Real Estate Transactions

Creative Opportunities Ahead

For years the office sector has held a prominent place (i.e., a 40 percent share) in institutional portfolios, at least as measured by the National Property Index and the National Fund Index. And while Class A office space remains robust in top markets, with foreign capital especially flowing into urban core and secondary markets in the West, some observers suggest the sector has reached its peak. Portfolio sales are down 45 percent through July 2016 compared with a year ago, according to one report.75 A momentary cloud doesn’t ruin a picnic, of course, but it does make one start thinking about umbrellas. Savvy investors won’t bristle at the widespread sense that economic growth over the long term will continue at a snail’s pace—yes, better than Europe, but snail-like nonetheless. But they will use this environment to find agile and creative opportunities in real estate sectors. Investors in the office sector are responding to an ever-widening price gap between soaring central business district office space in gateway cities and dipping suburban office space by exploring portfolio diversity options.76 One bright spot is in the medical office space, where vacancies are at a nine-year low even with 3.5 million square feet of new medical office space delivered nationally in the first six months of 2016 and another 11 million coming on line this year. REITs with senior-housing investments in their portfolios have been diversifying into the medical office space, by one estimate, because of the expanded medical insurance coverage offered by the Affordable Care Act, because of an aging population, and because of the rise in “retail” walk-in medical clinics.77 But another investment opportunity has emerged in the creative office space—a new design model with which developers are realizing premium rents by answering the needs of a new generation of millennials who have moved to cities like Denver, which, in March of this year, topped U.S. News & World Report’s list of the 100 most livable U.S. cities. In some cities, the creative office trend is manifesting itself in former industrial zones that are being redeveloped and reimagined; in other cities, like Miami, you’ll find the creative office aesthetic emerging in brand-new construction.

At one point in his best-selling Where Good Ideas Come From: The Natural History of Innovation , Steven Johnson describes Microsoft’s Building 99, in Redmond, Washington, which opened in 2007 and houses the company’s research division: “All the office spaces are modular, with walls that can be easily reconfigured to match the needs of the employees. Larger ‘situation rooms’ house groups working on high-priority projects, with a mix of private workstations, conference tables, and sofas. Most walls are write-on/wipeoff, so if inspiration hits on the way to the restroom, you can quickly sketch out an idea for your colleagues to see.” It’s a passage that describes what Johnson calls “liquid networks”—in this case, interior spaces that encourage conversation and the serendipitous emergence of collaboration. Indeed, as Johnson writes of the building and its designer, “[Martha] Clarkson built the water coolers first, and then designed an office building around them.”78 This trend in collaborative work spaces has accelerated, percolating into popular culture and even taking a star turn in the CBS series The Good Wife, which, as astute office sector aficionados might have noticed in Season 5, the upstart partnership of Florrick/Agos & Associates (having jumped from its old white-shoe firm of Lockhart/Gardner) finally moves into its bare bones but fantastically hipper new digs—an old T-shirt factory with a loft-like atmosphere, a freight elevator, an open floor plan, exposed brick walls, and concrete floors—all visual cues that come straight out of the creative office/ Building 99 playbook. Indeed, the creative-office-as-celebrity appearance is no fluke—it’s a design trend with legs, one that is reshaping the office sector as a whole.

You know it when you see it: large common rooms—no cubicles—open plan design, conference rooms flooded with natural light streaming in from high factory windows. A piece of heavy equipment might hang from a ceiling like found art from the Second Industrial Revolution. You might see clusters of creatives at Ping-Pong tables or collaborative work stations or small teams brainstorming by poring over Post-it notes and drawings, and the live/work/play ethos is fully engaged.

It started in Silicon Valley, where coders liked to work weird hours and take breaks to play foosball or walk into a kitchen at 4:00 pm and make Nutella crepes. High-tech firms like Google, Apple, Pixar, and Microsoft changed the interior spaces of their companies to encourage collaboration, teamwork, and fun. It also made economic sense: Intel Corporation, for example, found that 60 percent of its workstations were empty at all times—while other studies suggested an average of 40 to 60 percent in workstation vacancy.79 Other people started to notice. Advertising and design firms caught on. Then—skipping ahead a bit after the dot-com bubble burst—the Great Recession left millions of people unemployed. In time, many millions would find work again or start off on their own—but now they were contractors or vendors, a contingent workforce of the self-employed that amounts to 8 percent of the workforce or 11 million jobs, according to the most recent numbers from the U.S. Government Accountability Office.80

“The subleasing of shared coworking space has become a national phenomenon that is having a profound influence on the office sector as a whole.”

And here a real estate opportunity emerged for owners or investors to create entrepreneurial office hubs with meeting rooms, tech support, free coffee and Wi-Fi, break kitchens, and assorted office amenities—all services shared under sublease contracts by dozens of individual freelancers, temporary gig workers, or groups of very small companies. By means of this shared economy model, coworking space was born—buildings have been retrofitted, reused, adapted, and repurposed to the collaborative space vibe to make places where contingent workers and small companies pay a few hundred dollars a month to firms like StartHub, WeWork, and NextSpace to share big-office services without the prohibitive sunk costs of leasing an entire floor of a building.

It’s been called by many names—creative office space, open-office configuration, open-plan design, or even millennium space—but whatever one calls it, it’s beginning to shape how new offices as a whole are being built. Indeed, at a recent South Florida Future of Office! panel discussion, moderated by Akerman’s Neisen Kasdin, Pipeline Workspaces’ Philippe Houdard reflected on the larger cultural trends that are opening up today’s work spaces. “Coworking was initially identified as a space overwhelmingly for the sort of 20-something crowd that wears hoodies and is focused on development,” said Houdard, “but what we’ve also seen, is it’s for people of all ages and in all businesses.”

“There’s a need to have space that is adaptable to the flexibility and work schedule that so many people now have,” says Akerman’s Steven Polivy.

Big Four consultancies aren’t the only ones moving in the direction of the creative office. According to a survey conducted by the International Facility Management Association, nearly two-thirds (58 percent) of responding companies said they had increased the number of people working in unassigned or collective use spaces.81 The creative office space, in other words, is a transformation that is well underway—and may reflect greater societal trends, according to Pipeline Workspaces’ Houdard. “If you take a look at the past 50, 60 years, people have grown more and more isolated. People belong to fewer organizations, community groups, and religious organizations, which has led people to feel a sort of sense of solitude in their life,” Philippe says. “And now we’re seeing a reversal…people want to connect.”

That trend, moreover, has revealed opportunities for investors to adapt industrial or old and neglected (perhaps even historic) building stock into creative office space. In gateway cities like New York, for instance, office tenants are moving from traditional midtown spaces into downtown offices located by the old Hudson rail yards. Asking rents for midcentury traditional office space in the midtown area have dropped to $87 per square foot in the fourth quarter last year from $91 per square foot in the third quarter. Vacancy rates in midtown are 7.1 percent compared with the 5.1 percent rates in Midtown South, which includes Hudson Yards. A New York Times article reported that “business districts carved from industrial areas and other nontraditional areas are vying for prominent tenants.”82 And when they move, they’ll find buildings designed with creative office space in mind: yes, there are corner offices, but there are also open floor plans with huge views looking out over Manhattan and the Hudson River, street-level retail, entertainment, hotels, and parks—the entire live/work/play package.

“There’s a need to have space that is adaptable to the flexibility and work schedule that so many people now have–creative workspace allows people to move wherever the next project may be.”

That demand signal is even stronger in the gateway city of Los Angeles, where a massive switch is under way from traditional office space to creative space. One expert projects that within the next five years, roughly 30 million square feet of traditional office space in Los Angeles will expire and be renewed by new tenants. Akerman’s Jane Hinton remarks, “I think that’s right, and remember that much of it is driven by how people are more transitory in their work life—how they’ll move from project to project, maybe spend three months in Los Angeles, then go to San Francisco or New York, and creative workspace allows people to move wherever the next project may be.” Many industries, Hinton adds, once used large amounts of space to store files, but since the digital and cloud revolution have made that file or library space redundant, much of it, according to Hinton, is being repurposed into collaborative office space.

In Dallas–Fort Worth, Granite Properties is remodeling a 113-year-old former bakery into Factory Six03, with a creative office design based on similar projects in San Francisco and Boston. Of its 240,000 square feet, seven floors will be dedicated to creative office space. Nearby, and also in the city center, developer Matthews Southwest is restoring a grand old gem of a building, the former Dallas High School, into creative office space that will house architectural and engineering firms along with some retail shops.

“In addition to the getaway cities, demand for redesigned office space continues to rise in metropoilitan areas like Boston, Dallas, and Denver, thanks to their growing lure as foreign investment hubs,” says Akerman’s Eric Rapkin. “Coupled with this growing influx of foreign investments, the changing needs of the workplace have led to the development of new spaces aligned with the latest design trends.”

“Demand for redesigned office space continues to rise in metropolitan areas like Boston, Dallas, and Denver, thanks to their growing lure as foreign investment hubs.”

Chicago’s gravitytank, a design firm housed in an old building on Illinois Street, was recently selected as that city’s top creative office space. The place seems emblematic of the whole creative office trend—a top floor with hands-on creative labs and workshops, a sound studio, a photo lab, and a gourmet kitchen. From here, ideas seem to flow downstairs via a kind of gravity and alchemy to get hashed out in creative bays and project bays filled with moveable project boards. “All value is created from people. That’s the reality,” says gravitytank’s founding partner Scott Ternovits. “And without these interactions between people, you don’t have that kind of energy and that value being built.” That seems to sum up the changing relationship between buildings and the people who work in them—a key insight that may be ushering in a new era of office design.

In Tier 2 markets, a typical pattern emerges: artists and nonprofit organizations move into neglected industrial space, followed by residential pioneers, which, if this is followed by enough growth, leads to restaurants and retail outlets and finally to office space. “Buildings that stood derelict in neighborhoods experiencing this pattern of growth are now being considered for office use,” according to the National Trust for Historic Preservation.83

In Costa Mesa, Orange County, California, for example, an hour’s drive south of Los Angeles, near Interstate 405 and Harbor Boulevard, a local company is investing $100 million to convert a former printing plant for the Los Angeles Times into a new space called The Press—300,000 square feet of creative office space. Tenants generally pay north of $300 per square foot for premium office space in Orange County, but they seem willing to pay more than $400 per square foot for creative office space. Employees seem to like what they find in such spaces, and tenants like that employees are happy in their work environments—The Press amenities will include volleyball courts, grills, and outdoor seating—and so demand is growing in Orange County. Some estimate that one million square feet of creative office space exists in the county, with another two million in development.84

“The changing needs of the workplace have led to the development of new spaces where the stratification of hierarchies has diminished in favor of collaboration.”

In Denver, developer Jason Winkler of Wink Inc., is investing $23 million to adapt a 120,000 square-foot wholesale food warehouse to construct Industry Denver, a new shared office space concept located in the River North Arts District (think industrial hip art studios and small-batch breweries down by the railroad tracks) with Uber as its anchor tenant.85

The collaborative-office idea is even shaping the design of new offices under construction. Miami’s Brickell City Centre, home to Akerman’s Miami office, is a good example of a new office stock designed and built specifically with the new creative office in mind. “We are living by the principles of new office design trends and have established collaborative spaces where stratification of hierarchies has diminished in favor of collaboration,” concludes Akerman’s Neisen Kasdin.

In September of last year, Marriott International closed on its $13-billion acquisition of Starwood Hotels & Resorts Worldwide, making Marriott the largest hotel chain in the world, with more than 5,700 properties and 1.1 million rooms in more than 110 countries.86 In its wake, the Starwood deal reveals a great deal about how hotel companies are repositioning themselves for 2017. Against the backdrop of a much-anticipated potential oversupply in the hospitality market and concerns about other late-market fundamentals, a split-screen narrative seems to emerge. On one hand, observers point to a projected average daily rate growth of 1.7 percent—the smallest increase in key sector indicator since the end of the Great Recession—and to a decline in occupancy levels—the first such decline in the past eight years—as cautionary signs for the hospitality market.87 For global brands like Marriott, however, acquisitions make strategic sense. “We’ve got immediately $250 million worth of cross synergies,” said Marriott International’s CEO, about the Starwood purchase. M&A activity is expected to continue in 2017 as big players pursue advantages of scale to leverage booking power and negotiate fees with online travel agencies. Other notable acquisitions this year included Accor’s purchase of Fairmont and Raffles for $2.7 billion and Chinese conglomerate HNA’s acquisition of Carlson, which includes the Radisson Hotels brand.88

Concerns about oversupply notwithstanding, a sector-wide building boom continues apace, with the number of hotel rooms under construction increasing to 3.5 percent of existing rooms nationally compared with 2.6 percent last year. New York leads the nation in new hotel starts, at 14.5 percent existing room supply, but Tier 2 cities have exploded. New construction in Denver, for example, has risen from 5.6 to 10.1 percent of room supply compared with last year, and new construction in Seattle has soared from 3.1 percent last year to 11.5 percent of existing inventory—a jump of 270 percent. This reflects a sector-wide trend nationally, according to one estimate, in which about 70 percent of all new hotel construction is happening in the burgeoning select-service space, a category falling in between bare bones limited-service and full-on luxury hotels—a segment that recently attracted a $2-billion investment by China Life into Starwood Capital Group’s portfolio of 280 select-service hotels across 40 states.89 Other trends include the adaptive reuse of older buildings, which is also expanding into Tier 2 cities like Dallas and Houston and cities on the West Coast, where new construction of hotels and adaptive reuse of other sites is expected to set records in the next two years.90 “In South Florida, the hospitality market is still very hot,” says Akerman’s Richard Bezold, “We’re still very bullish on investors’ going after established products and even on the development of new hospitality products as well.” What all of this suggests is a hospitality sector strategically adapting to a number of significant changes in the marketplace.

“The hospitality market is still very hot: M&A activity is expected to continue in 2017 as big players pursue advantages of scale to leverage booking power and negotiate fees with online travel agencies.”

“The market supply of hotel units has seen exponential growth in recent years, along with the rise of alternative accommodations outside traditional lodging models,” adds Akerman’s Joshua Bernstein. “This overarching trend has affected pricing metrics per hotel unit, fueled the advent of sophisticated amenities, and influenced property valuations, particularly for foreign investors on the hunt for trophy assets.” What follows is an overview of the strategic choices that key players in the hotel sector are making in response to the new realities of an ever-changing hospitality marketplace.

Recently, Virgin Hotels CEO Raul Leal cited a study by Cornell University’s Center for Hospitality Research that suggested Virgin Hotels should rethink its business strategy to better accommodate an emerging market-making demographic: women. According to the study, the number of female business travelers had doubled in the past 10 years and would soon amount to half of all business travelers.91 The same study found that female travelers had more multiple-night stays than men did and are likely to tack on some leisure time at the end of business trips.92 Some redesign was in order. Focus groups were assembled. Women reported that room service was often awkward, so Virgin redesigned its rooms to be more female friendly, including dividing doors with peepholes so that room service can enter while guests remain comfortably unseen. “We’ve taken a typically 300- to 400-square-foot room, and we’ve just made it flow better,” says Raul. “So it feels like more space than a typical guest room, more amenities that are user-friendly not just for female business travelers but for men as well.”

The digital revolution is changing the way people search for, book, and pay for accommodations and services, entertainment, and activities offered by hotels. That so much of this is now being done via smartphone applications is, according to Akerman’s Jane Hinton, one of the biggest game changers for the hospitality sector. “The different ways people can choose their hotel or lodging is what’s going to drive markets,” says Hinton, and this trend, in which 34 percent of people in the United States use third-party online agencies for their travel needs, has sparked a tug-of-war between popular algorithm-based search platforms and the hotels themselves over the very customers that each is trying to serve. According to a recent study, two-thirds of customers book directly with hotels, but many hotels are seeking to expand this segment with new book direct incentives—free Wi-Fi, lower rates, room selection, and other benefits.93 Indeed, most hotels in a recent survey reported they will spend more in 2017 to create a digital-friendly environment and enhance mobile engagement in particular—with 84 percent of hotel operators surveyed reporting they will roll out hotel-branded customer mobile apps in 2017.94 This last piece—connecting directly to clients’ mobile phones—will allow hotel operators a number of ways to fully harness the power of mobile connectivity. The Fontainebleau Miami Beach, for instance, using prearrival and checkout offers on its mobile interface, earned a 141 percent ROI in the first month of using its new mobile check-in provider.95

“By tapping into the millennial predisposition to find and connect with each other via social media, hotel operators are tapping into the powerful, market-shaping forces of millennial behavior.”

Virgin Hotels now offers its customers their own mobile personal assistant, dubbed Lucy, which guests can use to check in or check out on their smartphones, or to find local hot spots, or, using a chat board, find like-minded travelers staying in the hotel. By offering, in effect, a digital concierge, and by tapping into the millennial predisposition to find and connect with each other via social media, hotel operators are tapping into the powerful, market-shaping forces of millennial behavior. As one recent report put it, “Digitally empowered millennials want personalized communication, seamless planning…and an authentic, customized travel experience.”96 In other words, people are increasingly looking less for full-service hotels than they are for hotels as social hubs for experiences and adventure beyond the hotels themselves. “People aren’t looking for a 1,500-square-foot palatial suite anymore,” says Akerman’s Steven Polivy, “because now they’re more interested in finding friends by using a chat room feature often provided by the hotel and then going out to spend their time with these new friends in restaurants, at shows, shopping, and taking advantage of whatever city in which they find themselves.” It’s a view echoed by the rise in popularity of apps like CheckedIn, a kind of LinkedIn for travel buddies looking to find affinity groups or other travel-enhancing adventures with newfound friends. In this regard, the hotel sector is making its own distinct shift toward services of the sort we’ve seen companies make in other industries—GE’s rebranding of itself from a company that makes turbines, for instance, to a digital and consulting company.

“People are increasingly looking less for full-service hotels than they are for hotels as social hubs for experiences and adventure beyond the hotel themselves.”

Strategic partnerships are emerging between major hotel brands and Uber, for instance, or in so-called dual-branding projects where a Residence Inn and SpringHill Suites, for instance, will colocate in the same building. All together, 46 multibrand properties are in operation in the United States, with another 41 slated to break ground within the next year, mostly in cities where land for development is in short supply and construction costs are increasing.97 But the relationship between hotel companies and credit card companies may be among the most important of them all, especially in a changing marketplace where customers increasingly expect a seamless travel experience—finding, booking, and paying for travel accommodations by using smartphone apps, for instance. How important will seamless payment synergies be, for example? According to Marriott’s CEO Arne Sorenson, within an hour of his company’s initial offer to purchase Starwood, he received a call from JP Morgan Chase CEO Jamie Dimon and from American Express CEO Ken Chenault. Intersecting with the high priority that hotels are giving seamlessness, is the emphasis on loyalty and rewards programs. “Loyal customers are the primary reason for doing this deal,” said Sorenson, whose first priority was to make sure that members of Starwood’s Starwood Preferred Guest loyalty program and Marriott’s Marriott Rewards program remained “enthusiastic about this deal.”

According to this year’s Akerman Survey, Chinese investment is expected to account for nearly 70 percent of all foreign investment in U.S. hotels this year—and that staggering projection for 2017 represents a falling off from 2016. No newcomer to U.S. real estate, Chinese investors, by any measure, drove hard to the hoop in 2016—with $7.7 billion invested in U.S. hotels, which represented 76 percent of all overseas capital funneled into the sector that year—or more than double the total foreign investments in U.S. hotels in 2015.98

The hotel sector is discovering pocket markets in unexpected destinations such as Detroit, which opened 954 new hotel rooms in 2016 and which has more than 4,000 rooms in the pipeline. Hyatt will open at least 11 new Hyatt Place, Hyatt House, and Hyatt Regency hotels in other Tier 2 cities like Houston, Denver, Asheville, North Carolina, and Scottsdale, Arizona. Virgin Hotels is planning brand-new hotels in Nashville, Dallas, New York, and Palm Springs, California. “We’re looking for good locations in primary and secondary markets,” says Virgin CEO Raul Leal, “and we have the ability to do whatever works.”99

“The crowded nature of gateway markets is now steering interest toward secondary markets–most developers don’t want to wait five years to have a hotel open.”

Many of these new hotels are of the limited-service variety—those that offer guests a breakfast bar rather than a full-service restaurant or a cavernous meeting room, and this seems in keeping with the hotel-as-hub phenomenon. And as gateway markets become saturated, many investors, particularly from Asia, are looking to invest in limited-service-hotel properties in Tier 2 markets. Asia has long been a major investor in the U.S. hospitality sector, of course, with China the most active buyer of hotel properties, accounting for 44.7 percent of total Asian capital invested in the U.S. hotel sector last year, but increasingly, companies in China, Thailand, and Singapore are turning their sights to the limited-service sector in secondary and tertiary markets.100 The crowded nature of gateway markets is now steering interest toward secondary markets.101 Today most developers and financiers, whether it’s a bank or private equity, don’t want to wait five years to have a hotel open, says one sector expert. With limited-service properties you have a little more certainty regarding when the hotel will open and when you can start getting the return on your investments.102

Industrial and Retail Re-evolution

Is there really anything sexier, in all honesty, than an industrial warehouse or fulfillment center? Not if, like so many millions of online consumers nowadays, you expect same- or next-day delivery of a book or a barbecue grill. Growth in e-commerce sales (up 16 percent in the second quarter of 2016 compared with the same period the previous year) has created a burgeoning U.S. market for warehouse space all over the country, with demand—a year-to-date national absorption of 233 million square feet— racing ahead of the 182 million square feet of supply. And if you consider the rising national average sale price for industrial space ($76 per square foot), a compressing cap rate of 7 percent, and sector-dominating year-to-date investment returns for industrials of 26.7 percent, well, it’s no wonder that the investment picture for the warehouse sector is so bullish.103 Such indicators—along with continued positive signs of growth in the U.S. economy and an awareness among cross-sector investors that industrial tends to weather economic turbulence better than other assets do—have led many observers to give real estate industrial top investment ratings for 2017.104

“New construction of big-box fulfillment centers continues at a staggering clip.”

New construction of big-box fulfillment centers continues at a staggering clip. In a Joliet, Illinois, business park some 50 miles west of Chicago, for instance, IKEA has established a Midwestern distribution hub—two massive warehouses, each about 1.4 million square feet that now compose the better part of an entire square mile of warehouse space equipped with the latest in smart warehouse technology—real-time location systems that continually track items, inventory flow enabled by radio frequency identification technology, robotic shelving units, and other Internet-connected physical devices that have brought about the era of one-click shopping for millions of retail customers and led to a corresponding explosion in demand for more fulfillment centers. Indeed, eight new 1-million-square-foot distribution centers have been built in the past 18 months.105 And it’s not just the major gateway cities that need the warehouse space. To solve the last-mile problem for same- and next-day delivery, companies like Amazon are on a buying and leasing blitz in secondary and tertiary markets. Amazon’s all-out warehouse push includes fulfillment centers of nearly one million square feet or more in Monee and Romeoville, Illinois, Fort Worth, Texas, Carteret, New Jersey, and San Bernardino and Eastvale, California. But it’s not just smart warehouses and fulfillment centers that are booming. Demand for U.S. industrial space is soaring—the 2016 average warehouse vacancy rate, nationally, of 5.7 percent, represented a historical low. By one estimate, 62 million square feet of new warehouse supply was completed in the third quarter of last year alone, and while total new construction for warehouse space last year (216 million square feet) also broke a historical record, year-on-year vacancies plummeted in 82 percent of the warehouse market. All of this has led to a spate of spec construction in the industrial sector. Indeed, nearly two-thirds (or 126 million square feet) of all new warehouse space in the U.S. is speculative construction.106 In Miami, according to Akerman’s Eric Rapkin, the industrial market continues to be “incredible, with a capital I. The supply–demand imbalance in South Florida is a very real thing,” says Rapkin. A similar story could be told for other cities across the country, where industrial warehouse stock, having grown obsolete during the past 25 years, now needs to be retrofitted or torn down to make way for a new era of smart hubs. “Most industrial developments need a major revamp across the country,” says Akerman’s Cecelia Bonifay. “Construction of those assets is getting closer to many city centers, particularly distribution and fulfillment sites, to ease up the retail model of immediate purchases.” And because, by some estimates, transportation and logistics costs represent roughly half of all e-commerce supply chain costs, distributors will, for the foreseeable future, likely seek to improve efficiencies in transportation costs by exchanging higher rents for warehouses located nearer to their growing online customer base.

“Most industrial developments need a major revamp across the country. Construction of those assets is getting closer to many city centers, particularly distribution and fulfillment sites, to ease up the retail model of immediate purchases.”

The Great Recession and the rise of e-commerce once seemed to spell the end for physical retail, but reports about the death of brick-andmortar stores, as the saying goes, have also been greatly exaggerated. Retail, it’s true, has mirrored more closely than other real estate sectors the perturbations of an economy’s slow recovery. Demand and supply, for instance, have lagged behind their long-term averages, and they are projected to stay that way for some time.107 As a sector, moreover, retail has been sensitive to the levels of discretionary spending by middle-class families, whose median household income in 2014 was 4 percent less than it was in 2000 and whose median wealth (assets minus debts) fell by nearly a third from 2001 to 2013.108 One often hears of the “shrinking middle class,” but another way to imagine the current situation with retail is to contrast it to a period when times were better. In the era of thriving retail malls in the 1970s, for example, it’s useful to note that in 1970, middle-class American wealth was approaching two-thirds (62 percent) of the aggregate share of U.S. income. Say what you will about the dolorous effects of the Great Recession, that historic, benighted period when retail shopping was a form of recreational activity fueled by greater aggregate wealth for most Americans. By 2014, however, that figure had dropped to 43 percent.109 Perhaps even more illuminating, according to a recent study of millions of tax records and U.S. Census data, is that only half of today’s population of 36-year-olds make as much money as their parents did. For this key segment of the U.S. retail and real estate market, the index of the American Dream, according to the study, has fallen by 50 percent.110 Apart from this trend of reduced discretionary spending, the global rise of e-commerce has, without question, had its effect on the retail sector, with 109 million people shopping online Thanksgiving weekend 2016—compared with 99 million in-store shoppers during that same weekend, according to a recent survey.111 And yet, in a period of dead malls, slow economic growth, and e-commerce, a certain amount of catastrophizing has also occurred regarding retail even while focus upon the sector has become more granular, and lessons are being learned. The rise of e-commerce, as it happens, has been something of a boogeyman, amounting to just 8 to 9 percent (about $1.9 trillion) of a global retail market of $22 trillion. By 2020, with global retail projected to reach $27 trillion, e-commerce will account for about $4 trillion, or 14.6 percent of the global marketplace.112 Languishing, dead malls are being snapped up, repurposed, and transformed into town centers in an interesting, mixed-use Class B play that may help reimagine suburban American life. In an interesting ironic twist in the e-commerce revolution, in fact, some of those same dead malls are being evaluated by developers for repurposing as potential last-mile distribution centers.113 Akerman Survey respondents, moreover, suggest investment opportunities in retail may be in the offing for 2017, with 41 percent projecting that retail cap rates will increase during the year.114 Most look to a targeted focus on so-called high-street retail—niche centers anchored by a good grocery chain or an attractive urban infill location—where some investors have seen rents rise 6 percent higher than prerecession rates.115 Physical stores can still thrive in other ways, in urban, mixed-use areas where the live/work/play model has been adopted and where being in a store, being able to touch and see merchandise, has become a gateway to online purchases. People are still buying, it turns out, but they’re more often moving from the showroom to the Web room and from brick to click.116

It’s one thing for brick-and-mortar retail to address the risk of disintermediation by e-commerce; it’s an entirely different thing altogether— an interesting and challenging puzzle—when cultural tastes and their corresponding sumptuary laws change to enable the emergence of an entirely new sector for a product that 60 percent of Americans, according to a recent Pew Research poll, say they want to buy but that has been, until now, illegal: marijuana.117 As of mid-December 2016, when a law legalizing recreational use of marijuana survived a recount in the state of Maine, marijuana has been legalized in some form in 26 states and the District of Columbia. In seven additional states, bills have been introduced for 2017 that would legalize marijuana for recreational use, (in Delaware, New Jersey, and New Mexico, for instance) or that would (in strikingly conservative states like Texas or Kentucky) at least amend current laws to allow for “compassionate use” of medical marijuana for people suffering from debilitating or terminal diseases—a change in law that has often been a harbinger for further market liberalization. Against this backdrop of change, a fascinating story is playing out in eight states (Washington, Oregon, California, Nevada, Alaska, Colorado, Massachusetts, and Maine) and D.C., where marijuana is now legal for recreational use and where a number of key stakeholders—lenders, insurance companies, building owners, growers, retailers, and investors—are grappling with the interesting and often unforeseen challenges of bringing cannabis products from their former place in a shadow economy into the bright light of everyday retail shopping.118

Advocates of legalization have long argued that retail marijuana would be a boon to state coffers—and recent evidence bears this out: from 2014 and 2015, the state of Colorado collected a total of $211 million in taxes and licensing fees, and excluding licensing fees for 2016, the state generated over $1 billion in total marijuana sales, collecting $151.4 million in taxes through October 2016.119 Oregon has collected $25 million in tax revenues since it legalized marijuana in July 2015; and by July 2016, Washington State had collected more than $250 million in excise taxes since legalization in 2014.120

“Key stakeholders—lenders, insurance companies, building owners, growers, retailers, and investors—are grappling with the challenges of bringing cannabis products into the bright light of everyday retail shopping.”

But what would a cannabis economy look like at scale? Akerman’s Jonathan Robbins addressed this and other business considerations in an article published in November 2016 in Law360. The author points to California, in particular, which has the largest economy in the country and the sixth-largest economy globally. The state’s recent passage in November of Proposition 64, the Adult Use of Marijuana Act, according to Robbins, could eventually generate more than $1 billion annually in state and local taxes and create more than 100,000 jobs in the new cannabis economy.121 Legalized marijuana is already a $45-billion marketplace, according to a recent study by the Tax Foundation, which estimated that if legalized nationally, cannabis commerce could generate $28 billion in annual tax revenues for federal, state, and local governments—including $7 billion in federal revenues.122 It’s anybody’s guess, of course, whether such a green rush would sweep the country, especially given that Donald Trump’s pick for attorney general, Jeff Sessions, has been confirmed by Congress. Sessions has been openly hostile to the marijuana sector and could undermine or even roll back recent state legalization efforts, according to sector observers.123 For now, cannabis is a booming sector—but it’s also one that has been accompanied by unforeseen business challenges for the retail and industrial real estate sectors.

For starters, this new retail subset has an unusual banking, lending, and credit challenge. That’s because the Treasury Department still requires banks to report activity that may violate federal law, and, since marijuana is still illegal under federal law, banks that lend to businesses that cultivate, transport, and dispense marijuana put themselves “at risk of running afoul of financial reporting obligations,” writes Robbins. You can’t buy legalized pot from a retail store with a credit card nor can a grower—or, in fact, any business that touches the marijuana plant—get a traditional loan from a bank. The cannabis economy is, in other words, at least for now, largely a cash business. You could call it a problem of riches, according to Robbins. Landlords and lenders have a difficult time underwriting cash-based tenants—identifying assets, establishing creditworthiness, or accepting payments. But alternative forms of financing and investment have emerged. Crowdfunding and recent activity by real estate investment trusts to target medical-use cannabis facilities have become platforms that can help cannabis-related companies find the investors they need without running afoul of federal regulations.

“Crowdfunding and recent activity by REITs to target medical-use cannabis facilities have become platforms that can help cannabis–related companies find the investors they need without running afoul of federal regulations.”

Marijuana retail outlets are absorbing new costs—as the cash-based sector prompts increases in security expenses. Marijuana growers, moreover, need large, industrial-size indoor spaces—and word has gotten around to warehouse property owners, resulting in skyrocketing industrial lease rents. Real estate that was $4 a square foot six months ago is now $20 a square foot, which will need to be a consideration in any business model. Then there are insurance liability and leasing hazards. Companies that extract essential oils derived from marijuana and add these oils to food and other products use an extraction process where things can go explosively wrong at an industrial scale. Such companies are now paying more for insurance policies that can also exclude coverage for some industrial accidents—and this has now added unforeseen risk to operations.

All of these considerations will involve greater due diligence for stakeholders. Commercial landlords considering leasing space to cannabis-sector tenants will need to carefully consider the potential risk under federal law and will also need to amend standard leasing documents to provide for termination rights in the event of any enforcement actions, litigation or adverse change in applicable law. Local land-use and zoning laws will need to be understood. Investors will need to properly vet a cannabis company’s cash management structure to ensure compliance with federal anti-money laundering statutes. Protecting a cannabis company’s product brand, trademark, patents, and marketing innovations also becomes a challenge— once again because the federal agency that regulates these things—the U.S. Patent and Trademark Office—requires that applicants for patent and trademark protection demonstrate “legal use” of a commercial product. Until cannabis is legalized at the federal level, in other words, cannabis trademarks and brands will fall under a patchy mosaic of more-limited, state-level protections. California, perhaps the biggest potential market for the sector, refuses to register trademarks used on cannabis.

“Bigger players and many hundreds of millions of dollars are now entering the market, much of it now coming from hedge funds and private equity investors.”

So far, investors in the cannabis economy have been relatively small and local—and some of this has been legislated into the new state marijuana laws, many of which have been written to favor and encourage the development of local small-business owners—in an effort to give local small businesses a head start, before the big industrial agricultural fish move in. These local hero laws for small businesses should also be considered, even as increasingly bigger fish are moving into the market – private equity groups are entering the game, manufacturers of industrial lighting systems and irrigation systems, kiosk companies, and software companies that provide seed-to-sale tracking information. Celebrities are introducing branded cannabis products. Bigger players and many hundreds of millions of dollars are now entering the market, much of it now coming from hedge funds and private equity investors. The Wild West frontier of cannabis commerce, in other words, is quickly vanishing, and a maturing market is taking its place, opening up opportunities in the retail and warehouse segments of real estate.

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