Q&A … With Aaron Mesmer

Q: In the current commercial real estate (CRE) landscape, Kansas City’s success with industrial and multifamily has been well-documented; what is near- and mid-term expectations for other markets, such as office and retail?
A: They’re all related, but CRE covers four different primary property types, and each impacts the other. If your retail purchase is from an Amazon warehouse, for example, there is another a real-estate effect on industrial. There are a couple of factors that have played roles in retail and office that kind of make those less scary than everyone has been predicting. Certainly, I think the Class B and C office will struggle. The world has just changed in the way people use office space. I also think there’s a growing consensus among folks I talk to that there’s some benefit to having flexible working arrangements, but there are also times when you do need to get teams together in person to really communicate and do higher-level tasks that require more input.

Q: What have you seen occurring in the office market that makes Kansas City somewhat unique in the commercial realty space?
A: Even before the pandemic, I think the new construction in the Kansas City office market was restricted to a certain degree by the “Sprint overhang.” A huge amount of space was coming available that scared most developers away from building speculative office space. Now, you see the Cerner effect with the same result. I think that really slowed down our supply side more than if that had not been out there.

Q: The U.S. lifted its pandemic-related travel restrictions last month, but the after-effects will be felt for years in commercial real estate, especially office. What are your expectations there?
A: I think companies are still trying to figure things out; nobody is out there with a magic formula. It’s going to be different for each company as to what their culture and their work product requires. To use our company as an example, we can probably do monthly property accounting from anywhere. Collect the income, pay the bills and do the money monthly report on a property at home. Where you are matters less. However, to process a cost-segregation study, or to upgrade your tech on the back end, like integrating a new tool on your accounting software, for example, that’s hard to do remote. And it’s more difficult to train people remotely, for example.

Q: What does that dynamic look like across the broader market?
A: Well, there’s a lot of trial and error still going on. The world today looks different than it did in 2021. Some segments are growing rapidly, some are shrinking, some are stagnant with how they use space. Some are culture heavy, some not. The one thing I think I do know is that construction costs related to making big changes within office space, how you use it and map out different work stations, etc., has become very expensive.

Q: The consequence of that being …
A: People are trying to be very intentional about space planning. If they’re looking at a lease for five, seven or 10 years, they don’t want to spend $85 a square foot to redo a space and be stuck with something that doesn’t work for the next 10 years. That’s a bad bet. If you miss on the short side and don’t have enough room, and they do want people to be back in the office, that’s as much of an issue as overbuilding and people not using that space the way you’d planned.

Q: Any noticeable trends in office space usage?
A: Some. We saw one group in a 20,000 square foot space downsize to 9,000, but when you look at what came they out of and what they moved into, the new space was much nicer, much more functional, and they had the ability to do what they needed to. We expect there will be more changes, with a disproportionate impact on the B and C office space, partly because the costs of tenant improvements are so high. If you can’t get Class A rent, it’s difficult to justify the costs of retrofitting the space.

Q: Retail, of course, was in a transformation even before the pandemic, but has that all played out?
A: There has been so much published about its decline, and not many new stores or centers have been built, but if you look at the landscape, a lot of retail out there on 100 percent corners is actually pretty healthy. We’ve seen some retailers traditionally online starting to study sticks-and-bricks locations.

Q: That seems to be a significant shift from the moves we’ve witnessed in favor of on-line retailer  dominance.
A: An article in The Wall Street Journal recently talked about Warby Parker, traditionally online, hoping to open up to 900 stores to go omnichannel with delivery. Warby’s 200 stores today have already grown to make up about 60% of the company’s revenue, so they, along with many other traditionally online stores, are looking to add brick and mortar locations. Online retailers have recognized the need for that presence as a way to enhance the brands, but also to cover all the bases. The Warby customer buying glasses in person wants the exact fit and look; they’re not just after a pair of readers for the bedside. It’s something they find value in. Cushman Wakefield recently reported shopping center vacancies at 5.6 percent, their lowest levels since 2007, which indicates the strong corners are quite healthy.

Q: So is the transformation there more adaptive reuse relative to new?
A: There’s not a lot of ground-up construction, not outside of projects like Bluhawk located on logical traffic nodes. We’re seeing a focus on older developments incorporating more entertainment, medical, or some type of office/housing mix. Retail is still trying to find the secret sauce there, but retail tends to be well-located so they are having success in redevelopment.

Q: The multifamily boom, it was said, couldn’t last forever. But it sure seems to be trying.
A: Multifamily is simple: When people are employed, they’re forming households, the population is growing, there is demand for housing. When mortgage rates go form 3.5 percent to 6 percent, though, fewer people can afford to purchase a house. The demand is there, but I think the rate movement will increase the number who decide to rent for a period of time. With our Class A properties, the biggest reason for leaving is purchasing a home. In 2022, our Class A renewal rate, typically about 55 percent, increased to 70 percent when the market mortgage rates changed.

Q: What’s the downstream effect of that on single family?
A: The mortgage rates changed, and a lot of people potential buyers are hanging on longer, maybe waiting for the market to soften. And sellers are probably sitting on a low-rate mortgage and reluctant to replace that with a higher-rate loan. If you refinanced three years ago, you’re not motivated today to sell, even if you need space or a change of venue. If looking for a small change, you really have to think about that. But given the cost of construction and low motivation from sellers who don’t want to lose those low rates, that’s restricting the availability of for-purchase homes. And that will, in some ways, create more demand for multifamily.

Q: How is the Fed’s move to fight inflation with higher rates impacting all of those segments?
A: Interest rates impact CRE in two ways. The first is your capitalized interest on new development. For example, if you assume during a two-year construction period the rate would be 4 percent, but now it’s 7 percent, and the average loan balance over that period is $30 million, you just added 3 percent annually. That’s $1.8 million of additional project cost. So there’s a real up-front cost to higher rates.

Q: That second impact?
A: While nobody wants to pay $1.8 million more for the same thing, the more significant impact is on cap rates. Say you own a property and that cash flow is $400,000 a year at a 4 percent cap rate. With where rates were last year, that’s a $10 million property value. Using that same income, changing nothing on property operations, but now with a 5 percent cap rate, it’s now $8 million value. That 1 percent change in the cap rate reflects a 20 percent back-end devaluation. That, more than the upfront interest carrying costs, is what has made developers really think about whether they want to move forward on a new project. Pricing on the back end is lower, so there’s less margin for error on the development side. 

Q: And on the operating side?
A: Rates impact your ability to generate cash flow from existing investments. If you have a rate at 4 percent that matures next week and you go back to 5-1/2 or 6 percent, you’re getting less cash flow. Your fundamentals might be great, especially in industrial and other sectors that are doing well, but you’re still getting less cash flow. Those are the impacts you see from changing rates. There’s a lot of anticipation about where rates will go, especially the federal funds rate. With the yield curve inverted today, it tells us that Wall Street is betting on rates coming down again in the future.