Chattanooga Commercial Real Estate 2019

Over the past six months I have begun to wrap my head around the Chattanooga Commercial Real Estate (CRE) market, the drivers and the things that move the market. I’d like to share a few of observations and see how these evolve over 2019.

[As a reminder these observations – and this blog in general – are focused on the downtown urban core. The Eastside / VW area is not considered in the discussion.]

The Boom Times:

Arriving deep into this most recent development cycle the pent up demand was not obvious to me. What was clear was that everyone was building residential as fast as they could. Single family homes are clearly the tip of the boom cycle but even large conversions of older office buildings to apartments; the ground up of downtown mixed use buildings and the fields of homes and townhomes popping up on the Southside.

All of this was and is encouraging. This kind of building (SFH especially) can be a good indicator of a growing area. An area people want to be and are moving to.

https://www.timesfreepress.com/news/business/aroundregion/story/2018/sep/25/chattanooghome-starts-rise-nearly-24-percenth/479845/

Looking ahead to 2019 there are no obvious local issues that would portend a slowdown in this frenzy. There has been some talk of ‘running out of land’ but that will just drive demand back into the built up areas and increase remodeling of existing homes.  The positive local news far outweighs, lead by the rumors of VW possibly adding the building of all electric vehicles to its local plant, which would nearly double its size.

The national outlook may be the key indicator here. The potential to increase lending rates over the year, the ripple effect of tariff / trade war and general market volatility may create some drag. However, there are still plenty of investors and companies scouring the country for yield and Chattanooga presents a great option.

So Much Space:

This one took me a while to unpack. Where are all the tenants?

While I have yet to source a reliable vacancy rate for the city it’s safe to say it’s higher than it should be. I mused on the retail rate issue earlier this year (https://chacre.com/2018/10/25/retail-lease-rates-who-is-underwriting-this-stuff/) but it’s not just retail. Office shows a similar lack of demand. A lack of users to fill the available spaces. The saving grace of office is that people don’t look to be building more of it. Retail on the other hand is seeing a steady increase as every developer wants to build that elusive hip and cool mixed use project.

My take is that developers see the affordable ground pricing, a willing city, and a product that is working in so many other places and decided to build it. This means the market is being led by supply and not demand and you don’t have to be an economist to see the problems that creates. It leaves the North Shore with piles of vacant first floor retail in all the new and proposed developments. The lease rates being asked for these spaces further show the disconnect between the actual market conditions and those underwriting projects. I would estimate that – across the board – retail lease rates in the city are 30%-40% higher than where they should be. Again, you don’t have to be an economist to see the chilling effect this has on the, already struggling, retail market.

The second issue with the retail is the size of the spaces. This goes hand in hand with the pricing problem. This is a national trend and everyone is going to a smaller physical space that is focused on the customer experience. So long as underwriters and builders continue to believe that 2000sf at $28psf is viable we are going to have substantial vacancy and an oversupply of retail.

In short,  we need more retail and office businesses to fill the existing and proposed space, but a large component of this is the size and pricing of the space available. Smaller, more affordable spaces will provide a pipeline, a growth environment, for people to start and grow businesses. The bonus is that, at least as retail is concerned, smaller spaces create a far superior customer experience.

The Apartment Fire:

Last but not least let’s review apartments. In my first week here a banker told me he thought multifamily was already overbuilt and wasn’t interested in lending on any more projects. Since then five or six major (200+ unit) projects have been announced or broken ground. The obvious question is why? Is there demand for this many units? As we have already seen with retail and office the answer is no. You don’t have to look very far to see that demand is well behind supply: https://chacre.com/2019/01/05/ahead-of-demand-the-developer-risk-of-chattanooga/

So, why then are there so many projects going up? The simple answer, again, is that developers are taking advantage of seemingly cheaper ground prices to build product in anticipation of demand. This is the only way I can see any underwriter allowing a project to run at less than 50% vacancy for more than a year. The ground was so cheap that the property can make enough to cover its costs if it hits 50% occupancy. A recipe for a bubble if there if there ever was one. Regardless the driver is the developer and the investor and not the market. This strategy has a chilling effect on the rental rate of all projects and likely will take five to ten years to recover to a sustainable occupancy level.

I am inclined to agree with bankers: Chattanooga is overbuilt with apartments and I would advise other developers to steer clear of the city for a long while. Unless of course their investors have a long, long time horizon.

A Paper Tiger?:

So, where does that leave us heading into 2019? In short overbuilt and under-tenanted. It leaves us with a downtown that has some very cool blocks, thriving with local businesses, and others with brand new spaces sitting vacant for a long long time. All with fewer people on the street than you might expect to see.

While some complain of parking being a problem – it is not – the real problem is having a good reason to go downtown. From the perspective of the built environment all of these are problems that can be solved and fairly painlessly. However, someone is going to be first and lead the way.

Chattanooga is going to have a very good 2019. A number of high profile projects will dominate the news and continue the perception we are an up and coming place to be. A cool downtown with plenty of options. For the investor there will be quite a few opportunities, however, they will require a bit more analysis and careful underwriting to maximize their ROI.

 

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