Main Street, U.S.A
Why Your Downtown has (at least) 3 Banks, 2 Nail Salons, a Chinese Restaurant and Several Vacancies
Bakeries, butcher’s, bars, diners, five and dimes, ice cream parlors, true farm to table grocery stores and restaurants. Slightly angled parking without the meters, thank you very much. This is the Main Street of our collective memory. That platonic ideal of what every town must have in order to consider itself wholesome, and worthy of adoration. But these streets rarely exist in the wild anymore. Where they do, they’re either supported by special circumstances, like wealthy enclaves employing a luxurious bit of revisionist history, or remain compositionally intact because they weren’t prosperous enough to attract larger flows of capital.
How did we get here?
Let’s talk history quick. The decline of Main Street began in earnest in the ‘60s. Newly constructed highways enabled a transformational demographic shift out from cities. While some settled near the historic downtowns of older suburban villages, most mid century growth took the form of tract housing on greenfield sites away from Main Street. This type of development would not have been possible without the Interstate Highways System and widespread production of private cars. From 1925 to 1965, registered automobiles on the streets increased by more than 4x, rising from 17.5 million to 75 million.
Commercial developers followed the residential outflow. Adhering to pseudo-scientific zoning restrictions on just what could go where, developers expanded upon the legacy of the earliest strip malls. These drive-up strips were alright for running small errands, but they couldn’t compare with the selection that urban department stores and speciality shops offered. To get these goods, suburbanites would have drive into the very place they worked so hard all week to be able to get away from. Going into the city on the weekend? Verboten.
Sensing this tension, developers staged a coup that would have been unthinkable a few decades earlier. Luring historic department stores into the suburbs with incentives too good to resist, shopping was brought to the people. Department stores were given the royal title of “anchor” and rent far below what reasonable market prices would dictate. In doing so, mall owners hoped to attract higher margin “in-line” tenants.
Department stores anchored a new building typology: the covered regional mall. Architects re-imagined Main Street as an interior haven. Free from the elements, shopping was made comfortable year round, safety was ensured by fleets of security guards and the variety of goods on offer was unprecedented. Parking was not just guaranteed, it was a God given right stretching as far as the eye could see. Thousands of customers were drawn from a radius of several miles to malls strategically sited on major highways. In broadening the addressable market, malls could provide anchors with the volume of traffic needed for their business plans to succeed, while also leasing space to unique retailers who might not have done so well in the provincial downtowns.
Small businesses packed up shop and moved to be where the customers were. Life was hollowed out of most downtowns. As suburban sprawl oozed outwards, strip malls, power centers and single tenant pads along multi-lane roads tore through formerly bucolic fields. Main Street was on its death bed.
Places with good bones are resilient, however. Despite gut punch after uppercut, the pendulum of growth swung back to Main Street & urbanity. Malls are now down for the final count. After decades of environmentally and socially destructive growth patterns, demand increased to be back in the heart of the action. Here, one can live, work, eat, drink and shop without relying on a car to take multiple trips to accomplish each one of these things in their own discrete locations.
But with this demand came a painful irony. Those businesses that were able to survive through the depths of the mid 20th century suddenly found themselves struggling against those who so adamantly avoided downtown in the past generation. Many could not compete. The reason: simple economics.
When a company or an individual invests in a commercial property, they usually take out a loan from a bank or private lender to finance the sale, much like a residential mortgage. Each lender has certain requirements for loaning out their money. The most common metric, Debt Service Coverage Ratio (DSCR for short) measures the annual net income to the annual debt payment on the property. If this ratio is lower than 1.20 (20% more net income than debt), a loan is unlikely to be given. The surest way to secure a loan, and stave off default, is to get as high of a rental payment from a tenant as possible.
In most cases, banks are the highest paying tenants. It’s not uncommon for a bank to pay more than twice the rent per square foot of a neighboring store. This is because a bank’s asset base is far higher than every other tenant on the block, and they’re willing to pay top dollar for the most prominent locations. High rent isn’t the only reason banks are attractive tenants, though. They are not intensive users of a property, and require little managerial oversight. Most importantly, banks have the highest credit ratings of any prospective tenant. This gives the lender of a property a higher degree of certainty that the tenant will not fold and will be able to pay consistently over the life of the lease.
Let’s do some math quick (it won’t be that bad, I promise). Properties are valued at capitalization rates, a metric that calculates the annual rate of return derived from a building. If a building generates $10,000 in Net Operating Income (NOI), and is valued at a 5% cap rate, (NOI/cap rate), that building would be worth $200,000. The cap rate has an inverse relationship with value; the lower the cap rate, the higher the valuation. A low cap rate signifies a low amount of risk, say a building in the heart of Beverly Hills with Bank of America as a tenant. Higher cap rate, higher risk, lower valuation. It is every property owner’s desire to “compress” cap rates lower and raise rent & NOI to increase a property’s valuation. The easiest way to do this? Lease your space to a bank.
For a just a bit more trouble than our prior math, let’s dive into a property owner’s mind when they make a decision on who to lease their space to. In this case, a simple one story property with one retail space.
— Prospect A is a multi-national bank with a AAA credit rating from Moody’s, hundreds of billions of dollars in assets, and two other locations within 5 miles. A proven success. They have proposed paying $75 psf in rent for a 2,000 square foot store front. Annual rental payments amount to $150,000 ($12,500 a month). Due to the lease type they have signed, they will pay for most of the expenses at the property, yielding an annual net operating income of $120,000. Because of their pedigree, the lender would be willing to provide an interest rate of 3.5% on a prospective refinance, at a cap rate of 4%. The value of the property in this scenario would be $3,000,000.
— Prospect B is a local couple who would like to sell books, coffee & pastries, school supplies and hold community events. The owners have little experience in retailing, and barely have a tolerable credit score, to say nothing of a credit rating. They can only pay $35 psf in rent for an annual payment of $70,000. The couple would not be able to pay for as high a proportion of the property’s expenses as the bank, and so the net operating income would only be $45,000. Because of their lack of experience and unproven business model, the bank could only provide a 4.5% interest rate and appraise the property at a valuation 6.5%. The value of the property in this scenario would be just shy of $700,000, less than a fourth of the value of the property if Prospect A leased the space.
The difference in value is $2,300,000. There is no question of who to sign. When the property owner down the block hears the terms their friend got, they’re eager to reel a bank into their own space. The new bank sees that the existing bank is doing quite well. If the demographics and location are good enough for Bank of America, there’s no reason for Capital One not to move on the block. This cycle repeats itself until Main Street resembles a memo from the FDIC.
New small businesses can’t compete for prominent space, as just detailed. If longstanding mom and pops don’t own their own properties, they risk their building being sold on to an investment group who will acquire their building as a “value-add” opportunity. The value that’s being added is in removing a neighborhood institution (in some cases) for a multi-national corporation that can pay 3x in rent.
That takes care of our three banks on Main Street. What about the two nail salons? Nail salons, barber shops and hair dressers have been touted as e-commerce proof. Until one can get their hair cut through Amazon, these aren’t going anywhere. While they don’t pay as much in rent as banks, their high volume of customer turnover, recurring revenue, and low operating costs ensure them a seat or two at every downtown table. Salons & barbershops can fit in small spaces that are less desirable for other types of businesses. They are a trusted solution to the problem of leasing difficult space.
Finally, takeout restaurants (usually of the Chinese-American variety) are a staple of any Main Street. They offer cheap, delicious, and comfortable food at most hours of the day. Whether they’re serving $3 cartons of fried rice or slices of roast duck for the more refined palates, their status as a bastion of reliability is unquestioned. Similarly to salons, takeout restaurants enjoy a high volume of customers, and are not as picky on their location along the Main Street. As their business is more of the run in, run out variety, they are not competing with banks and other upmarket retailers for more prominent locations.
Landlords won’t take a risk on an unknown when there is so much money at stake. Where they lever up their buildings with debt, they can’t take this risk. Illogical as it may sound, it is in an owner’s basic economic interest to leave a storefront vacant in the hope that a high credit, high rent tenant will come forward. This may be 6 months, one year, two years, or more. To use the example above, $45,000 in net income lost over 2 years is nothing compared to losing $2.3 million in valuation that could be pulled out in a refinance. The money is not in the rent. It’s in the refinance. And so, spaces sit vacant under the current rules of the road because it is the economically wise thing to do. Vacancies pile up along prime streets. The story is much the same in small town America as the most valuable commercial streets in New York.
It takes a concerted effort on behalf of an investor/developer to work with small business owners. One has to want to care about the outcome of the community they’re invested in. When the property one owns is 500 miles away, it is much easier not to care. While there are of course only so many banks & chains that could feasibly locate on a street, it is nonetheless difficult to not go after these types of tenants when the rewards are so significant. This is not to say that good returns cannot be yielded in working with smaller business, as in the long run stronger places are more valuable. But, it is only rational to seek out the highest possible returns on an investment. If one invests on behalf of limited equity partners, it is their responsibility to do just this.
Upholding the platonic ideal of Main Street is a luxury. Wealthy communities with high levels of disposable income can support nascent businesses like juice bars that sell $15 açai bowls or boutiques with $200 sun dresses. Stroll down Greenwich Avenue in Greenwich or Main Street in Park City, and the energy of downtown is palpable. Vibrancy doesn’t just come from wealthy enclaves, of course, as tourist destinations and college towns each enjoy strong Main Street cultures. But these are not average places. They’re buoyed by special circumstances. For every special Main Street, there may be 5 or 10 average Main Streets with limited hope of cultivating strong, local connections in the current state of real estate investment & financing.
Though I’m not a fan of over-regulating the built environment, as history has proven this a disastrous course of action, there have been some successes in recent years that prove limiting chain store involvement can bolster small businesses. This on its own is not sufficient to supercharge downtowns, who need to free themselves from the confines of restrictive zoning codes to allow for more mixed-use housing, offices, and parks at the expense of functionally unusable open space and parking lots. But it would be a step in the right direction. Perhaps distress from the Coronavirus will present a reset. Vacancies may have become more visible in the last 6 months, but the fabric of Main Street has been stretched thin for a long while. Even before the Pandemic, banks were decreasing their branch locations. Those high rents are not sustainable in markets with declining deposits and less need for human to human interaction. Most banking services can be completed through an app or on a phone. Branch locations will scale back, and our Main Streets will have to make do with one or two banks, as opposed to 3, 4 or 5.
Not one to diagnose a problem without offering a solution, I’ll be writing a follow up to this piece on how Main Street & small businesses can thrive. Hint: more walking, more opportunities for connection, more support for nascent entrepreneurs, and where needed, more building. Main Street has proven its resilience over the last few decades, especially in communities that are wealthy, or rely on colleges or tourism. The challenge now is to spread the success that small businesses have had in communities with special circumstances to everyday downtowns. This will not look the same in every community. That is the point. Places need to leverage what makes them unique, even the smallest idiosyncrasy. Towns & cities cannot try to copy the perceived success of other places. A square peg may work well in a square hole, but certainly not in a round hole. Main Street is heading in the right direction, but it now needs a push to get on the right path.