Back in the bad old days of mainframes, “Time-sharing” was how computing power and database storage were provided to the large corporations that could afford it. Computing was less the purchase of goods than a service.
The modern cloud-based era has seen the rise of “Software as a service” (SaaS).1 This approach was based on the idea that it was more cost-effective for the consumer and more efficient (and profitable) for the provider to offer computing operations as services instead of physically distributed goods.
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Since the pandemic ended, it has been obvious that the flexibility of “Work from Home” (WFH) and its preference among many employees was not going to end. The results have been office buildings operating far below historical average occupancy rates, resulting in a significant fall in value for commercial real estate (CRE). The resulting impact on CRE land and liabilities is a risk factor for the banking sector, and potentially a threat to the broader economic system.
The response has included upgrading buildings to modern class A levels, extending loan provisions, and converting office buildings to residential spaces. So far, these have achieved only mixed success.
I want to float a new concept to CRE owners: Retail as a Service (RaaS).
In the pre-2020 seller’s market, building owners found ways to make nearly every square foot of CRE property profitable. Not just the upper floors that tenants rented, but the ground floor retail as well.2
Rents charged by the building were dependent upon the flow of traffic of tenants. A fully occupied office tower could be counted on to provide enough foot traffic to support a retail store, coffee shop or restaurant. Low vacancy rates not only allowed for higher overall office rents, but that in turn made the non-office spaces attractive to tenants.
The current era has demolished that model.
Retail is a tough business in the best of circumstances; costs are high, profit margins are razor thin, and the vast majority of new stores and restaurants fail to survive two years. In prior circumstances, the biggest threat was the state of the economy. But in the current era, when foot traffic is reduced anywhere from 10% to 40%, the businesses are guaranteed to fail.
This is true for the small shops that rely primarily on a building’s tenants, as well as the larger restaurants and chain retailers that rely on the entire neighborhood as their clientele.
Unattractive or missing ground floor tenants reduce the desirability of any office building to both new potential renters and existing tenants re-signing their leases. It creates a negative image for the building, leading to reduced occupancy rates and lower overall rent rolls. As building values fall, it creates a negative cycle that can be challenging to break.
Worse still, it raises the potential for higher crime rates, further damaging property values. Walk through any urban neighborhood that has below-average office vacancy rates, and it looks like you are in an era of economic depression. It’s a variation of the “Broken Windows theory” – visible signs of economic distress lead to crime, antisocial behavior, and civil disorder. This creates an urban environment spiraling downward in a vicious cycle.
Retail as a Service is a means to halt this problem.
The idea is that attractive ground-floor retail stores and restaurants drive foot traffic and activity. They raise the desirability of an office building, increasing its rent rolls and value. However, the challenge of reduced foot traffic requires a dramatically different approach, one that includes substantially reduced rent to ground-floor tenants.
This requires a major change in perspective. For many years, ground floor retail were profit centers. Building owners today need to rethink those spaces as marketing expenses. This will not just help specific buildings but will give a boost to neighborhoods in their entirety.
These challenges were a long time in the making. Retail has been challenged by online shopping since the late 1990s. And the technology that has made WFH possible has been around for over a decade. The changes that took place in where people worked and shopped weren’t created by the Covid-era, they were merely accelerated by it.
The status quo – high rents for ground floor spaces, significantly reduced office occupancy rates – is obviously unsustainable. Fixing this is going to require wrenching changes, including a rethink of the basic CRE business model.
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There is an interesting parallel in the language of SaaS and CRE: Described as “multi-tenant architecture” with customers as “tenants,” it very much borrows jargon from real estate. Now CRE needs to borrow some of the efficiencies and cost savings of SaaS.
Work from Home has created very specific challenges for CRE. It is hard to imagine we are ever returning to the occupancy rates that existed pre-2020. Hopefully, commercial real estate owners and their financers are up to the challenge of creating innovative, productive solutions.
Retail as a Service is a promising part of those potential solutions…
Previously:
WFH vs RTO (February 16, 2023)
Of Course WFH is “Really Working” (March 29, 2023)
Back in the Saddle (May 4, 2021)
Sorry, We’re Closed (March 13, 2020)
See also:
Why NYC Apartment Buildings Are on Sale Now for 50% Off (Bloomberg, February 4, 2024)
60 Minutes on Commerical Real Estate (CBS, January 14, 2024)
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1. That subsequently allowed for Infrastructure as a service (IaaS) and Platform as a service (PaaS).
2. Some building owners found they could even use auxiliary floors such as basements or 2nd floor, which did not work well for office tenants or retail, but might do well as a gym, yoga studio, or classroom.
