What’s With the Vacant Storefronts? 8 Reasons for Empty Commercial Spaces
This article was originally published, in slightly different form, on founding Strong Towns member Seth Zeren’s Substack, Build the Next Right Thing. It is shared here with permission. Images were provided by the writer.
There are many aspects of real estate that appear senseless, wasteful, or even cruel to those uninitiated to our dark arts—but when you peel back the structures and incentives, they turn out to be rational for the decision-makers (even if less than ideal for society at large). One such phenomenon is the recently completed urban mixed-use apartment building whose ground floor retail sits vacant for years after the apartments are fully leased up. What gives! Why is everyone so wasteful? Or stupid? Are the developers to blame? Amazon and e-commerce? Or was it city planners or neighborhood advocates that made the developers do something dumb?
Strong Towns board member Andrew Burleson recently wrote an excellent summary of the “extend and pretend” phenomena, where “in many cases, lowering the rent on a building will force the bank to foreclose on it.” I couldn’t explain it better, so you should go read his piece and come back after.
But extend and pretend generally only applies to a portion of the real estate industry, which we might call “corporate” or “institutional” or just “the big boys.” It is a function of the particular characteristics of financialized, leveraged real estate as a financial product. There are other (often compounding) reasons why storefronts sit vacant. Better understanding the logic behind those other situations can hopefully help developers, advocates, and regulators build better, more successful mixed-use districts in the future.
But first, a little bit about my bona fides. I have been a real estate developer now for about 12 years (commercial and residential, with roles in property management, development, construction, leasing, and now a partner in our firm). Prior to that, I was a zoning planner for a city outside Boston. I have been involved in one way or another in completed projects exceeding $200 million and we have several exciting projects in the pipeline. I don’t come from money, so I’m bootstrapping my way with partners and other people’s investments. I am a licensed real estate broker and Realtor, specializing in commercial leasing. I lead our firm’s in-house leasing for around 350,000 square feet of commercial space in Providence, Rhode Island, which is about 95% full right now. I am more than an apprentice, but I certainly don’t know everything. The longer you work in this crazy, complex, and dynamic field the less you feel that you confidently know. But I know a few things that may not be obvious to folks who don’t have experience inside the industry.
In addition to the “extend and pretend” pricing dynamic that Andrew highlighted (which is definitely real), I’ll try to give a taxonomy of other reasons a storefront might sit vacant, applying to both professionally new built and legacy storefronts.
1. They Don’t Really Care
It is fashionable in planning, architecture, and urbanism advocacy circles to expect new infill projects to include ground-floor commercial space. This stems from the true observation that all great cities have a lot of ground-floor commercial space and from more particular observations by Jane Jacobs about the value of mixed-uses in neighborhoods. So projects may be required to provide commercial by zoning or to satisfy elite opinion (city council, mayor, advocates) or angry neighbors. But the developer may be including retail only because they are required to, and they may underwrite the value of the commercial at ~$0 in their internal proforma. However, because it will help them get a larger loan, they are very happy to include its putative rental value in their valuation to the bank (hence the extend and pretend phenomena).
Basically, they are making all their money upstairs with apartments or lab space or whatever, and they basically don’t care. The company may only really do residential or office or whatever and have no internal competency with retail. Now because the retail is an afterthought, you get our second problem…
2. Architecture That Misses the Market
As an afterthought, the retail spaces in a building tend to be poorly designed. The biggest problem I tend to see is that they are too big for the market. You’ll have a 3,500-square-foot restaurant space in a market where 2,000 square feet is what works (a smaller restaurant for fewer customers with less staff and other overhead). Operators who don’t have a lot of experience with commercial leasing and are being pressured to add ground-floor retail may think it’s easier to manage fewer tenants.
They are also not designed to be easily (cost effectively) subdividable (doors, plumbing in the wrong places, combined HVAC and electric panels). The building looks good in a rendering or from the highway, but up close the storefront architecture lacks any character or detail and can feel soulless to prospective tenants. The options for signage are weird. There is too much glass, or not enough. And so forth.
Basically, it’s not very good space–and the owner has underwritten it as top of the market rents… So why would anyone do that deal? But you’re not even getting calls because…
3. Marketing that Misses the Market
Again without any internal capacity for commercial, the large developer relies on third-party commercial brokers, typically national companies with brand recognition. These companies are well connected in the world of “credit” tenants — a big company or wealthy individual who you can be certain will always pay the rent — and they can help you land a Starbucks if they are looking in your market. But they are generally not effective at recruiting all the fun quirky (non-credit) businesses that make a mixed-use district great. There are some exceptions, but they are small boutique regional firms.
Other than hanging a sign in the window and posting the space on their website, the big boys won’t do much to market the space. You’ll basically never see them post to Craigslist, where our company actually draws a lot of new-entrepreneurial tenants from. They are generally not getting word-of-mouth calls and emails from artist or bar or restaurant networks. But even if they did, the bad design situation means that it’ll be hard to come to a deal, for a few reasons…
4. Tenant Improvements Are Costly
When a developer creates a storefront space, they don’t typically finish it all the way. After all, they don’t know what a future tenant will need in the space and don’t want to waste money building something that they will tear out in the future. There are several tiers of completion a developer could achieve (with gradations in between):
Cold dark shell — no fit out; no HVAC; no lights, just an electric panel. Basically just walls and structure, maybe not even a floor. The least work for the developer, and the most work for a tenant to finish.
Warm shell — as above with HVAC, plus some lights and electric plugs.
White box or Vanilla box — walls finished for paint; HVAC and electric, including some distribution; probably even a finished bathroom or two. The most investment for the developer upfront, but the lightest lift to finish.
As part of a lease, there’s a negotiation between the developer and the tenant on who is responsible for what parts of the buildout. Developers may provide an additional “tenant improvement allowance” (“TIA”) to help the tenant finish building out the space. This, combined with brokerage fees for securing a tenant, can be quite large, easily $100,000 or more for larger spaces. (Meaning the developer needs to get a high enough rent to pay the cost of leasing on top of the base cost of building the space — i.e. Leasing more is often not good for cash flow that year.)
5. Lease Term Ties You Up
The tenant is also likely to spend tens of thousands or often much more on finishing their space with kitchens, nicer bathrooms, lighting, HVAC distribution, flooring, paint, light fixtures, counters, tables, shelves, chairs, etc., etc. To make this big investment in money and the tenant’s own time, sweat, and tears, they want to know they can stay in the space for a long time. Depending on the business, that is often five to 10 years of lease term. This is a big, long-term commitment to each other.
6. Option Value Matters More Than Rent
In agreeing to a long-term lease like that with a tenant, the developer is giving up what we call option value, essentially the possibility that something better will come along during that period, or market rents will go up faster than what you’ve agreed to, or interest rates could surge, or any number of other risks or opportunities. You’ll feel pretty dumb if next year Starbucks is in the market and you just leased that space to a small mom-and-pop that might not make it and is locked into a lower rent for 10 years.
In some cases, as we’ll see below, the option value includes potentially tearing down the building and redeveloping it or selling it to someone, either for their own use or for them to redevelop. Long-term leases greatly reduce the attractiveness of a property for those opportunities.
And it’s actually worse than that because in principle, while you can’t kick out a tenant on a long-term lease, they can certainly close up and declare bankruptcy, and how likely are you to get your rent at that point? And still worse, the tenant’s buildout may be so custom that any new tenant needs to rip it all out and start over again.
Together, tenant improvements, lease term, and option value mean that sometimes leasing the space incurs more direct costs (and forgone opportunities) than you’ll get back in rent any time soon, especially when multiplied by the risk the tenant will fail. Therefore, it’s economically rational to leave the space vacant.
7. Obsolete Space Is Harder to Rent
Now we’re getting out of the realm of the shiny and new. There are many storefronts that are kinda functional but basically “obsolete.” They may be leasable as a sketchy cellphone repair shop but are unable to secure high rents without major upgrades. (Having a certain amount of these buildings in the market is good for your economy, though, because this is the cheapest space there is going to be.)
To make it nice again, you need to repair or replace the storefront, install new HVAC, upgrade the electrical service, repair the floor (including that soft spot in the structure), upgrade the fire alarm, deal with the water in the basement, fix the drain line so it doesn’t back up, etc. That's $100,000, easy.
You can either keep collecting a modest rent from folks who don’t demand stuff, or you can engage in a major costly upgrade. Which brings us to another major archetype in commercial real estate, the long-term mom-and-pop owner with low or no leverage and a fully depreciated building…
8. Low Debt and Cash Flowing, So Why Change?
There are lots of buildings that have been in a person’s or family’s hands for a long time. They have little or no debt on the building. They do only minimally necessary maintenance. The building isn’t assessed highly and the taxes are low. The building might only be half full, but with few expenses it’s “cash flowing” well. The owners may be living on the cash flow without big savings set aside for improvements. Upgrading the building to get better rents or just make gross spaces leasable means spending money now to get more someday. The owners may be older and won’t live to see the benefit. So, the building sits, and they can live with a progressively declining quality of tenants. Rents may even go down adjusted for inflation over time. But with little debt and low taxes, there’s nothing making them change course. If they are thinking about selling the building to a developer someday, they may even prefer to keep spaces vacant, progressively emptying out the building and then waiting for the “make me sell it” offer to come along, so they can retire and move to Florida.
This is not an exhaustive list, but I hope it helps folks understand some of the many dynamics that go into persistently vacant storefronts. Please share more examples in the comments!
I think these vacant storefronts are a problem. (I also don’t think every building must be mixed use. There’s a lot of value in simple buildings that are either all residential or all commercial.) But we’ve had mixed-use buildings since antiquity all around the world; it’s not rocket science, and we should be able to figure it out again. If you agree that neighborhood stores are important for a healthy neighborhood, we should be looking for strategies that might start to change these dynamics. I’ve got some ideas that I’m working on. But that’s another piece, for another day.
Want to hear more from Seth? Join us at the National Gathering in Providence, June 9-11! From walking tours and presentations to debate nights and food trucks, there’s something for everyone. Get your ticket before spots run out.
Seth Zeren is a recovering city planner turned neighborhood developer, advocate, and educator. Seth is a founding member of Strong Towns and occasional contributor over the years. He grew up in the San Francisco Bay Area before moving to the East Coast for college and settling down in Providence, Rhode Island, where he lives with his wife and two young kids. He writes at Build the Next Right Thing.