Retail is a process of reconstruction, but some key aspects of the industry remain

John McNellis

John McNellis helps manage McNellis Partners out of a beautiful Victorian house in Palo Alto that has been converted to office space years ago. The setting speaks volumes about the firm’s philosophy–always at the center of activity but doing things in a tried-and-true way. McNellis has been a valuable and affable partner of ours. His contributions to the Bay Area real estate narrative have been invaluable, and his monthly column in The Registry is closely followed by the top brass of the industry in the region and beyond.

McNellis Partners has primarily focused on retail, which is why we wanted to get his read on the industry and what lies in front of us. Here are his thoughts on the year ahead.

You have been observing the slow but steady growth of e-commerce to the detriment of brick and mortar retail, what surprised you the most in that process over time?

That Wall Street has yet to demand that e-commerce actually turn a profit. It’s 1998 all over again. Designed to ramp up revenue, the e-commerce playbook is, “Give it away and they will buy.” While it’s true that bricks & mortar can’t compete with free home deliveries and no-charge returns, it’s also true that e-commerce has an unsustainable business model. And once e-commerce charges what it really costs for deliveries and returns, the bricks & mortar approach–having the customer drive the last mile–will become much more competitive. Most people will spend a ½ hour to pick up a $50 item to save a $15 delivery charge.

I’ve predicted 5 out of the last 3 recessions.

Many have been professing the death of brick and mortar retail real estate mainly because of Amazon’s onslaught on the industry, but you’ve taken a different approach to that line of thinking? How would you characterize Amazon’s efforts in the industry?

Simple. Amazon is on its way to becoming the world’s biggest bricks & mortar retailer. Keenly aware of the last mile delivery cost conundrum (if you charge it, you will lose), I believe Amazon will be absorbing more struggling retailers to acquire not so much their businesses, but their locations, and the company will, within a few years, have a nationwide chain of stores to which 90 percent of the country can drive to pick up its online purchases. In other words, Amazon will become the internet incarnation of Wal-Mart, just as Wal-Mart, by the way, is becoming the bricks version of Amazon.

What in your mind poses a greater threat to the retail real estate industry?

Rather than threatened, I would say the retail real estate industry is challenged. Retail isn’t going away–Americans will always buy too much stuff–but its evolution is about to kick into a higher gear. Tomorrow’s successful retailers will be selling heavily both online and in-store, which means that their physical stores will become much smaller, more like showrooms, while the bulk of their inventory sits in warehouses. Instead of carrying 100 shirts of every size and color, the retailer will have a handful in the store, you will try one on, buy it and then order five more on the spot for home delivery in a few days. As store sizes shrink, shopping center owners will be faced with a lot of empty square footage that will be challenging–and expensive–to backfill.

The other challenges to the industry are age-old: over-building and the retailers themselves.

Millions of square feet of empty storefronts litter the countryside and must be dealt. The best locations will likely go mixed-use (usually adding multi-family), the good locations will recycle as pure retail, and the bad locations will be used as backdrops for cheesy Netflix series about the dystopian future.

Due to the net, the private equity mafia and their own incompetence, retailers today have a shorter life span than ever before, one of them dying every day and leaving its sad remains behind for its landlords to inter. The best way for a landlord to join a retailer at the mortuary is to follow it to a secondary location. Today, more than ever, location is king.

Your focus over the years has been on neighborhood retail centers in the greater Bay Area/Northern California market. How is that changing? Where will your focus be going forward?

We are still buying and developing neighborhood retail centers, but doing so carefully. We are working with one thriving supermarket chain to develop new stores for it. We rezoned a six-acre parcel in Hercules last year on which we’re planning a neighborhood center anchored by a top-end Safeway market. And we just purchased a Rite-Aid in Orinda as a long-term investment. What these properties have in common is an irreplaceable retail location and a tenancy we believe is internet-proof.

That said, our focus today is divided between our traditional retail approach and developing higher-end small residential projects in the Palo Alto area.

You have mainly done retail development and owned properties in that asset class, but McNellis Partners does more. How do you evaluate these other opportunities outside of retail?

We are definitely more cautious when we consider asset classes outside our wheelhouse, but we get there eventually. It’s daunting, but not impossible to learn other disciplines. If you can speak retail development fluently, then with a little bit of effort, you can learn at least rudimentary office or residential development. And vice versa. It’s like if you know Spanish, you can fake it in Italy, but instead of needing different words to get by, you need to learn different parameters, math and risks.

Construction costs have steadily increased since the Great Recession, how are you dealing with these and how are they impacting the development community?

Construction costs are like the weather, you can’t do anything about them. You live with them or stay home. You make sure your development pro forma has a healthy contingency for overruns and that your numbers work. Thus far, rents have been healthy enough to offset the overruns.

The Bay Area has seen a steady flow of large, institutional investors looking to make their mark in the region. How has this made you rethink the way you do business?

It hasn’t. We made a conscious decision years ago not to swim in the deep end of the pool, to forego institutional partners and keep our deals below the $20 million range, a level too shallow for institutional diving. Like the wary old lady said about the spider on the wall, “It’s not bothering me, and I’m not bothering it.”

You spend a lot of time mentoring young professionals in the industry through your association with ULI. What are some common or recurring challenges that you see for this generation of real estate professionals, and are you encouraged by the ideas they bring and their future in the industry, in general?

The biggest challenge facing every young person in the Bay Area today is housing affordability. Over the years, a number of my brightest mentees have simply given up and left, convinced they would never be able to afford a home from which they could reasonably commute.

On the brighter side, the millennials who do stay are the ones developing the new ideas–modular housing, autonomous cars, ride-sharing, home-sharing, pizza-sharing, you name it–that have the potential at least of helping solve the woes brought on by the Bay Area’s success.

What excites you about 2018, and what will be challenging for the industry in the year or so ahead of us?

With the passage of the tax bill, the government just hit the economy’s nitro switch. It’s going to be fast and furious for everyone in business. Development will rock this year and next and probably the year after that. The problem is that sooner or later race cars bump up against the brick wall, and only time will tell how bad the crash will be.

What are some of the things or key indicators that you personally track and follow that give you a sense of the market and where it is going to be in the near future?

I’m always so wrong on predicting where the market’s heading that I’ve given up trying. Like the old joke goes, I’ve predicted 5 out of the last 3 recessions.

Alma Village