Today, we are featuring a guest article on the complicated reasons for residential and commercial vacancies, even in booming cities such as Washington, DC. It was originally posted on Greater Greater Washington, and it is reprinted here with permission.

4982 Elm Street in downtown Bethesda went vacant when Ten Thousand Villages closed in April 2017 (top). The space was vacant for one year, until a Club Pilates location opened (bottom). Top image is a screenshot from Google Street View; bottom image by Daniel Warwick. Composite by the author.

4982 Elm Street in downtown Bethesda went vacant when Ten Thousand Villages closed in April 2017 (top). The space was vacant for one year, until a Club Pilates location opened (bottom). Top image is a screenshot from Google Street View; bottom image by Daniel Warwick. Composite by the author.

In an area like DC where the population is growing, one question often vexes neighbors: why is that house or storefront vacant? It just doesn’t seem to make sense. Why do landlords leave properties empty when they could be getting rent?

Land Speculation and/or (Re)development

4620-4624 Wisconsin Ave. NW in Washington's Tenleytown neighborhood is currently vacant while UIP works on redeveloping it. It might be vacant for a long while, as some neighbors are challenging the PUD permit in court. Screenshot from Google Street View by the author.

For both residential and commercial properties, the answer might be land speculation. In a market like DC, it's not uncommon for the land underneath a building to be more valuable than the structure itself. If an investor has purchased the land and is holding it for future redevelopment or sale, they might not want the property encumbered with a tenant.

It might seem ludicrous that there are investors out there with so much money that they can just hold assets like that without putting them to work in the interim. However, all forms of property management and land use have costs, and depending on the condition of the building and the land, the costs of putting it to work might be greater than the potential rental income—even something as marginal as a surface parking lot on a vacant parcel.

Sometimes it's as simple as the fact that the owner of the building may have had it for a long time and paid off any mortgage. The cost to hold is minimal, so vacancy doesn’t feel urgent. Or, the owner has passed away, and the home or storefront is now owned by 16 grandkids who can’t agree — or can’t even be found.

Commercial Leases Are Long

Commercial property leases tend to be much longer than apartments. You might think of a two-year lease on an apartment as a long commitment, but office and retail tenants tend to sign for five to 10 years. This partly reflects the risk involved in commercial property management, as well as the preference of the tenants in having a sense of permanency.

Office tenants sign the longest leases. According to data from CBRE, Inc., a major commercial real estate brokerage firm, the average office lease term in the Washington region is 11.2 years since 2013. (Full disclosure: Michael is an employee at CBRE.)

Retailers also want to signal a long-term commitment to their customers in a community, so it is not in a retailer’s interest to move from location to location frequently. You could imagine how difficult it would be to find a business on Google Maps if they were moving every few years, and the consequence is that retail leasing tends towards long terms.

This brings the average lease term for retail to 7.9 years since 2013, although it is ticking up to 9.6 years in 2018 as commercial property owners try to minimize risk. Also, restaurant leases tend to be 10 years while retail leases tend to be five years, so the recent uptick in average lease terms can be because we’re seeing more restaurant leasing in 2018.

Retail Leases are Unique

In urban areas like DC, retail often comes in the form of mixed-use development with offices or apartments above, and retail below. This makes retail often an accessory to a larger office or multifamily development, and creates a chicken-and-egg problem. Many retail tenants do not want to commit until the office or apartment spaces are leased and establish a customer base, which may hold back the financing of a project.

This is one of the many challenges that makes mixed-use, smart growth developments difficult because the financing is increasingly complex. Later on, when a office building is being slated for redevelopment, the owner may choose to leave the retail portion vacant to not commit to new leasing while they await the move-out of a major office tenant.

Secondly, retail tenants are highly particular in their location choices, so developers and landlords go to great lengths to “curate” retail environments. This means that more and more, retail corridors try to find a very specific mix of retail offerings. A landlord might struggle to attract a restaurant because the adjoining retail is not suitable to that specific tenant, or a specific shoe store might want to be close to specific clothing shops that cater to a specific market segment. This might result in a landlord waiting out for the “right kind” of retail tenant, rather than committing to the first tenant that comes around, which might not match the retail environment.

Finally, some retail leases include clauses like “right to go dark” and termination or “kick-out” rights. Right to go dark means that if a retail tenant, like a bank branch, chooses to close that location for business reasons, they can close their operation while still finishing out their lease. In these cases the tenant still is paying the landlord their rent, and while the community might see a vacancy, the space is still “leased” even if not active.

In a kick-out termination clause, the landlord may terminate a lease for lack of performance on the part of the retailer. Some leases are written as “percent rent,” meaning the rent is based on sales, and blended leases are increasingly common.

“Retail leases are diversifying,” according to Melina Cordero, Americas head of retail research at CBRE. “You’re seeing more blending and staggering rents where the lease term changes every few years. So the challenge with percent rent is that as more sales go online, you’re not capturing that in store sales.”

A lack of performance with a kick-out termination clause might lead to a vacancy.

Retail Gentrification and “National Credit Tenants”

Recent trends in retail have negatively converged in some neighborhoods. Online shopping is growing at a rapid pace. On top of this, major back end changes to the logistics, technology, and marketing that support street retail that are invisible to consumers can be seen in the rise of chains and franchises, which typically pay a higher rent per square foot than a local retailer.

This “retail gentrification” is further exacerbated by the fact that it’s standard practice for lenders to offer better terms to developers with national credit tenants, because not only do they pay more rent, they are viewed as less risky. Increasing foreign equity investment in American real estate also means that the landlord might be far away, and multinational chain brands are what they know.

At Park Place Apartments at the Petworth Metro station, one storefront has been vacant since the building was delivered in 2009. (Base images from Google Street View.)

Other times, landlords are simply used to a certain rent level from high-end retail chains like a Marc Jacobs or even Gap. If the market changes, the landlords sometimes may hold out in expectations of higher rents. Behavioral economists would call this a combination of “loss aversion” and “anchoring,” where landlords index their expectations based on past experience.

“Sometimes owner expectations lag behind market fundamentals,” says Lisa Stoddard, executive vice president at CBRE. “Our job is to make sure we educate our landlord clients not only on real time market conditions, but industry trends as well. Both are very fluid and important to understand as we are presenting merchandising strategies and deals."

Some cities have tried to punch back on the smothering blanket of chain stores by limiting or banning them. The bad news is these policies have for the most part also harmed local retailers and exacerbated vacancy.

Financialization of Real Estate

F1RST Residences is a new 325-unit apartment building in the Capitol Riverfront neighborhood. Screenshot of F1rst Residences website from August 21, 2018 by the author.

The financialization of real estate means that some of these properties are constrained by pro formas that require them to get a certain rent or default on their construction loan, or jeopardize their ability to refinance. This is common across all forms of income-producing property, including both commercial real estate like office buildings and residential product like multifamily rental apartment buildings.

The valuation of a building, and thus how much a bank will loan you on it, is based on the rental income. If your rents go down, your valuation goes down. There's no such thing as "one month free" rent, only a fragile financing bubble that allows the building's owner to show leases with a higher rent on them and then charge tenants less.

This picture is further complicated by the embrace of real estate and infrastructure as asset class by portfolio landlords and equity investors. These finance giants can write off losses from one part of the portfolio against profits from another, increasing tolerance for vacancy.

Buildout Problems

Not all “mixed-use” developers have the motivation or expertise to build useful and/or manage profitable commercial storefront spaces. Many residential developers are building “mixed-use” simply because local zoning requires first-floor retail. This means that in some new construction these days, the spaces they build on the first floor may be too big, or require too much buildout to be useful commercially. A typical landlord might offer $20 to $50 per square foot in tenant improvements to build out the space, known in the industry as “TI” (not the rapper).

Facade improvements to brand storefront faces like these in Reston Town Center are an example of tenant improvements (TI) that are often paid for by the landlord. Image by Canaan Merchant.

On a 10-year lease, the low end is equal to $2 per square foot annually, and the up-front sum would be $200,000 on a 10,000 sq. ft. space — about the size of a Nike store. Retail rents in DC hover between $45 to $50 per square foot annually, so TIs can actually be a high up-front cost to the landlord.

On the one hand, TIs are a way for landlords to give concessions without actually lowering quoted rents and thus the building’s valuation. On the other hand, small or inexperienced commercial landlords may be completely unprepared to meet the current expectations of tenants on the market for five or six figures in TI.

The buildout challenge does not just apply to new construction. In an older building, a retail space that might have thrived a generation ago as a small grocery or a furniture store might now be viable only as a restaurant — but it can cost $50,000 or more and months or years of permits and construction to install a commercial kitchen and additional bathrooms.

Or, a building that had a grandfathered use and occupancy permit for a long-time tenant might lose that tenant, and now the building has to be brought up to code in order to be rented. That might mean five or six figures in behind-the-scenes work like ventilation, sprinklers, and elevators before even getting to the buildout costs the tenant might want, like facade improvements. These costs are often prohibitive to occupancy in all but the most lucrative markets.

Vacancy harms communities, so what do we do?

In communities with high concentrations of foreclosed homes and/or a housing shortage, residential vacancy is particularly frustrating when banks don’t maintain, rent out, or sell the homes, instead allowing them to slowly decay for years. When the house next door looks haunted, that hurts the curb appeal of your home, affecting its resale value. You can’t borrow a cup of sugar from your neighbor. Vacant homes are at risk for vermin infestations, fire, and squatters.

Real estate is cyclical, and these banks are attempting to wait for the market to recover from the 2008 housing crash. At this point, however, it’s been 10 years. They might not want to wait much longer.

This slowly decaying bank-owned vacant home in Mount Rainier, MD is no one’s favorite neighbor, unless you know the Secret of NIMH. Screenshot from Google Street View by the author.

On the retail side, vacancy means lost sales tax revenue for the local government, lost agglomeration/foot traffic for neighboring retail, and lost amenities for the neighborhood, as well as the harm to security, walkability, and curb appeal. Even office vacancy is arguably harmful, as it reduces the market for the adjacent retail.

Communities nationwide are pushing back on high and persistent vacancy. DC charges a higher property tax rate on vacant houses. I (Tracy) introduced model legislation (the first of its kind in Maryland) to do the same in Mount Rainier, Maryland in 2017.

Many landlords argue that taxes penalizing retail vacancy in particular don’t help solve the fundamental problem of retail oversupply in many communities in the US, a problem created in part by zoning that in many cases mandates construction of the retail and then under-caps the density needed to support it. Instead, landlords argue that if what communities truly want is vibrant retail, they need to give the sector more time to try new retail strategies, like popups.

While in many cases it feels like these two “sides” are talking past each other, each has legitimate points to make. If it was easier to permit and build things, developers would not need to attach these high fixed costs to economies of scale and could do more incremental projects. On the other hand, if access to capital was more progressive and distributed, then local entrepreneurs who already know their communities would have more opportunities to fill vacancies.

Ideas for how to solve the paradox of urban capitalism are not new. What’s missing is the political, philanthropic, and social will to scale them.

About the Authors

Tracy Hadden Loh loves cities, infrastructure, and long walks on the beach looking for shark teeth. She holds a Ph.D. in city and regional planning from UNC-Chapel Hill. By day, she is a data scientist at the Center for Real Estate and Urban Analysis at George Washington University. By night, she is an activist, a law enforcement spouse, and the mother of a toddler. She served two years representing Ward 1 on the Mount Rainier City Council in Prince George's County, MD.

Michael Rodriguez, AICP is Leader for Market Research and Insights at CBRE, Inc., and visiting Director of Research at Smart Growth America. He focuses on transit-oriented design, walkability, housing, and the economic impacts of infrastructure decisions. He is also a PhD student at the GWU Trachtenberg School of Public Policy and Public Administration, focusing on urban policy of agglomeration economies. He lives in Tysons, Virginia and walks to the Metro.