A recovering housing market may lift all boats — including commercial real estate.

“When Warren Buffett and Sam Zell comment about distressed single-family homes being one of the best investment opportunities in the market, people tend to listen,” says Ken Wimberley, CCIM, managing director of Noble Crest Property Group/KW Commercial in Arlington, Texas. “We are seeing strong sales as a result of investor purchases for single-family residential homes.”
Like most CCIMs, Wimberley doesn’t work in the residential market, but as a KW Commercial affiliate, he has a strong relationship with its residential division and keeps abreast of housing trends and how they affect the commercial market.

One of the strongest trends to come out of the residential market this year is the investor interest in single-family homes. Home sales are up 6 percent this year, and about 30 percent of all sales are cash, says Kevin J. Thorpe, chief economist for Cassidy Turley, meaning that some investors are parking their money in residential.

“Investors have been very active in the Twin Cities buying single-family homes as investments,” says Herb Tousley, CCIM, director of the Shenehon Real Estate Center at the University of St. Thomas in Minneapolis. “Many of these sales have been distressed properties that are renovated and converted into rental properties. Low prices have made these properties very attractive as investments and many of these sales have been cash sales. The rental market is very strong and these investors are achieving favorable rents.”

From local mom-and-pop investors to private equity funds such as Colony Capital, which owns about 3,600 single-family homes, investors have turned to residential and for those who got in early, it’s beginning to pay off: In September, existing home sale prices rose for the seventh consecutive month year over year, according to the National Association of Realtors. That number of back-to-back monthly increases hasn’t happened since the height of the housing boom from November 2005 to May 2006, says Lawrence Yun, NAR’s chief economist.

Even Las Vegas, hit very hard by the housing collapse in 2007, has seen a dramatic turnaround, according to Soozi Jones Walker, CCIM, SIOR, with Commercial Executives. “This is a very strong market,” she says. “Investors from all over the world have been purchasing homes for long- and short-term investments. The buy-and-flip market is strong and due to short inventory, multiple offers are back.”

Walker says the housing inventory has gone from 24,000 to 4,000, due in part to Nevada’s anti-foreclosure laws that restrict banks from foreclosing on properties. The limited inventory has pushed up housing prices, according to the Greater Las Vegas Association of Realtors. In September, the price of Las Vegas single-family homes was up 13.5 percent from a year ago, and condo and townhome prices rose 24.3 percent YOY.

Like many CCIMs, Walker has her roots in residential, and although her firm is strictly commercial now, she understands the relationship between the two markets. “The two go together like a hand and glove. Without jobs we don’t need residents, and without the residents we will not have the job force,” she says. “Las Vegas has many small businesses that rely on the local residents to support them. Everything from clothing stores, to pet grooming shops and restaurants are affected. As hiring has slowly stepped up so has our commercial real estate market.”

How Strong Is Residential?
Unlike the commercial market, the improving residential market is not restricted to major gateway cities and core markets. In September, 99 metros in 33 states saw improving residential conditions, up from 80 metros in August, according to the National Association of Home Builders, which defines improving as six consecutive months of rising housing permits, employment, and home prices. Markets added to the list in September include smaller cities such as Tucson, Ariz.; Jacksonville, Fla.; Springfield, Ill.; Greenville, N.C.; and Bend, Ore.

“While economic and political head winds remain, it is obvious that the residential market has turned the corner,” says George Ratiu, NAR’s manager of quantitative and commercial research. “Sales have recorded moderate growth, prices have advanced throughout the year, and the share of distress has been in decline.”

Many CCIMs note that the number of distressed properties for sale is declining in their markets, tightening supply. While some of that decline is due to foreclosure slowdowns, NAR reports that, nationally, distressed property sales — both foreclosures and short sales — accounted for 24 percent of total sales in September, down from 30 percent in September 2011.

But we’re not out of the woods yet, Tousley notes. “Historically high levels of foreclosures will still be with us for the next two years, but the percentage of distressed sales has been moderating during 2012 and I expect that to continue through 2013. The shadow market of properties that are in the foreclosure process is probably not going to overwhelm the market in 2013.”

Lower inventory and strong demand have builders moving forward on projects, giving rise to the thought that housing is ready to reclaim its spot as the recovery’s economic engine. Housing starts — up 20 percent this year — should rise an additional 15 percent for both 2013 and 2014, according to Mark Vitner of Wells Fargo Securities. He adds that the Federal Reserve’s recent decision to pump $40 billion a month into mortgage-backed securities should ease financing troubles for both buyers and builders. “The added liquidity … should also bolster builder and lender confidence, which should provide a real boost to sales and construction activity during the key 2013 spring selling season…,” he says. “This spring could very well see the pace of the housing recovery ratchet up in a significant way.”

As residential builders gear up, land brokers have been busy, says Bill Eshenbaugh, CCIM, ALC, of Eshenbaugh Land Co. in Tampa, Fla., but buyers remain particular about location. National builders have been very active, he says, bidding up the price on the finished available lots in class A locations.

“But there’s a big fall off from A sites,” Eshenbaugh adds. “Builders are ready to buy entitled but undeveloped land in good locations rather than buy existing lots in inferior locations.”

He adds that the activity for residential lots has included a lot of bigger players: “We had a lot of private equity and hedge funds buy residential land from builders, failing developers, banks, and CDD bond districts; now these investors are developers and/or sellers.”

But not everyone is convinced that single-family residential has turned the corner, and local markets may not always reflect national trends, Tousley says. Although Twin Cities housing prices are up almost 6 percent YOY, “June and July have been the first two months since February 2011 that the median price of a traditional (non-
distressed) home sale has been higher than the previous year’s levels,” he says. “I will be a believer that this housing market recovery is for real if the median price of a traditional home remains above last year’s levels for the remainder of the year.”

Commercial Spillover?
Tousley adds that the residential meltdown had a serious effect on the Twin Cities commercial markets, but that the improving housing market bodes well for everyone. After the large drop in home prices, “this ‘negative wealth’ effect changed the way people felt about their financial security,” he explains. “Consumer confidence declined and the retail and office markets were among the first to be impacted. We are just beginning to see signs of recovery. Home prices are a leading indicator, and if they continue to increase, commercial real estate will follow the trend.”

On a business level, some CCIMs have benefited from the strong residential market — at least those with ties to residential agents. “We readily share leads and referrals back and forth,” Wimberly says of the arrangement between KW Commercial and Keller Williams. “Just this year I have received over 20 referrals from our residential division.”

The commercial deals resulting from residential leads run the gamut for Wimberley’s company, including industrial and restaurant tenant rep assignments, a medical office purchase, two multifamily listings, and four other buyer rep assignments.

Of course Wimberley has the good fortune to be located in the Dallas/Fort Worth market, where the strong local economy is turning out jobs and attracting transplants.

But the uptick in residential came over the summer, he says. “The past three months have quickly transitioned from a buyer’s market to a seller’s market,” he says. “My land developer clients are getting back in the market and searching for 20- to 50-acre tracts to start the process of putting lots on the ground again.”

Jones Walker in Las Vegas is also benefiting from residential referrals. “We have completed over 16 transactions in the past 12 months with referring agents,” she says. “They were all residential agents who were selling homes to clients moving to the area to open their businesses or, in the case of three referrals, local residents wanting to purchase buildings knowing that prices had declined from 40 percent to 60 percent from the top of the market.”

Two of the strongest housing markets are Florida and the West Coast, where shortages are actually occurring. “Sales have picked up dramatically to the point that there is two to four months’ inventory,” says Janet K. Robinson, CCIM, with Coldwell Banker Commercial NRT in Sarasota, Fla., who has been getting two to four referrals a week from residential agents. “Rental property is also seeing strong activity including limited inventory. New home development is picking up, but is still limited primarily to the under $200,000 market.”

On the West Coast, Juan Huizar, CCIM, a broker with Accrued Financial Services in Signal Hill, Calif., who does both residential and commercial, says the Long Beach, Calif., residential market “is hot, bottom line. Inventory is down by over 40 percent YOY. There are fewer foreclosed homes on the market and currently more buyers than sellers. People are having to overbid in order to win the deal.”

Huizar is also seeing cash investors gravitate to residential, picking up bank-owned houses and condos. “A condo under $150,000 provides owners a great cash-on-cash yield, with minimal risk,” he says. “Vacancy is extremely low and rents are forecasted to increase, so these condos rent fast. From a broker’s standpoint, if you don’t have a cash buyer for these condos, you simply don’t stand a chance.”

Huizar says the residential uptick has not translated into commercial activity in his market, and many CCIMs report a similar situation. But, says NAR economist Ratiu, residential’s return is still a good sign for the commercial market: “With rising sales, property values also tend to increase, … appreciating values should lift consumer confidence and, over time, consumer spending.”

In addition, the residential market provides an indication of where consumers are going, he says: “Demand for housing relates to consumers’ appetite for spending and their medium- to long-term outlook. Upward trends in both would indicate a strong economy.”

And, when people buy houses, they buy lots of other stuff to fill them such as furniture and appliances. Today’s home buyers have exceedingly low mortgage interest rates, which translates into more disposable income. “A lower cost of financing leaves more money for spending in retail stores, which drives demand for consumer goods, increases trade, and directly impacts demand for industrial space,” Ratiu adds.

The apartment market has also been influenced by the residential market, he says. “The level of inventory and supply of residential space are other important indicators, directly tied to the apartment market,” he says. “In an environment of high supply and high inventory of homes, along with low interest rates, such as the first half of the 2000s, demand for apartments may be low. On the other hand, in the post-2009 period, low levels of new construction, low supply and tight lending standards, in addition to the fallout from the foreclosure crisis, have elevated demand for apartments.”

But will the demand for single-family housing eat away at multifamily demand? Hardly a chance, says Cassidy Turley economist Thorpe. The pent-up demand for household formation stands at about 1.3 million units, enough for both multifamily and single-family residential to sustain healthy markets for several years.

In fact, NAR economist Yun predicts single-housing shortages — and price appreciation — in the near future, as supplies dwindle and homes sell more quickly. “Ironically, if housing construction doesn’t pick up to normal levels within two years, supply shortages could be sustained for an extended period and lead to above-average appreciation,” he says.

No one sees a return to the wildly inflated home prices of the housing bubble, but a little appreciation would go a long way toward increasing consumer confidence, which, in a low interest rate environment, would lead to more demand, more sales, more new construction, and more jobs, setting in motion the wheels of a true recovery.

The Great Recession took a heavy toll on the nation’s banking industry and dramatically reshaped its makeup. A total of 465 banks failed and their assets and deposits redistributed to the country’s remaining 7,176 institutions, fewer than many feared, but still a major and expensive disruption. It has been well documented that in almost all of the recent bank failures, commercial real estate lending was a major factor in weakening them to the point of collapse.

Rather than rehash that point, a new federal audit and evaluation took a different view and examined how banks with heavy CRE loan concentrations survived through the recession’s critical years and avoided demise.

The FDIC Office of Inspector General (OIG) completed a study of FDIC-supervised institutions with significant acquisition, development, and construction (ADC) loan concentrations that did not fail during the recent economic downturn.

ADC loans are considered the riskiest type of commercial real estate (CRE) lending. During the recent financial crisis, FDIC analysis shows that failed institutions had concentrations of ADC loans to total assets that were roughly three times the average of concentrations of non-failed institutions.

The objective of the new audit was to identify factors that may have helped banks mitigate the risks historically associated with ADC concentrations during periods of economic stress. The banks the OIG studied had characteristics and ADC loan concentrations similar to those that failed. In general what it found was that the banks that did not fail had a combination of the following six characteristics:

Geographic Location Played a Significant Role in Financial Performance

For starters, it helped that almost all of them were geographically immune. Most bank officials the OIG interviewed emphasized that the economic decline was not as steep in their marketplace as it was in other areas of the country. Although every region of the country was impacted by the financial crisis to some extent, the economic fallout was not uniform across the country. Bank failures were more concentrated in areas that experienced greater economic distress – including Georgia, Florida, Illinois, and California. Of the banks that survived, the OIG found only one bank that was located in one of the states with the greatest number of failures.

Implemented More Conservative Growth Strategies

In general, the banks that failed pursued aggressive growth strategies centered in ADC lending, which left those institutions more vulnerable to the economic downturn. While the 436 banks in the OIG study experienced some increasing ADC concentration levels from 2005 through 2007, most of the bankers it spoke with characterized their institution’s risk appetite as being conservative or moderate. Bank officials from one bank explained that the bank was aggressive early but also “got scared” early. In addition bankers stated that once the economy declined, they mitigated the risk associated with their ADC loan concentrations by intentionally reducing their ADC loan portfolio, thus further diversifying their loan portfolio,

Implemented Prudent Risk Management Practices and Limited Speculative Lending, Loan Participations, and Out-of-Area Lending.

Most banks included in the study had stronger loan underwriting practices than failed banks and, consequently, a lower risk profile in general. Generally, bank officials said that speculative loans were originated only on a limited basis before the economic crisis, if at all. Furthermore, in cases where banks did fund speculative ADC loans, bank officials indicated that loans were made to existing borrowers and were tied to strong customer relationships. Most of the banks that survived either did not originate out-of-area loans or did so only on a limited basis to existing customers.

Posted Lower Level of Non-Current Loans and Losses Associated with ADC Loans

The successful banks in the FDIC study generally experienced a lower level of non-performing loans and losses. For institutions that failed, non-performing ADC loans represented 8% of all nonperforming assets in the first quarter of 2000 and rose to a decade-high of 54% in the third quarter of 2008. For survivor institutions, non-performing ADC loans also rose but not as much – from almost 4% in the first quarter of 2000 to 23% in the third quarter of 2009.

Maintained Stable Capital Levels and Had Access to Additional Capital If Needed

Of course, capital serves as a buffer between operating losses and insolvency. The more capital a bank has the more losses it can withstand. Losses associated with ADC loans were not as significant for surviving banks compared to the banks that failed. In addition, most bankers commented that their bank’s access to capital was not restricted. If needed, their shareholders or outside investors were willing to invest additional capital.

Relied on Core Deposits and Limited Net Non-Core Funding Dependence

Examiners have historically categorized core deposits as stable, less-costly deposits obtained from local customers that maintain a relationship with the institution. Brokered deposits are considered potentially volatile, interest-rate-sensitive deposits from customers in search of yield. The FDIC’s research indicates that core deposits may reduce a bank’s probability of failure because they typically provide a bank with a stable and relatively cost-effective source of funds and are a direct indication of a bank’s valuable customer relationships and franchise value.

Secondary and tertiary markets benefit from key demand drivers.
It didn’t take long for Jeff Castell, CCIM, SIOR, to find a buyer for his client’s 704,000-square-foot distribution center in Franklin, Ind., earlier this year. A principal at Cassidy Turley in Indianapolis, Castell knew the property’s 32-foot clear heights and massive size fit the needs of today’s most active industrial users. And with his client planning to vacate the space after the sale, there was an opportunity to capitalize on user demand in this suburb on the south side of Indianapolis, which is one of the most sought-after markets for distribution centers in the country.

Castell’s team identified a tenant, Anderson Merchandisers, to take the entire space, and, based on that lease, was able to sell the property in March to a joint venture of Alex. Brown Realty and Biynah Industrial Partners. Less than a month later, the joint venture sold the property again, to Stag Industrial, for a staggering $18 million or nearly $25 per sf.

Midwest in Demand
The transactions underscore the brisk pace and healthy pricing of both leasing and investment deals today in the Midwest industrial markets, and particularly in Indianapolis, where proximity to large population centers and resurgent manufacturing is driving demand. “There’s a combination of continued demand and lack of product in central Indiana,” says Castell. “As a result, we’ve got between 3 million and 3.5 million sf of speculative construction under way right now.”

Industrial Developments International is developing one of those speculative projects, an 800,000-sf distribution building at AmeriPlex Business Park, next to Indianapolis International Airport, says the company’s broker, Jeremy Woods, CCIM, SIOR. The industrial vacancy rate in Indianapolis is 7 percent overall and a scant 5 percent for the most modern space, according to Woods, who is executive vice president at Summit Realty Group in Indianapolis. Historically, the market’s vacancy rate has averaged about 14 percent. “We are at an unprecedented low vacancy rate in that modern bulk space,” Woods says.

The tight market stems from a banner leasing year in 2008, when the market absorbed about 8 million sf of industrial space at the same time that speculative construction came to a halt. Absorption has continued to eat away at available space ever since, as companies have taken Indianapolis buildings in order to consolidate their supply chains and reduce costs, Woods says.

What is Indianapolis’ secret to success? In addition to the city’s geographic advantage for supply chain hubs, recently passed right-to-work legislation has increased Indiana’s appeal to corporate users seeking affordable skilled workers, Castell says.

The availability of non-union, skilled labor is also helping to drive demand for manufacturing space in western Michigan, says Duke Suwyn, CCIM, SIOR, president and CEO of Colliers International in Grand Rapids, Mich. The most active leasing activity of late has involved manufacturers of food and specialized automotive parts, but makers of pharmaceuticals and other specialized, low-volume products are also taking space.

“We’re in a crazy situation here — we are out of inventory and we have very strong demand for space,” Suwyn says. In July, one of Suwyn’s clients received final approval to develop an 85,000-sf structure for light manufacturing and distribution uses in Kentwood, Mich., in a build-to-suit for an undisclosed user. “That will be the first new standalone industrial construction we’ve seen in years,” he says.

A Nation Recovers
The Midwest is perhaps the brightest spot among industrial markets in 2012, but it isn’t alone. The U.S. industrial market showed marked strength at midyear, with a net 22.5 million sf of space absorbed by tenants in the second quarter, according to New York-based research firm Reis. The national vacancy rate ended the quarter at 13 percent, down 30 basis points from the first quarter and down 80 basis points from a year earlier.

“The second quarter was the strongest quarter we’ve seen in the past year,” says Brad Doremus, Reis’ senior analyst. “Rents were also the highest we’ve seen them grow since one year ago as well.”

Asking annual industrial rent averaged $5.35 psf in the second quarter and was up 0.5 percent from the first quarter, Reis reports. Effective rent, which factors in incentives, was $4.81 psf, up 0.6 percent from the previous quarter. “Incentives have started to tighten, which is a good sign for owners,” Doremus says.

He attributes the healthy occupancy numbers in part to a remarkably small supply of new construction in the pipeline. Developers delivered just 2.3 million sf of industrial space in the second quarter, down from 2.5 million sf in the first quarter. “We’re seeing some of the lowest construction figures we have ever seen,” he says.

Industrial Hot Spots
Manufacturing and a resurgent automotive industry is fueling leasing activity in the Midwest, Doremus confirms, and seaport activity is driving up occupancy and rental rates all along the West Coast. Absorption is increasing in the Mid-Atlantic markets of Atlanta and Raleigh/Durham, N.C., and even in Tampa, Fla., all of which may be benefiting from the pending expansion of the Panama Canal, Doremus   speculates.

Here are a few of the trends generating deals today, based on a recent survey of CCIMs.

Denver is a great place to live, and businesses that support its growing population are driving industrial demand there. Vacancy is less than 10 percent, according to Steve Poole, CCIM, vice president of industrial sales at Cassidy Turley Fuller Real Estate in Denver.

From Denver northward, a thriving oil and gas industry has soaked up nearly all of the older industrial stock, says Mark Bradley, CCIM, SIOR, managing broker of Realtec Greeley in Greeley, Colo. Exploration companies and venders serving the sector are chiefly interested in industrial buildings they can drive a truck into, with plenty of space for truck courts and outdoor storage. “Our vacancy rate has gone from 18 percent or so a year ago to 7 percent or 8 percent right now,” Bradley says. “Absorption has been strong all along the Highway 85 corridor from North Denver to Wyoming.”

In Texas, industrial demand is strong in the Tarrant County area to serve industries ranging from automobiles to call centers, food, importers, and security, says Jennifer Gray, CCIM, broker and managing partner for Northeast Tarrant and Denton counties at Bradford Commercial Real Estate Services in Southlake, Texas.

Shannon Owens, CCIM, vice president of Glacier Commercial Realty in Irving, Texas, says a number of companies new to North Texas are leasing spaces from 20,000 sf to 30,000 sf while they test the market. Many of her technology and engineering clients have doubled their headcounts and square footage over the past 18 months to handle increased business.

And in California’s Inland Empire, manufacturers are taking space as a more affordable alternative to properties in Los Angeles, where port-related demand keeps lease rates at a premium, reports Tony Guglielmo, CCIM, broker/owner of Allied Commercial Real Estate in Ontario, Calif.

Challenged Markets
Many markets that entered the recession with an overhang of space continue to struggle with weak demand and anemic rental rates. Lease rates are down 20 percent or more from their peak in Goshen, Ind., according to Steve Pettit, CCIM, senior associate broker at CB Richard Ellis|Bradley. In Columbus, Ohio, it is still a tenant’s market due to a space glut, reports Kevin McGrath, CCIM, associate vice president at Cassidy Turley in that city.

A chicken-and-egg dilemma is hampering industrial development in the Carolinas, brokers say. Both Brooke Gibson, CCIM, broker at Hart Corp.|International Industrial Real Estate in Charlotte, N.C., and Mike Ferrer, CCIM, vice president for industrial brokerage at Avison Young in Mount Pleasant, S.C., say there is a shortage of modern distribution space in their markets. Yet banks won’t fund speculative construction to meet that need, and tenants are reluctant to commit to space before it is built.

Atlanta may be hardest hit industrial market in the nation as it struggles with an oversupply and weak demand, says Rick Tumlin, CCIM, SIOR, senior partner at Lee & Associates in that market.

Indeed, the recent uptick in industrial demand is a shadow of what it was in healthier years, with the number of retailers seeking industrial space down about 60 percent since 2008, according to Paul Waters, CCIM, SIOR, FRICS, executive managing director of industrial brokerage for the Americas at NAI Global in New York City. Waters works with major corporate end users of industrial space and currently is helping a discount retailer re-engineer its supply chain by developing a half-dozen large distribution centers around the country.

Of the few corporations seeking industrial buildings, most prefer large, modern buildings measuring 450,000 sf to 1 million sf. “And in most cases, they’re looking to build,” Waters says, adding that companies can take advantage of favorable market conditions to construct space that fits their needs exactly rather than adapt to existing digs in most markets.

Waters doesn’t paint a rosy picture for 2013, either, predicting that demand for space will continue near current levels until employment improves and boosts consumer spending. “We need to put people back to work so they can buy things that retailers sell,” he says. “People are expecting great changes after the [November] election, but I don’t see any change coming for industrial next year.”

But Doremus, the Reis analyst, is optimistic about 2013, trusting that once the markets move past the uncertainties of 2012, companies will adjust to conditions at home and abroad and make more real estate decisions. That means absorption will accelerate, and rents will rise soon after.

Matt Hudgins is a real estate business writer based in Austin, Texas.

Industrial Investors Gravitate to Secondary Markets
Investors are increasingly seeking high-quality industrial assets in second-tier cities as an alternative to acquiring properties in primary markets where bidding wars have driven prices to unpalatable levels, CCIMs tell CIRE.

In primary industrial markets like Chicago, investors are buying fully leased, well-located class A properties at less than a 6 percent capitalization rate, according to Kenneth Szady, CCIM, SIOR, executive managing director and head of the Midwest Capital Group at Newmark Grubb Knight Frank in Chicago.

When cap rates fall below that 6 percent threshold, investors begin to either look for lower quality or less well-located assets in the primary markets, or they begin shopping for class A properties in secondary markets, Szady says. In either case, those investors will acquire assets in a cap rate range from 7.5 percent to 8.5 percent.

That’s based on Szady’s experience over a 24-year career in which he has closed $7.2 billion in transactions, including two of the largest deals of 2012. This past summer, he represented the Gullo family in selling a 330,000-square-foot industrial portfolio in Elk Grove Village, Ill., near O’Hare International Airport, to Morgan Stanley. In March, he closed a 1.35 million-sf build-to-suit transaction for the Clorox Co. in University Park, Ill., on behalf of an institutional client. (Szady was executive director and head of capital markets at Cushman & Wakefield at the time of the March deal).

Indeed, CCIMs in secondary markets with low vacancy rates, including Indianapolis, northern Colorado, Texas, and other markets with expanding regional economies, report strong investor interest in industrial properties. “Yields look pretty good here especially when coupled with the excellent story Indy can tell,” says Jeremy Woods, CCIM, SIOR, executive vice president of Summit Realty Group in Indianapolis. “We are also seeing an appetite for class B value-add properties as the newer, more modern space is beginning to get frothy.”

At least for the next year or two — until construction can introduce new supply to the primary markets — investors will be active buyers in the secondary markets, Szady predicts. “We’re just opening the floodgates into the secondary markets,” he says, “and it’s the beginning of the cycle.”

No property taxes for five years. No closing fees and no capital-gains taxes. With a blitz of housing incentives set to expire Dec. 31, Puerto Rico is courting high-end home buyers—and sparking a real-estate revival.

The Puerto Rican government introduced the aggressive incentives two years ago to boost the island’s flagging housing market. The stimulus seems to be working: New-home sales were up 51% by volume in 2011 and 38% for the first six months of 2012, compared with 2010, when the incentives were enacted, according to the Puerto Rico Federal Affairs Administration.

The stimulus means a buyer who purchases a $1 million home will save about $25,500 in closing costs and property taxes. And a homeowner who rents out the property can waive rental-income taxes through 2020.

The incentives apply only to new homes, and the buyer must hold on to the property for a minimum of six months in order to waive capital-gains taxes upon selling. (There are also some incentives for buyers of existing properties.) Currently, the Dec. 31 expiration date targets only buyers of second homes; the incentives will continue for primary-home buyers.

Although the incentives have warmed up the market, asking prices remain 30% below what they were during the market’s peak seven years ago.

The island’s real-estate community is hoping the program will bring Puerto Rico back to its glamour days. In the late 1950s, financier and conservationist Laurance Rockefeller opened a resort west of San Juan that attracted actresses like Ava Gardner and Elizabeth Taylor, and post-World War II presidents like John F. Kennedy.

Today, it remains to be seen whether the commonwealth can reclaim its stylish mystique. That’s because for the past two decades, Puerto Rico has focused on the cruise-ship crowd and only recently found its footing in multimillion-dollar properties, says Ani González Brunet, a broker in San Juan.

Acquamarina, a 47-unit development designed by Enrique Gutiérrez, the architect behind Miami’s Bacardi buildings, is one of the newest offerings in San Juan’s Condado neighborhood. Located on Ashford Avenue, San Juan’s equivalent of Rodeo Drive, the terraced building is walking distance to Cartier, Ferragamo and Budatai, one of the top Latin-fusion restaurants on the island.

When plans were released in 2006, the building’s options sold out quickly. But the real-estate market tanked in 2008, and many Acquamarina buyers pulled out, leaving the property virtually empty when it opened in 2009. The recent tax incentives have spurred sales in the development, as did an exclusive affiliation between its sole seller, Trillion Realty Group, and Christie’s International Real Estate. Today, three units remain, including the $5 million resale of the 8,379-square-foot, three-story penthouse with an elevator, floor-to-ceiling windows and an infinity pool overlooking the ocean.

Competition is sizzling on opposite coasts, where two luxury developers are vying for the same buyers. Built on former coconut plantations, both family-developed properties are marketing their gated communities to eco-friendly buyers, a message that is in sync with recent green initiatives pushed by Gov. Luis Fortuño.

Thirty-five minutes west of San Juan is Dorado Beach, a Ritz-Carlton Reserve, built by the family-owned Stubbe Organization and the Caribbean Property Group. In addition to a hotel, there are two residential sections: On West Beach, 13 condos have been built, and a second phase of 14 additional condos, priced from $2.5 million, is in progress. On East Beach, there will be 10 single-family villas starting at $4 million. When the development opens in December, homeowners will get to borrow artwork through a partnership with the nonprofit Art Production Fund. There’s also an eco-adventure program in the works that will include snorkeling, hiking and wetland tours. The Ritz-Carlton and the Stubbe Organization declined to elaborate on the project.

On the opposite end of the island, 27 miles from San Juan, sits Bahia Beach Resort & Golf Club, a 483-acre resort on the edge of the El Yunque rain forest. Developers are emphasizing exclusivity and the natural surroundings by keeping 65% of its land undeveloped and capping heights on residences at below tree level. The St. Regis-branded properties at Bahia, developed by Puerto Rico’s Interlink Group, are on a private island with 26 lots, 16 of which are still available. Prices for homes on the island start at $3.5 million. St. Louis Cardinals outfielder Carlos Beltran and former boxer Oscar De La Hoya have built tropical plantation-style homes here that include infinity pools, travertine floors, lily ponds and coral-stone terraces.

Bahia’s environmental focus has earned it a certification from Audubon International, meaning the developer takes specific measures to help preserve the environment.

The environmental efforts are what attracted Marie Helene Reinhold, a jewelry-store owner with homes in San Juan and Sun Valley, Idaho, to build a 9,200-square-foot home with her husband on Bahia’s private island. Ms. Reinhold says she enjoys feeding the birds, eating at Fern, chef Jean-Georges Vongerichten’s restaurant on the property, and watching turtles lay eggs on the beach. “I’ve lived in Puerto Rico for 40 years and didn’t know such beauty existed here,” she says.

Puerto Rico’s renaissance has experienced its share of growing pains. Airlines increased the number of flights to the island before new roads had been built, so travel times are longer than expected. High-end developments have round-the-clock security, but the island has seen crime rates rise in recent years, mostly attributed to drug trafficking and an unemployment rate that has been above 13% since December 2008. And while the allure of traveling without a U.S. passport attracts some people, it can be off-putting to others who view Puerto Rico as a destination for less-well-heeled tourists.

But Leticia Brunet González, a principal owner at Trillion Realty Group, likens the island’s recent ascendancy to a prized Gucci bag: “It was put in the drawer while people tried something else. Now they’re taking it back out.”

By: Mark Heschmeyer / CoStar Group
September 12, 2012

There has been much speculation that single-family housing prices could take a hit as increasing numbers of baby boomers downsize and leave larger homes behind as they move into retirement age. That assumption is too general to be entirely accurate, according a pair of major economic papers on the topic of aging and property prices.

What is clear is that this ongoing population shift holds important ramifications for the multifamily property sector, including senior and assisted living facilities. And it is also becoming an issue of increasing importance for commercial real estate investment researchers.

“As Baby Boomers enter retirement age, many ‘empty nesters’ may downsize, leaving their current homes in favor of smaller condos or age-restricted communities. Therefore, prices for large single-family homes located in high property tax areas could be under pressure over the next decade,” Tim Wang, senior vice president and head of investment research for Clarion Partners in New York, told CoStar News. “However, seniors today are often healthier and live longer; because of this we believe it is still premature to invest in assisted living or nursing homes.”

“In terms of locations, we do not expect all seniors to relocate to Sun Belt cities. In fact, many seniors prefer to live near their children and grandchildren and to remain close to their lifelong friends,” Wang said.

John Rosenfeld, general counsel for Oxford Investment Partners in Phoenix, said that shifting single-family dynamic of baby boomers has been disrupted by the Great Recession and that has already helped boost the multifamily sector.

“Despite the popularity of various retirement investment vehicles, the largest part of most baby boomers’ nest egg is still their homes. Converting those real estate nest eggs into retirement cash could pose the prospect of a “correction” as the baby boomers become a sellers’ demographic,” according to Rosenfeld.

“The timing and severity of the Great Recession has interrupted this dynamic,” Rosenfeld said. “First, home devaluations of 30% or more over the past five years have depleted home equity, making it undesirable-even infeasible-to sell in the current market. We’ve seen this cause some retirees to describe themselves as “stuck” in their homes.”

“What this has done is temporarily push back the onset of the disposition trend for baby boomers and made that trend more dependent upon the dynamics of the residential market than the age of the boomers,” Rosenfeld said.

Rethinking Retirement

“A second effect is more lingering,” Rosenfeld continued. “The Great Recession has caused many baby boomers to rethink their retirement plans. Boomers not only lost significant home equity, but also had to dip into more liquid retirement savings. Many baby boomers suffered layoffs and significant reductions in household income during what should have been their prime earning years. The downturn has flattened and skewed the earnings curve for many boomers, causing them to push back their retirement date or ratchet down their expectations.”

“So boomers may be inclined to stay in their family homes for longer since they will be working longer. This could elongate the residential disposition timeline for the boomer generation overall, but result in a better fit with absorption,” he said.

“Third, the Great Recession has caused an uptick in the residential rental market. This may have a mixed effect on housing values as baby boomers enter retirement. Today many people are not only renters of necessity, but by choice. That’s a reversal of a mindset that dates back to the early 20th Century, if not before,” Rosenfeld said. “The improved rental market may also provide opportunities for boomers to down-size without being forced to sell their family homes.”

Sandra Ware, director and a member of the land practice group of Newmark Grubb Knight Frank in Wilmington, DE, sees the same phenomenon at work.

“What we are facing is a Lost Generation of homeowners, who would normally be buying the larger homes that the baby boomers are selling (or try to sell),” Ware told CoStar. “Now we have a gentrified group of new baby boomers who worked hard for what they have and are suddenly facing the untenable situation of staying put in their ‘empty nest’ homes, without being able to tap the hard earned equity that would have contributed to an easier lifestyle.”

“The underwater homeowners must stay put, must continue to work to keep what they have, and worse, cannot afford any health issues, as the cash reserve cushions are no longer available,” Ware said. “It is a truly scary situation for those experiencing it. Estimates are over 19 million people are in the same situation, with no solution in sight.”

“As far as senior living home prices, and retirement communities, these prices have been frozen in time as there are less and less qualified buyers, less people in the market without homes to sell , and all the while the safety cushion of retirement is ‘plugged up,’” Ware said.

What About the Echo Boomers?

Between 1945 and 1964 a total of 76 million to 79 million people were born. Now the children of the baby boomers qualify as an even larger demographic group. From roughly 1980 to 2000, 80 million or so echo boomers — Generation Y, Generation X, Generation Next, or whatever you want to call it – were born.

Scott Ostlund, principal and president of Ostlund Equities, which owns and rents single-family homes in throughout Nevada, Arizona and California, foresees demand for properties being shed by downsizing baby boomers being fueled by the echo boomer home buyers. As a result he claims the impact on single-family housing prices will be minimal or could even continue to drive property prices. Ostlund is also principal and senior vice president of Lee & Associates in Ontario, CA.

“Yes there is a big population of people shifting out of housing but the population of people buying houses is also growing,” Ostlund said. “There won’t be an oversupply. There are more people to buy properties and there hasn’t been any measurable new homes built in the last five years.”

“So how much of a degree does the shifting population demographics affect property pricing,” Ostlund asked. “It’s way way down the list,” he answered.

Pete Chinnock, senior associate with Penn-Florida Cos. in Boca Raton, FL, said he too thinks the echo boom will mitigate the impact of aging baby boomers.

“In my opinion it’s a very simple answer. It’s as easy as Accounting 101, “Supply and Demand,’” Chinnock said. “We go through one of these economic cycles every seven to 10 years and real estate prices are always affected negatively and then positively. They always seem to come out the other side and peak higher than the previous peak.”

“The demand for single-family home ownership will always be a goal regardless of age and as long as the combination of internal birth rate and immigration continue to create increases in the population the demand for housing will continue to increase,” Chinnock said. “The only variable I see is the type of housing required, based on age, health care needs and economic ability, will shift between single-family, multifamily, senior housing and assisted living due to population demographics, and prices will follow the supply/demand curve for each.”

More About Credit Markets than Age Demographics

And there is economic theory to support Ostlund’s and Chinnock’s views that shifting population is not the most significant factor that will drive future property prices.

What made housing vulnerable to a bubble? And why has the housing market been so impervious to attempts at resuscitation?

Housing is unusually susceptible to booms and busts because simply because of credit conditions, according to Adam J. Levitin, professor of law at Georgetown University, and Susan M. Wachter, professor of real estate and finance at Wharton Business School at the University of Pennsylvania, in a current working economics paper entitled Why Housing?

“Housing market distress transmits to the macroeconomy through a balance sheet channel, a construction channel, and a collateral channel,” the two argue. “Because housing is credit-backed and such a large asset class, failure will impact the financial system itself and pull down the economy as a whole. The dual-use of housing, its ubiquity on consumer balance sheets, its highly correlated pricing, and its linkage to the macroeconomy make it a particularly painful type of asset bubble to deflate.”

However, according to Kiyohiko Nishimura and El?d Takáts, economists in the Monetary and Economic Department of the Bank for International Settlements, property prices are affected by both aging and money demand.

In their working paper released this month, the two argue that when the baby boomers joined the workforce and started saving, money supply and property prices entered a rising trajectory.

“We conclude that demography was the long-run driver of this process, basing our argument on data from 22 advanced economies for the 1950-2010 period,” the two concluded. “According to our lifecycle model, large working-age populations saved for their old age by investing in property and broad money instruments, such as deposits. In the past, savings activity by baby boomers drove up property prices and also increased demand for money. As baby boomers retire, these dynamics will go into reverse.”

Ah! Youth

Yet another wrinkle to factor into this complex equation was put forth by Mark Russell, is the City Assessor for the City of Yonkers, NY. Just because there is an echo boom coming into its prime earning years, doesn’t necessarily mean they are as interested or in financial position to strive for their parents’ dream of homeownership.

“We have seniors that need to down size their homes or acquire a (single-level) apartment… and they will be unloading their homes in record numbers. But who will buy these homes?” Russell asks. “With oversupply, there has to be a reduction in price especially with gun shy young people that do not even know if their jobs are secure. Also a young person may want to maintain the flexibility of being able to relocate without the burden of unloading a home.”

“So you have an upcoming glut… due to downsizing, young people with less income and desire to be locked into anything for 15 to 30 years, and increasing requirements for down payments,” Russell said.

All signs point to long-term reductions in housing prices and ownership, and a more rapid increase in rental costs, Russell said.

Not so fast, adds Diane J. Macunovich, professor of economics at the University of Redlands in California. She suggests all the fuss over an aging population may be focused on the wrong age group. According Macunovich, what we should be worried about are the gaps in the youth populations that may trigger future recessions.

In her paper, The Role of Demographics in Precipitating Crises in Financial Institutions, more than 70% of major declines in the proportion of 15-to-24-year-olds in the population have been associated with declines in GDP growth, according to her study of worldwide data from 1960 through 2005.

“A boom in the population of young people seems to boost producers’ expectations,” Macunovich argues. Unfortunately, those producers fail to cut-back when the boom abates, “and the passing of the bubble causes defaults and bankruptcies, which prompt foreign investors to withdraw funds and speculators to unload the local currency.”

“This appears to have been the pattern in four financial crises since 1980, as well as Japan’s “lost decade,’” Macunovich argues.

Meanwhile, Clarion Partners’ Tim Wang sees several economic factors affecting this key age group that is and will continue to drive demand in the multifamily market.

“Multifamily properties primarily serve renters age 20-34. This demographic cohort is expected to increase substantially as Echo Boomers graduate from college. Most of them will not and cannot afford to buy homes. Tightened lending requirements, the flexibility of renting, large student loan debt, and the trend for young people to postpone marriage and start a family all affect decision making to the clear benefit of the rental property market,” Wang said. “Therefore, we believe that the demand for multifamily rentals is likely to remain strong over the next several years.”

Puerto Rico’s $8.5 billion food market untapped by local agriculture

A close look at the economic output of Puerto Rico’s agricultural industry over the past 50 years presents a very telling picture of how much the island’s agriculture has plummeted, a pace directly proportional to the amount of locally produced food consumed.

Those disturbing statistics are difficult to comprehend, when economists estimate 70¢ of every dollar spent on locally grown food remains in Puerto Rico’s economy.

As reported by CARIBBEAN BUSINESS (June 9, 2011), after decades of governmental mismanagement, the local agriculture industry produces only about 20% of the food we consume, while 80% of our food is imported. Yet according to industry experts, 90% of the food we consume can be grown or cultivated in Puerto Rico.

In 2010 alone, we imported $3.5 billion in agricultural and food products at wholesale prices, according to the latest Puerto Rico Planning Board estimates. That is money that could have stayed in Puerto Rico’s economy.

In total, island residents consumed about $8.6 billion in food products at retail prices during that year. Industry sources interviewed by CARIBBEAN BUSINESS agree the island should be producing at least 45% to 50% of the products we consume. That is being conservative. We have the capacity to produce 90%, or roughly $7.7 billion worth. We are far short of that capacity.

If Puerto Rico were able to replace 90% of its agricultural imports with products grown locally, it would represent $3.15 billion staying in the local economy and roughly 85,000 new jobs in the agricultural sector.

It also would lower the cost of food, given savings in transportation expenses, and provide a secure food supply for the island.

THE MYTH OF FOOD ABUNDANCE

Rapid world-population growth along with global climate change and emerging consumer markets competing for existing food supplies are putting at risk the availability and affordability of the world’s food.Sooner rather than later, Puerto Rico will be affected by this situation.

In addition, experts on the subject point out that Puerto Rico has merely three weeks of food supplies in the event the island’s shipping infrastructure were to sustain a catastrophic blow. Were there to be a natural disaster such as a hurricane or tsunami, Puerto Rico would be disproportionately dependent on emergency aid. Should the maritime-transportation industry’s infrastructure—responsible for moving the majority of the food consumed on the island—be drastically affected, industry executives inform that it would take a few weeks for the industry to become operational, with estimates predicting it would be at about 25% to 30% capacity. Re-establishing operations to full capacity could take months. Refrigerated cargo could be a bigger concern depending on the availability of electrical power on the island.

“Because of the way they work the vessels, barge carriers could be partially operational sooner than ship operators that use cranes to load and unload vessels,” José Nazario, administrative vice president at Crowley Maritime Corp.’s Liner Services, told CARIBBEAN BUSINESS. “Ships using cranes might take much longer depending on the damages cranes sustain and the time needed to either repair or replace them. In any scenario related to a major catastrophe, it could take a long time before food-import levels go back to normal.”

Eduardo Pagán, Sea Star Line’s vice president, agrees. “We could work the roll-on/roll-off section of our ships without cranes, but that would just be a portion of our ships’ capacity; there also is the possibility of working our ships at the Port of Ponce facilities, but that is assuming its cranes don’t sustain damages. All in all, it would be a difficult situation,” he said.

The truth is that although the likelihood of sustaining such catastrophic, long-lasting isolation is very slim, there are plenty of compelling reasons to examine closely the shortcomings of the industry.

X-RAY OF CONSUMPTION

About 27% of local food consumption comes from meat and related products, which make up the largest portion of food-related expenditures. Fruits and vegetables comprise 24.7%, followed by dairy and related products, constituting 11% of the total spent, according to consumer statistics from local market research & analysis firm Estudios Técnicos.

According to the CARIBBEAN BUSINESS 2012 Book of Lists, the island’s 32-largest food services and product distributors took in more than $3.5 billion in revenue largely through imports, most of which could be substituted by locally grown products.

A variety of fruits, vegetables and other agricultural products are harvested year-round in Puerto Rico, and it is widely known that for every dollar spent on local agricultural products, 70¢ stays in the island’s economy.

In addition to the financial aspect, increasing local agricultural production has myriad benefits. First, locally produced food products would be fresher at the point of sale than imported ones.

On average, food products imported from the mainland U.S.—the island’s main food supplier—travel 2,800 miles from the source of production to the dinner table. At the very least, they must spend three days at sea. Products coming from China, the second major food supplier, travel some 9,500 miles, a nearly month-long voyage. The transportation of food cargo costs at least $300 million a year.

There are other environmental benefits of growing more food in Puerto Rico as well. A thriving agriculture industry serves to enrich the soil and protect the air and water quality.

To develop the local agriculture industry to its full potential, from the current 20% production level to 90%, will require the industry to operate like a well-honed business. Doing so will keep money in the local economy and create thousands of jobs.

This is clearly not happening. There are several reasons why.

AGRICULTURE CEOS

Most local farmers don’t necessarily have the skills to run their farms in a business-like manner. Entrepreneurial and marketing abilities are needed to get products from the farm to kitchens and markets locally and abroad.

According to the most recent figures, from the U.S. Department of Agriculture Census of 2007, the average farm size in Puerto Rico is 35.4 cuerdas (34.4 acres) down from 39.1 cuerdas (37.9 acres) in 2002. These small farms, on average, produced only $32,752 worth of agricultural products at market value. Of the large farms, there are 422 measuring 260 cuerdas (252 acres) or more, 66 less than in 2002.

The past few decades have seen the local Agriculture Department become little more than a provider of government funds. Farmers are producing based on government incentives instead of market demands.

In effect, the island’s agriculture industry has become similar to a planned state-run economy, with the government determining production instead of market forces. However, after decades of falling production, it is clear that neither the Agriculture Department nor the island’s small farmers can truly predict market demand. That has to change, say industry insiders.

“The industry has to analyze the market, see what products are in demand and produce to fill those needs,” Gualberto Rodríguez, president of Caribbean Produce Exchange Inc., one of Puerto Rico’s principal fruit and vegetable distributors, told CARIBBEAN BUSINESS. “Historically, that has not been the case. Farmers have an artisan approach toward the industry; they harvest the products that, for generations, they have grown without considering market needs. In the end, when there is no demand for those products, the Agriculture Department ends up subsidizing their crops.

“This model is not productive; instead of the government subsidizing inefficiencies, those funds could be used to provide education and make new technologies available to farmers, which could help promote other crops that meet market demands and generate profitable business activities.”

Former Agriculture Department Secretary Javier Rivera Aquino agrees. “People have to start seeing this industry as a good business investment,” he said. “The first step in this process is to focus on productivity and get away from government subsidies and protection. This change has to do with the fact that we need to have the right products available when consumers need them.

“We need to create a business culture within agriculture,” Rivera Aquino said. “We need to adopt new technologies to improve production.”

A DECLINING INDUSTRY

Back in 1947, before Puerto Rico moved from an agricultural society to an industrialized economy, agriculture represented 20% of Puerto Rico’s gross national product, or GNP. That figure has gone down to less than 3%, according to the latest government statistics. (See chart on page 15)

Agricultural jobs have also followed that trend. According to the 2007 Agriculture Census, some 15,000 people were working in the island’s agriculture sector, down from more than 40,000 in 1947. That only represented 3% of the labor force and was 2,000 fewer than in 2005. The census also shows some 10,000 farmers earn $20,000 or less annually. (See chart below)

Meanwhile, food imports have more than doubled, from $1.5 billion in wholesale prices in 1989 to almost $3.5 billion in 2010.

The following is a breakdown of the imported percent of total staple foods consumed in Puerto Rico:

Tomatoes, 50.96%
Onions, 76.88%
Sweet potatoes, 81.28%
Yams, 85.76%
Yucca (cassava), 95.36%
Tannia (malanga), 93.36%
Chicken, 66.75%
Fish and seafood, 90.29%
Pork meat, 89.87%
Rice, 100%
Beans, 99.27%
Red meat, 84.18%
Traditionally, observers have blamed Puerto Rico’s high labor and production costs for the inability of the industry to achieve growth. This isn’t necessarily true.

A NEW APPROACH

There are management approaches that could maximize efficiencies and build more market share.

Puerto Rico’s entrepreneurial community needs to see agriculture as a business. Industry experts offer some recommendations: The government should assist in pairing groups of farmers with entrepreneurs who see the industry’s possibilities, connect farmers and retailers, and invest in the industry. Grouping several small farms will allow farmers to enjoy economies of scale in negotiating raw material purchases and sales contracts, which also gives retailers confidence that contracts will be fulfilled, with products delivered in the quantities needed and on time.

One company that is successfully collaborating with farmers is Wal- Mart. The retail giant, with more than 8,500 stores in 15 countries, operates more than 50 stores in Puerto Rico, and represents $2.1 billion of the $35 billion local retail sector. These include its flagship Wal-Mart stores, as well as Sam’s Club and Amigo supermarkets.

Four years ago, Wal-Mart moved to increase its purchases of locally grown foods. Since then, the company has increased locally sourced buying, from 20 farmers to more than 500 in 2012.

The move is part of the company’s global attempt to rebrand itself to attract both low-price shoppers, as well as those interested in sustainability. The rebranding has seen Wal-Mart change its slogan from “Always low prices” to “Save Money. Live Better.”

Iván Báez, head of corporate affairs for Wal-Mart Puerto Rico Inc., explained that the mega-retailer’s local program revolves around working with local farmers to increase local agricultural production.

“Buying from local producers, fresh from the farm, allows us to minimize imports of food to the island,” Báez said. “We save in energy consumption and minimize our CO2 emissions by not having to transport food across the globe. We also create local jobs and contribute to a sustainable economy.”

To deal with the fact that most of the island’s farms are small, Wal- Mart affiliates with farmers of all sizes. Some farms, for example, only supply one store, while other farmers have the capacity to supply many more.

The program’s partner farmers receive training along with technical and business-management support so they can produce well-planned, sophisticated crops. Among the products the company buys locally are cabbage, and various root vegetables such as yucca, yams, sweet potatoes, oranges, mangoes, avocados and mushrooms.

Báez said Wal-Mart is still looking to expand its local purchases by as much as 20%. He believes there is still much to be done to improve the local agriculture industry.

To this end, Wal-Mart is joining forces with the Agriculture Department and local farmers to develop crop plans, allowing the company to forecast its local purchases in advance, and ensuring farmers will have a buyer for their crop. The plan has helped to eliminate the uncertainty retailers and farmers have faced in the past.

“We feel proud that we are helping the local agriculture industry and contributing to the development of Puerto Rico’s nutritional sustainability,” Báez said.

Carlos Flores, the Agriculture undersecretary added, “This is a groundbreaking initiative that has been proven to work; we are glad to participate in it.”

Importantly, Wal-Mart has broken the myth that agriculture production is not viable because of high local-production costs.

AGRICULTURE MUST BE INTEGRATED INTO PUERTO RICO’S FOOD-INDUSTRY ECOSYSTEM

One of Puerto Rico’s leading economic sectors is the food industry. With about $8.5 billion in annual sales, the sector has continued to grow at a steady pace during the past decade.

A HUGE MARKET AT HOME

Total food sales represent about 25% of the island’s $35 billion annual retail sales in an ecosystem that includes food-industry importers, distributors, retailers, wholesalers, restaurants and convenience stores or colmados.

The industry is also an important source of employment, with a staggering 110,000 direct jobs. These represent about 12% of the local workforce, including 17.5% of private- sector employment, according to figures from the Chamber of Food Marketing, Industry & Distribution (MIDA by its Spanish acronym).

These facts present a great opportunity for the local agriculture industry, which could be supplying most of the food needed instead of the 20% it does now. This can only be accomplished by integrating agriculture into the food industry, understanding its needs and producing accordingly.

Puerto Rico’s gastronomic sector, or restaurants, represents about 44% of the local food industry. If the agricultural sector moves beyond growing just a handful of products and diversifies, it could tap into this enormous business opportunity. There is a real business potential in the fact that local agroentrepreneurs and food-related companies have a captive market of about 7,000 restaurants, which are mostly supplied by imports.

BUY LOCAL: A POSITIVE NEW TREND

In the past, local consumers had a tendency to support imported products based on a belief that they might be of a higher quality. This isn’t the case anymore.

According to an islandwide survey conducted by Gaither International, 95% of those interviewed said they purchase local products regularly; this validates the market’s untapped potential for local products.

When surveyed, nearly six out of 10 consumers, or 57%, report having purchased a Puerto Rico product during the past seven days, while a substantial 86% reported making such a purchase during the previous two weeks.

“These figures show that consumers aren’t only expressing a willingness to acquire local products, but also that the inclination has actually turned into a common consumer pattern. The implications of this new trend in consumer behavior are far-reaching and indicative of tremendous growth opportunities for the near future,” concluded Beatriz Castro, director of syndicated research for Gaither International.

Asked which local product(s) they purchased most recently, the vast majority of respondents mentioned food-related products such as viandas (root vegetables), other vegetables, fruits and milk. One-third of respondents frequently buy local coffee, and seafood was mentioned by 6%.

AGRICULTURE: HELP WANTED

If Puerto Rico is to succeed in growing its agricultural sector, the availability of a labor force will be a very important factor. Demand for agricultural workers will increase, but will people take those jobs? Even with the sector under-performing, getting people to fill those agriculture jobs has been an uphill battle.

Even when Puerto Rico faced an unemployment rate higher than 16%, half of the island’s coffee crop went unharvested in 2010 and 2011 because of a lack of workers, representing a $17 million loss in 2011 alone.

Government incentives to increase the number of workers in the industry, such as allowing low-wage earners and the unemployed to keep their benefits while performing agricultural work and offering convicts reduced sentences, have largely failed. These measures don’t address the real problem in agriculture: A rural workforce once living near farms has moved to urban centers.

BRINGING THE FARM TO THE WORKER

Since Puerto Rico started industrializing in 1947 with Operation Bootstrap, the population near agricultural centers has steadily declined. The workforce has since moved to urban centers, abandoning rural agricultural municipalities, to work in factories and other businesses in urban areas. With the local economy’s six-year recession, many of these laborers are now unemployed and could be potential candidates to work the farms. However, it isn’t cost-effective for them to drive every day from the urban centers to the fields. In many cases, they don’t even own a form of transportation.

To address these issues, during harvest seasons, the government could offer transportation to and from the fields, and housing when needed.

It is estimated that for the coffee harvest, an additional 6,000 workers are needed. These workers need housing, food and other basic amenities for living on farms during the week. Some workers could be shuttled to the nearest town, where they could obtain public transportation, while others could ride in groups with workers who have vehicles.

The Migrant & Seasonal Agricultural Worker Protection Act sets federal labor-related standards with respect to the transportation and housing of agricultural workers, including requirements for payment of wages and employment conditions. The act also deals with the relationship between agricultural workers, their employers and farm-labor contractors.

The local government could incentivize the construction and maintenance of housing, and sanitary and kitchen facilities for farm laborers that meet the act’s requirements. The government’s investment would be more than returned by the amount of money that would remain in the economy, as well as the taxes paid by the farmers, investors and businesses along the agricultural-production chain.

NEW TECHNOLOGIES NEEDED TO INCREASE PRODUCTION

The latest figures from the Agriculture census show that, in 2007, the industry accounted for 24.7% of land used in Puerto Rico. However, in fiscal 2010, the industry represented less than 1% of the island’s gross domestic product (GDP), and as previously mentioned the industry produced only 20% of the food consumed locally.

To produce 90% of the food consumed in Puerto Rico, the agriculture industry will have to become more efficient in its land use. According to the agriculture census, only 57.5% of agricultural land—320,822 cuerdas (311,197 acres) out of a total 557,528 cuerdas (540,802 acres)—was actually used for crops, pasture or grazing; new technologies promise to make the use of land more efficient. (See chart on page 17)

Hydroponics, a method of growing plants using mineral-nutrient solutions in water, forgoing the need for soil, is a good example of efficiencies provided by new technologies. While naturally, soil acts as a mineral-nutrient reservoir, the soil itself is not essential to plant growth. Using hydroponics, the plant roots absorb mineral nutrients directly from water.

The use of hydroponics allows farmers to plant on a fraction of the land needed in conventional agriculture. The advanced technique also allows farmers to be more productive and cost-efficient, leading to potential for higher wages.

Another promising technology combines biological sciences and agriculture to create bioagriculture. Puerto Rico bioscience industries have become home to nearly a dozen bioagriculture companies. These advanced agribusinesses develop and grow seeds for stateside crops such as corn, soybean, rice, sunflower, cotton and sorghum.

Seed production was Puerto Rico’s seventh-most important crop in fiscal 2008, representing 3.6% of the industry, more than pork, bananas and tomatoes. By fiscal 2010, it accounted for a $35 million business.

The research & development carried out by these companies, some of which is carried out in Puerto Rico, produces seeds with higher yields, greater resistance to pesticides and other improved characteristics. Developing advanced seeds for local agricultural production will benefit both the bioagriculture industry and the conventional agriculture industry. In addition, bioagriculture leads to higher-paying jobs.

These and other new farming techniques aren’t rocket science. If Puerto Rico puts bureaucracy aside and looks at agriculture as a great creator of jobs and revenue that will stay in Puerto Rico, then farming can help grow Puerto Rico’s economy in a significant way and provide the island with self-sufficiency.

‘Cosecha y Crianza’: A new approach to marketlocal agricultural products

The Puerto Rico Agriculture Department is betting the agency’s new “Cosecha y Crianza de Puerto Rico” (Puerto Rico Harvested & Raised) marketing initiative will create strong interest in locally grown foods.

Conceptualized to promote consumption of local agricultural products and increase demand, the new program aims to raise awareness of the quality and freshness of local products, and support farmers’ efforts by instituting a labeling system that identifies them.

The private sector’s positive reaction to the Puerto Rico Harvested & Raised initiative was instantaneous.

“I think this is a fantastic initiative,” Ferdysac Márquez, president of the Chamber of Food Marketing, Industry & Distribution (MIDA by its Spanish acronym), told CARIBBEAN BUSINESS. “What positively differentiates this initiative from others is that it integrates everyone involved in the food-distribution chain, from producer to distributor, retailer to consumer: It is a win-win for everyone.”

Products that meet Agriculture’s strict quality criteria will be identified with a seal. Fruits and vegetables, including root vegetables and other produce will carry the “Cosecha de Puerto Rico” (Puerto Rico Harvest) seal—meats, chicken, eggs, milk and other animal-derived products will be identified with the “Crianza de Puerto Rico” (Puerto Rico Raised) seal.

The seal costs $250, but industry observers agree this is a small investment for the benefits that local farmers will get from participating in the program.

The marketing effort includes onsite promotion of local products at supermarkets, other retail outlets and special events.

The initiative includes an advertising campaign featuring Iván “Pudge” Rodríguez, the Major League Baseball player; Chef Giovanna Huyke; and musician Giovanni Hidalgo; all local talent with great credibility, and living examples that demonstrate when Puerto Rico sets out to accomplish something, it “does it better.”

Market studies indicate seven out of 10 consumers think fresh local food products are of higher quality than those imported from other locations. Sixty-three percent place great importance on the origin of products.

“We congratulate the Agriculture Department for this novel initiative,” Márquez added. “It goes hand in hand with what MIDA has been promoting and working for, and it will definitely strengthen the island’s food chain.”

Mercado Central, San Juan’s contribution to the island’s agriculture

Proposed food processing & distribution center will offer new marketing opportunities to local farmers

Experts point out that one of the main obstacles to growth for local agriculture is the difficulty farmers face when trying to access markets that could purchase their products. If San Juan Mayor Jorge Santini has his way, this will soon change.

As part of a $1 billion urban-and industrial-development project for Kennedy Avenue, Mercado Central—the port’s anchor tenant and chief supplier to Puerto Rico’s $8.5 billion food industry for more than 50 years—will be moved from its current location on the Port of San Juan, across the street to a new, bigger facility designed along the lines of the most modern distribution centers of the world. According to the municipality’s statistics, Mercado Central’s annual economic activity represents more than $1.16 billion in annual sales, accounting for 11% of all foodstuffs consumed on the island, including 35% of all frozen items, 18% of all fresh meats and 14% of all fresh fruits and vegetables.

The new Mercado Central’s state-of-the-art, refrigerated distribution and logistics facilities were designed to support Puerto Rico’s food industry and help the island become the food-distribution hub of the Caribbean, fueling growth among local food producers and promoting sales of food-industry-related activities.

The project will set minimum quality standards for products processed and marketed at its facilities, thereby helping raise the bar on local farm products.

It aims to create a world-recognized quality brand, “the San Juan Brand.”

“Food production is important to every country,” Santini said. “Puerto Rico’s agriculture industry has been underperforming for many decades, but there is potential for growth. I know farmers that cultivate only a fraction of their total capacity because they don’t have buyers for their products; often a portion of their crops goes to waste. Mercado Central will create demand for these products, incentivizing agricultural production that will spur increased economic activity while creating new jobs.”

Operating at the facility will be food distributors who will add value to raw materials, transforming them into finished products and expanding exporting opportunities.

There will also be a trade center of agricultural equipment along with training centers for farmers and food processors.

The $275 million facility will occupy 79 acres within the district, including 61 acres of existing city property and 14 acres transferred by the Puerto Rico Industrial Development Co. (Pridco) to the municipality.

There are 14 companies interested in establishing operations at the new Mercado Central—nine of them already operating out of the old facility at the Port of San Juan area and five operating out of other locations.

Approximately 1,000 farmers and agroentrepreneurs also are interested in participating in the project that is expected to generate 1,525 direct and 2,000 indirect jobs.

Construction of the project is set to start early next year, and Santini said it should be operational in two years.

The project is also expected to capture a great portion of the cruiseship industry’s provision purchases, which currently take place at other jurisdictions.

Mercado Central, Santini said, will create a high-end agroindustry on the island that will serve as the backdrop “to launch the new San Juan Brand, a line of products including fruits, fresh produce, meats and fish that can be marketed through the local food industry, as well as abroad.”

The strong rebound reported in CRE development may represent light at the end of the tunnel for the U.S. nonresidential construction sector after several dark years, or it may just be a flicker that fades in the face of flagging confidence among investors and builders in recent months.

A report issued by Fitch Ratings is optimistic, concluding that increasing demand for commercial space coupled with almost no new supply in recent years has fueled stronger activity in 2012. Meanwhile, spending on commercial construction projects put in place jumped 23.1% to $143.2 million through the first half of the year from the same period in 2011, according to U.S. Census figures analyzed in a report by Fitch Director Robert G. Rulla.

Congressional approval in June of a new $105 billion federal highway bill will enable state and local governments to plan new longer term projects with more certainty, another potential boost for the nonresidential sector, Fitch said.

The benefits of the new highway bill are not likely to accrue until 2013 and the sector is by no means out of the woods. Public construction will remain flat through the end of the year before growing 2% in 2013, and highway/street spending will remain under pressure through at least the end of the year, according to Fitch.

Other factors that could level off growth in new commercial construction activity before year end include slow U.S. economic growth, lingering problems in key European economies and ongoing issues with developer access to construction financing.

While the latest Federal Reserve survey suggests that banks are easing lending standards, that view isn’t unanimous. Another survey indicated that standards remain tight, with little evidence that CRE credit availability has improved meaningfully. Fitch believes financing will remain constrained as cautious institutions continue to be picky about financing development projects.

For better or worse, developers aren’t proceeding with the confidence that marked earlier recoveries. The Construction Confidence Index (CCI) compiled by the Associated Builders and Contractors (ABC), measuring sales prospects, staffing levels and profit in the U.S. nonresidential construction industry, reflected declines in all three areas during the second quarter. The setback reversed much of the progress made in the first quarter, although the index values remain above 50, indicating that construction spending is still poised to expand, albeit at a slower pace.

Construction sales expectations fell from 68.3 in the first quarter to 62.3 at midyear. Profit margins fell from 57.9 to 53.5 and staffing levels declined from 64.3 to 59.8.

ABC Chief Economist Anirban Basu said the nonresidential construction industry continues to struggle to establish sustained momentum despite data indicating that the nation is now in its fourth year of economic expansion. Construction spending levels have barely managed to edge higher in recent months.

Contractor attitudes won’t likely improve until positive economic data emerges and the federal government resolves fiscal issues that in a worst case could plunge the nation back into recession in 2013, Basu said.

“Nonresidential construction firms have become unnerved by the possibility of the nation falling off a fiscal cliff due to a number of tax increases and spending cuts that take effect at the end of the year,” Basu said. “This would limit private nonresidential construction, which is among the nation’s most cyclical industries.”

Recession would also further hammer already weak federal, state and local government finances, likely leading to further declines in public spending, Basu said.

Among the most interesting findings in the CCI is that the proportion of contractors expecting substantial deterioration in business performance has risen from just 2% during the first quarter to nearly 13% in the second quarter.

Construction employment declined in 31 states between July 2011 and July 2012 and in 28 states in the past month, according to an analysis of U.S. Labor Department data by the Associated General Contractors of America. The drying up of public construction funding offset employment gains in homebuilding and nonresidential construction.

“Public construction cuts in particular are taking their toll on construction employment in many parts of the country,” said Ken Simonson, the association’s chief economist. “With economic growth remaining sluggish, there is a chance construction employment will begin to slip in even more places.”

Worse, if economic growth slows as businesses worry about future tax uncertainty, private demand for construction is likely to lag, the AGC said.

Accounts for more than 60% of exports, 25% of GDP, generates 25,000 jobs, or 26% of all manufacturing employment
The pharmaceutical industry is more than healthy in Puerto Rico, accounting for more than 60% of the island’s exports, 25% of the gross domestic product and some 25,000 direct jobs, or 26% of its total manufacturing employment.

“The local pharmaceutical industry has become a world player, and Puerto Rico’s pharmaceutical-industry technology, as well as its thoroughness and compliance, has brought companies from all over the world that are interested in importing pharmaceutical products manufactured in Puerto Rico,” said Frank Gutiérrez, president of the Pharmaceutical Industry Association of Puerto Rico (PIA-P.R.) & vice president & managing director of Merck’s Caribbean region.

“Before deciding to import from Puerto Rico, these countries send teams to evaluate the facilities, and we are proud that more than passing these inspections, those visiting inspection teams have been impressed with the quality of our operations,” he emphasized.

PIA-P.R. represents 12 research-based multinational pharmaceutical and biotechnology companies with operations in Puerto Rico. Of these, 10 have manufacturing operations—at 35 sites across the island—and two have a commercial presence. In June, PIA-P.R. held the 10th PIA/Food & Drug Administration Regulatory Conference “Science- Based Compliance: A Competitive Edge,” where compliance, regulations, import & export of pharmaceutical products were discussed.

Gutiérrez explained that a successful regulatory record, combined with technical transfer skills, as well as a highly skilled workforce, is supporting globalization efforts by local pharmaceutical-manufacturing operations. In fact, a survey conducted by PIA-P.R. of its members reported an outstanding record of regulatory inspections, with 100% success in preapproval inspections.

According to the survey, 17 regulatory agencies actively inspect local pharmaceutical and biopharmaceutical firms. Besides U.S.-based and European agencies, inspections have been conducted by representatives from Turkey, Germany, United Kingdom, Taiwan, Japan, Saudi Arabia, United Arab Emirates, Korea, Canada, Mexico, Brazil and Australia. From 2009 through April 2012, there were some 82 regulatory inspections, and PIA-P.R. expects some 30 more during the remainder of the year.

“There are two types of inspections, preapproval and good manufacturing practices,” said Gloria Martínez, head of the PIA-P.R. quality committee & director of corporate quality sciences for Amgen. “In the first type of inspection, what is being assessed is the level of readiness of a manufacturing site for a new product, from development to its launching, while good manufacturing practices inspections assess the total compliance levels of a manufacturing plant’s standards of quality.”

Modest economic growth keeps commercial real estate on the road to recovery.

The commercial real estate recovery continues to build momentum. A torrent of equity capital has been raised to purchase commercial properties and loans. Lenders continue to come back to the market, loans are being refinanced, purchased, and restructured, and the underlying fundamentals continue to improve.

While current market conditions are encouraging, concerns still abound about the mountain of loans coming due over the next few years, particularly those done at the top of the last cycle. The commercial mortgage–backed securities market also largely remains on the sidelines, although credit is gradually improving in that market as loans are restructured and sold.

In addition, interest rates should remain exceptionally low during the next few years. The heightened uncertainty in Europe has set off demand for liquidity, driving long–term Treasury yields well below the prevailing inflation rate. The Federal Reserve is largely thought to be on hold through the middle of 2014. Long–term expectations for interest rates are beginning to come down and there is growing expectation that economic growth, inflation, and interest rates will remain lower than at any time in the past 25 years — which makes real estate look much more attractive.

Property Sector Profiles

Multifamily. The underlying fundamentals for income–producing properties continue to improve, particularly in the apartment market. Demand for apartments remains exceptionally strong across most of the country. Nationwide, vacancy rates have fallen 1.3 percentage points over the past year to 4.9 percent, helping to push up rents 2.8 percent, according to Reis. Demand for apartments is being fueled by stronger employment growth, which is lifting household formations.

While conditions are improving across the country, rents are rising the fastest in areas that are benefiting from the explosive growth in mobile technology and social networking, as well as a few markets where major industrial development projects have significantly boosted job growth. When it comes to rent increases, major technology centers, including San Francisco, San Jose, Calif., Oakland, Calif., Seattle, and Austin, Texas, account for at least half of the 10 fastest–growing markets during the past year. Another top market is Chattanooga, Tenn., where a new Volkswagen assembly plant opened up during the past year, drawing a large number of skilled workers into a relatively tight apartment market. A similar dynamic is playing out in Charleston, S.C., where the opening of Boeing’s new commercial airliner assembly plant has bolstered job growth and in–migration, helping to increase rents by 3.5 percent.

Industrial. The strength in industrial development is also helping to drive gains in the warehouse and distribution market. Manufacturing employment has been rising solidly for the past two years and is up 2.0 percent during the past year, with the strongest gains coming in durable goods. Manufacturers have added nearly 500,000 jobs since manufacturing employment bottomed in early 2010. Gains are largely concentrated in the Midwest and South but are evident in most regions of the country.

The industrial market tends to follow manufacturing trends, and vacancy rates have fallen sharply in areas where manufacturing has picked up the most, including Detroit, Milwaukee, and Chicago, as well as in key national distribution markets such as Dallas, Phoenix, Atlanta, and Indianapolis. Conditions have also improved in tertiary markets benefiting from strong industrial growth, including areas like Janesville, Wis., Chattanooga, Lubbock, Texas, and Rockford, Ill., as well as rapidly growing port cities like Savannah, Ga., and Charleston.

In addition, Seattle, Washington, D.C.’s northern Virginia suburbs, Boston, and the San Francisco Bay Area are also seeing solid gains, benefiting from the nearby tech booms. Florida’s major markets have also improved, with Miami, Tampa, Orlando, and Jacksonville all posting solid gains in the past year.

Another trend benefiting the industrial market is the explosive growth in online retailing. Retailers continue to be some of the most active participants in the industrial market, building new facilities to handle both brick–and–mortar and online operations. Gains are most evident in the Sun Belt, where population growth is strongest. The mobile Internet industry is also helping growth in the data center market, which is gaining in virtually every major market. Mega data centers are clustering around major metropolitan areas, including New York, Washington, D.C., Los Angeles, Dallas, and Atlanta. Other significant data center clusters are popping up in tertiary markets in the Carolinas, Iowa, Nebraska, and Tennessee, where abundant inexpensive power is available and the availability of sustainable energy sources is growing rapidly.

Retail. While online retailing is booming, the retail market itself continues to struggle. Several big–box chains have reported disappointing earnings and are closing underperforming stores. The upside is very little new supply has come on line, and vacancy rates have edged slightly lower. The retail market is becoming increasingly bifurcated, with the strongest growth occurring at the high and low ends of the spectrum.

A bright spot is regional malls, which are performing surprisingly well. A new regional mall opened in downtown Salt Lake City during first quarter 2012, and a handful of additional malls are currently under development. Mall merchants have done a much better job of developing winning strategies to compete with online retailers.

Small variety–store merchants that deal primarily with lower–income customers are also doing well. Many are opening standalone stores that undercut the big discount chains. However, bookstores and electronics chains continue to struggle with growing online competition, which is leading to more store closings.

Office. Office markets are showing only modest improvement. Office employment has increased 2.2 percent during the past year, compared to average growth of close to 3.0 percent during the past cycle and well over 4.0 percent during second half of the 1990s. Moreover, firms continue to find ways to squeeze more workers into fewer square feet. Even with modest growth, net absorption has risen for five consecutive quarters, but growth is exceptionally modest by past standards. With little new construction, vacancy rates have edged lower, falling 0.4 percentage points over the past year to 17.2 percent, according to Reis.

While the overall market is seeing only modest gains, there are a few pockets of strength. Major technology centers, including the San Francisco Bay Area, Seattle, Austin, and Raleigh, N.C., all continue to see strong demand. Rents have grown the most in the San Francisco Bay Area and New York, which is also increasingly driven by the tech sector.

Despite the sluggish pace of recovery, office property sales have increased this year. Properties in key technology centers, areas with a great deal of exposure to healthcare, and a few major energy markets, such as Houston, continue to outperform most other major markets. New York appears to be successfully navigating the slowdown in the financial services industry and is seeing an influx of technology jobs. Washington, D.C., however, has seen demand for space and buyer interest wane as continued anxiety and uncertainty about the federal budget has sent chills through market. The suburbs of Washington, D.C., are faring better with the tech sector fueling gains in northern Virginia and healthcare driving gains in suburban Maryland and Baltimore.

Looking Ahead
With the rekindling European financial crisis and the U.S. presidential election coming into full swing, overall economic activity is likely to slow down during the second half of the year. Businesses will become even more cautious about expanding operations and hiring new workers, which means demand for commercial space is likely to drop. The capital markets may also suffer a few bouts of illiquidity if the woes in Europe take an ugly turn or another unsightly battle to raise the U.S. debt ceiling breaks out.

Despite these impending challenges, the most likely outcome continues to be modest economic gains across most of the U.S., with a few notable bright spots lighting the way, including the technology, manufacturing, agriculture, and energy industries. Better news from Europe and government agreement to tackle the massive fiscal issues facing the country would provide an upside surprise.

As young Americans move to cities, retailers that grew up in the suburbs are following them. And unlike previous efforts, they are doing it the cities’ way.

With little room to expand in the suburbs, retailers, including Office Depot, Wal-Mart and Target, are betting that opening small city stores will help their growth.

It is a significant shift from their approach in the past, when they tried to cram their big-box formats into cities, often prompting big fights. This time, the retailers studied city dwellers with anthropological intensity and overhauled things as varied as store sizes (the city stores are a small fraction of the size of the suburban ones), packages (they must be compact enough for pedestrians) and signs (they are simple, so shoppers can get in and out within minutes).

“The suburbs are basically saturated with retailers,” said Patrick L. Phillips, chief executive of the Urban Land Institute, an urban-planning research nonprofit, “but it’s easy to develop stores in the suburbs, and hard to develop stores in cities.”

Office Depot has revamped its stores to create an “economically defensible” way of expanding into cities, said Kevin Peters, Office Depot’s president of North America.

The main objective for shoppers in cities is speed. So a store in Hoboken that is a model for the company’s urban branches is 5,000 square feet, about a fifth of a normal Office Depot. The shelves are about six feet high, much shorter than in a suburban store, so visitors can navigate quickly. The signs above the aisles are simplified so customers do not waste time interpreting them. The service desk, where shoppers can send packages or copy fliers, takes up a big chunk of the store, so no wandering is required.

A typical Office Depot has 9,000 items for sale. This one has 4,500. It sells immediate-replacement items (a pen) versus stock-up items (a 25-pack of pens). At sites where Office Depot has replaced one of its big-box stores with a small store, Mr. Peters said, the smaller iteration has retained 90 percent of the sales of its bigger predecessor.

Still, he acknowledged that the model was not perfect. A shopper in search of a desk, for instance, would have to study tiny dioramas of office sets; sales of desks in the small-format stores are, unsurprisingly, not great.

But retailers are now willing to come into cities on the cities’ terms — with all the zoning headaches, high rents and odd architecture — because that is where the growth is. Most large American cities are growing faster than their suburbs for the first time in almost a century, according to a Brookings Institution analysis of census results released last month, largely because young adults are choosing urban apartment life. That population shift, along with Internet competition, have made the car-focused, big-box model less relevant.

Target opened its first City Targets, in Chicago, Los Angeles and Seattle, on Wednesday. At 80,000 to 100,000 square feet, City Target, at its smallest just over half the size of a remodeled Target, is aimed at urban shoppers. For instance, City Targets would not carry a six-piece patio set, but a three-piece balcony set instead.

“We see this as an opportunity for the people who live, work and play downtown, who probably have a suburban Target they call their home base,” said Molly Snyder, a company spokeswoman. “You’ll see less 12-packs of paper towels and more four-packs, knowing most people will arrive by foot or public transportation and will have to carry it home.”

Wal-Mart, though it continues to build in the suburbs, is also courting cities. Where it once stampeded into urban areas — and often met huge resistance from residents that led to its retreat — it now uses more diplomacy. In Chicago, for instance, it has agreed to build stores with union labor, and it has donated to politicians and community groups in cities where it hopes to build. Wal-Mart is testing several types of city stores, like the large supercenters being built in Washington, the small Express stores in Chicago and the medium-size Neighborhood Market format store it will open in Los Angeles.

“It’s become easier to site a Walmart, and we have become more accepted by the community,” Leslie Dach, executive vice president for corporate affairs at Wal-Mart, said last month.

Getting approval is only part of the challenge, though. Existing small retailers in cities can be nimble in changing their shelves, as owners can see who is coming in and whether they buy starch, say, in the form of Popchips, rice noodles or yams. Executives at big retailers have little personal contact with most customers.

“It’s much more difficult for a big chain who’s got gigantic warehouses across the country to be sensitive to the local market,” said Mr. Phillips of the Urban Land Institute. On the other hand, large retailers have servers full of data that helps them customize to city shoppers.

Take Wal-Mart’s city-store prototype near Toronto, a 90,000-square-foot store that opened this year. It found that many nearby residents were recent immigrants living in apartments, and one of the first improvements they wanted to make was to their bathrooms, said Alan Blundell, vice president for Wal-Mart merchandise operations in Canada. So the store stocks a higher-than-usual quantity of toilet seats and shower heads.

Walgreen, after it acquired New York City-based Duane Reade in 2010, studied how Duane Reade, a city retailer for 50 years at that point, customized merchandise by neighborhood using loyalty card data.

For instance, a store in Union Square attracted commuters and tourists using the subway there, while the store a few blocks north drew mostly local residents. So the Union Square site carried lots of foot products for the unprepared tourists, along with cosmetics and snacks, while the branch just north of it was more heavily stocked with household-cleaning items, toothpaste and the like. In richer areas, Duane Reade will carry gluten-free products and loaves from Eli’s Bread, said Joseph Magnacca, president of daily living products and solutions at Walgreen.

While Walgreen had city stores before it bought Duane Reade, it used the Duane Reade example to build and refine urban stores elsewhere. For instance, city shoppers dislike items in jars because of the weight. And weird architecture is often part of an urban store, so turn those pillars and columns into displays for candy, gum and magazines.

Over all, Mr. Magnacca said, the only standard element of running city retail is that nothing is standard.“No footprint is exactly the same and no product mix is exactly the same,” he said. “There is no one best solution.”