(Bloomberg) -- Not long after he leased out the shell of a once-iconic Phoenix steakhouse, developer Lorenzo Perez got an email from a broker. He learned that the new space, now home to an award-winning restaurant, a small garden store, and an independent bookshop, was worth about $195 a square foot. Nearby retail properties, the broker said, were being valued at 25 percent more.
Why the difference? While Perez was courting local businesses, his competitors had landed large corporate tenants.
“My income stream isn’t much different, and I have the nicer building,” said Perez. “Because they have a Chipotle or a Starbucks or a Jimmy Johns, their valuations are on a whole different level.”
This isn’t a sob story, exactly, but rather an illustration of the commercial logic shaping American cities. As far as landlords are concerned, restaurant chains and large retailers are safer bets than mom-and-pop stores, Perez says. The same thinking goes for banks lending to property buyers, who will generally extend better terms when a chain business such as a Gap or a Walgreens is on the lease.
Those dynamics have proven harder to resist in recent years as investors have bid commercial real estate to record prices and competition in marquee markets such as New York and San Francisco have sent buyers looking for bargains in smaller cities. These out-of-town investors, once they arrive in Cleveland, Nashville, or Milwaukee, have a tendency to rely on relationships with national brokers and large-chain tenants, says Stacy Mitchell, co-director of the Institute for Local Self-Reliance, a Washington-based nonprofit.
The result, she says, is that small businesses that help give each city its unique character struggle to stay alive.
A less-than-virtuous cycle ensues: Older shops can’t afford to pay what the new market will bear, so the vintage clothing store gets replaced by the national clothier. And it’s not just that the big chains can afford to pay more—they actually get to pay less than the local store. National retailers are often rewarded for their perceived credit worthiness with lower rents. For the same reason, landlords hoping to sell or refinance a building are more likely to sign those chains to satisfy a potential lender. The reason your favorite pizza place is now a Subway may be tied to perceived credit worthiness, the desire for refinancing, and satisfying lenders that call the shots.
“You pull on this thread and pull it all the way back, where do you end up?” asks Mitchell. “The global financial system, where so many problems originate.”
That’s a long way to go to explain why some small businesses have gone under the cresting wave of retail rents. There’s also a simpler, more traditional reason: Local shops that can’t sell enough goods and services to keep up give way to new business owners who think they can.
City governments have been grappling with how to get landlords to behave like Perez, the developer in Phoenix, and place a premium on leasing to local tenants. Last summer, lawmakers in San Francisco took a step toward offering financial incentives to landlords who extend long-term leases to certain small businesses. In New York, lawmakers have floated mechanisms to help shop owners negotiate renewals. Later this month, an advisory group formed by Seattle Mayor Ed Murray will publish a set of recommendations for helping independent businesses cope with rising rents, says Ken Takahashi, who manages the small business development team for the city’s office of economic development.
The big cities have been the first to fight retail pacification because they’ve already witnessed the worst of the chain-store invasion. “We think there is opportunity to influence behavior,” says Takahashi. “There’s interest from developers to work with local businesses—it’s just a question of showing them that there are successful local businesses.” It also helps to offer landlords financial incentives, he says.
Earlier this year, freelance software developer Justin Levinson in New York noticed empty storefronts in his hip East Village neighborhood, so he started looking for explanations. “It seemed like it was becoming a situation where an entrepreneur can’t try something interesting because the rent is too expensive,” he said. “I fell in love with this city because it was the craziest place in the world, not because it was dominated by chain stores.”
In August, following a deep dive through public records and long walks to document his findings, he published a map showing about 1,000 vacant retail spaces in Manhattan, some of which had been unoccupied for years. When Levinson researched the phenomenon, he was told landlords would rather hold out for a better price than sign a deal at a lower rent and be stuck with it for a typical term of 10 years. Many of them we’re waiting for their very own McDonald’s, or maybe a CVS Pharmacy.
That kind of calculation drives some leasing decisions, says Marc Wieder, a New York-based accountant who works for real estate clients at Anchin, Block & Anchin. For another kind of landlord, the issue is less about immediate cash flow and more about resale value. Commercial real estate is usually valued as a multiple of annual rent, meaning a small increase in monthly rent can be worth millions of dollars in the final sales price. A creditworthy tenant can have a similar effect.
All this may suggest there’s a new way to answer the lament that one’s city has lost its pizzazz. It’s not just the trust funded-college graduates who brought their suburban tastes or the landlords who killed all the neighborhood dive bars by jacking up rents.
The reason your neighborhood increasingly resembles a hometown mall is because somebody’s banker prefers it that way.