal velocity is unquestionably muted right now, he doesn’t anticipate a major reset of pricing based on the current bid-ask spread. The reason is the same — lack of product, or in this case, deals — to significantly move the needle.
“Everybody talks about price dislocation due to owners that have loans nearing maturity or that have higher leverage and may now be considering a sale, but there’s not a ton of those deals [in this market],” he explains. “Yes, some sellers are still looking for last year’s pricing, but they’re just not going to see it. The cost of debt is about 6 percent, and investors want to buy at pricing that reflects neutral to positive leverage. This dictates pricing today. The days of 5-cap stabilized retail are over for the foreseeable future.”
Moving Down the Chain
The internal response to hunkering down in the face of economic hardship tends to be contagious. In real estate circles, that means that when landlords feel pressure from lenders, that pressure tends to trickle down to tenants.
“Rate [hikes] hit everything, from acquisitions to leasing to longer deal cycles,” says Eisenhardt. “On the leasing front, that’s changed how we structure deals with tenants.”
As such, despite healthy sales across a variety of categories, sources say that tenants in the Boston retail market are redirecting funds away from expanding their store counts and toward investing in their existing physical spaces. And no matter the nature or scope of the endeavor, if outside financing is required, tenants and landlords alike better be prepared to wait.
“There’s still good velocity and activity in retail leasing right now, especially with convenience- and necessity-based retail,” Eisenhardt continues. “But deal times are slower, and the ways in which tenants finance their endeavors is different. There’s a lot more equity investments and landlord contributions, and some deals still aren’t penciling due to construction budgets that can inflate and can’t be financed.”
“Within our portfolio, the strength of sales on soft goods and food and beverage retailers — whether in grocery-anchored centers or retail in mixed-use environments — has largely continued to grow over the past couple years,” notes Patrick McMahon, senior vice president of regional development at Federal Realty Investment Trust. “Yet some of our tenants have had to explore additional financing options and find infusions of additional capital or find financing outside of conventional construction loans for their build-outs.”
McMahon says that unlike in the early stages of the post-pandemic recovery, tenants have not generally been hesitant to commit to lengthier lease terms. In addition, he notes that the opening period of 2023 was Federal Realty’s strongest first quarter in the company’s 60-year operating history, with leasing activity exceeding pre-pandemic levels by anywhere from 20 to 30 percent.
“We haven’t seen tenants only looking for two- or three-year terms with minimal build-out or capital outlay,” he says. “The fundamentals are strong, and there is capital available. But it’s taking more time to secure financing, and lenders are asking more questions and being more cautious due to the macroeconomic climate. And in cases in which the amount of capital from a traditional lender isn’t where it was several years ago, tenants have to go out and explore alternative sources of funding.”
“The standard retail lease is still 10 years of term with option periods beyond the initial term,” concurs Martin. “Coming out of the pandemic, shorter terms and flexible lease schedules were more prevalent, but since then, the leasing market has been very strong, and deal terms have returned to normal.”