Commercial Real Estate: Shrinking to Fit

We are going to need less commercial real estate in the future, at least on a per-unit-of-population basis. Advances in communications technology are causing profound and sometimes unanticipated changes in our lives.

Retail Markets
The coming change is most obvious in retail markets. Americans are increasingly shopping online. However, we’ve really just started to scratch the surface. According to the U.S. Census Bureau’s 2009 E-Stats report issued in May, 2011, E-commerce only accounted for 3.99 percent of U.S. retail sales in 2009.

I was surprised at how small that number was. Certainly it is higher now, and the 2009 number was almost double 2004’s 2.13 percent, but there is huge room for increased internet retail sales. This is a growth business with a capital G.

Originally, I believed that traditional brick-and-mortar retailers would have the advantages of customer service and product knowledge, and internet purchasers would be product-savvy shoppers looking for products that they already knew about. That has turned out not be the case at all.

It is true that the initial internet retail sales successes have been in products where technical knowledge is not critical, and tastes are well established; products such as music, movies, and books. However, online retailers have made impressive gains in providing customer assistance to shoppers looking for more technical products.

Ratings of products and retailers were an initial step, along with detailed technical data. More recently, internet retailers have added chat windows, some with pictures of the salesperson. It won’t be long until voice or live video are offered, if it isn't already.

It is now the case that you are more likely to find more informed assistance on the internet than you will from a brick-and-mortar retailer. This is not to say you can’t find good assistance at a traditional retailer. But your online experience is likely to be better than what you will receive if you walk into a store and deal with the first person you bump into.

As internet sales increase, expect to see fewer traditional retailers and less demand for retail space. Already, shopping centers anchored by a music store, a video store, or a book store have felt the impacts. This is only the beginning.

Commercial rents will be softer and vacancies higher in large regional centers and in neighborhood strip malls. This will tend to drive retailers to ever larger centers with more traffic. Smaller centers will likely slowly deteriorate and die. In the end, we'll have fewer retail centers, but the average center will be larger than it is today.

Office Markets
While the number of workers telecommuting is still small, it is growing; someday, it will be very large. Initially, the growth in telecommuting was driven by workers’ desires to physically commute on fewer days. Today, the initiative is changing to employers.

Companies that adapted to telecommuting employees began to learn how to supervise these workers. Some companies have gone further. My son works for a company that has closed many physical offices, but kept most employees. Everyone was told to telecommute.

For companies that have made the strategic decision to reduce office space, the advantages must be large. Certainly rent goes down, but other expenses go down too. Heating and cooling costs go away. The company no longer needs to support a local network, with the local network’s support costs.

I haven’t seen research on telecommuters’ productivity, but it is easy to imagine it increases. Think “happy employees are productive employees.” It is also easy to imagine that productivity decreases. Think “unsupervised employees are unproductive employees.” Clearly, telecommuter productivity is the key to profitably running an office-free operation. As someone once said “any job performed on a computer can be performed anywhere.”

The lower demand will result in lower office space rental prices and higher vacancies. Again, this should lead to office-dependent operations migrating to the better addresses. In the end, the less-desirable buildings will be empty.

Industrial Markets
We’ve seen the huge increase in overseas manufacturing, and we’ve seen the steady decline of U.S. manufacturing jobs. That is just the first stage of a profound transformation in the way things are produced. As the song goes., “You ain’t seen nothing yet.”

Manufacturing’s future is nicely exemplified by three-dimensional printing. Today, you can Google “three dimensional printing” to find links to videos of three-dimensional printers producing amazingly complicated products, or find companies that have three-dimensional printers. Or you can use a three-dimensional printer to produce something.

I expect the growth of three-dimensional printers to be something like what we saw with copy machines. The first copy machine I used was in a drug store, and it was coin operated. Then, the banks made them available to customers. Today, we all have at least one in our home and one at the office.

The day will come when three-dimensional printers will be ubiquitous. You will download instructions for products from some company like Amazon. Then you will produce your good, without the need for an industrial building or a brick and mortar retailer. Producers of products that can’t be printed will print parts, reducing the demand for other producers, inventories, and shipping.

Any Growth Areas?
Buildings associated with providing healthcare may be the major exception to declining commercial real estate demand. The aging population, new technology, and long-term wealth trends are likely to continue to drive growth in the economy’s only sector that has grown consistently throughout the recession. At least so far, technological advances in medical care have increased demand for space instead of decreasing it.

Specialized R&D space may also buck the trend. Many of these facilities can be specialized, however, to the point of being profitably used by only one company. That implies that these buildings are risky investments.

Policy Implications
The decline in commercial real estate demand will pose serious challenges to governments. We’re already seeing states and local governments struggle with loss in retail taxes from internet sales . Declining revenues are just the beginning, though. Expenses will increase.

Empty buildings generate crime. In the case of retail centers, the crime will be very public. Nearby residential property values could decrease, with additional lost revenue to governments. Residents will not stand idly by. They will demand effective action — action that could be very expensive.

To minimize the fiscal damage, local governments will need to be nimble, a characteristic that few governments possess. They will need to be willing to change zoning codes to adapt to the decline in commercial real estate. They need to allow owners of existing space to redevelop or change their product mix. They may need special tax districts to deal with the blight created by vacant properties.

Growing population and an eventual real recovery will eventually fix the residential real estate problem. Commercial real estate’s challenges will not be so easily addressed. The impacts are not only on owners, developers, and contractors . All of us will be affected. The time to plan for those changes is now.

Bill Watkins is a professor at California Lutheran University and runs the Center for Economic Research and Forecasting, which can be found at clucerf.org

Photo by Mark Lyon -- Full Floor For Rent.