Commercial real estate development, particularly in the retail sector, is experiencing a significant transformation due to shifting market dynamics. As people continue to migrate from California to states like Utah and neighboring regions, there’s substantial residential growth occurring. This demographic shift has created a golden opportunity for retail developers who, as one expert put it, “chase the rooftops” to bring essential services to these expanding communities.
However, the path to successful development isn’t without significant challenges. For the past five years, commercial developers have faced what many describe as “absolute pain” when trying to make their pro formas work. A pro forma, essentially a mathematical equation that determines the financial feasibility of a development project, has become increasingly difficult to balance in today’s economic environment.
The primary constraint comes from the disconnect between several key factors. Land prices remain stubbornly high, with owners often unwilling to reduce prices despite changing market conditions. Many landowners, particularly those with prime corner lots on busy intersections, are content to wait rather than adjust their expectations downward. As one developer noted, “They’re not making any more vacant lots on busy corners,” which gives these owners significant leverage to hold out for their desired price.
Construction costs present another major obstacle. The vertical construction costs (the actual building) have remained relatively consistent across markets. However, horizontal costs—those associated with site work, utility connections, and labor—often exceed the building costs themselves. Add to this the rising cost of commodities like copper, aluminum, and concrete, and developers are squeezed from multiple directions.
Then there’s the impact of interest rates. Since the Federal Reserve began raising rates in spring 2022, the dynamics of commercial real estate investment have fundamentally changed. Properties are valued based on cap rates (capitalization rates), which represent the unlevered rate of return. While cap rates have trended upward with interest rates, they haven’t increased proportionally, creating a mismatch that has dampened investor sentiment.
This creates a challenging environment when developing properties like drive-thru coffee shops or fast-food restaurants. For example, when developing a Dutch Bros coffee location, developers must balance multiple competing interests. The tenant (Dutch Bros) can typically only pay around 10% of their projected gross sales in rent and needs to remain profitable to keep the store open. The developer needs to make enough profit to justify the risk. The end investor who ultimately purchases the property post-development needs an acceptable return on investment.
When cap rates were lower, this equation was easier to solve. In August 2022, some Dutch Bros properties sold at a 3.95% cap rate. However, as interest rates climbed and 10-year treasuries yielded in the 6% range, these investments became comparatively less attractive. Why would investors accept a lower yield on a commercial property with tenant risk when they could get a higher yield from treasury bonds?
The time horizon for these investments has also stretched. What were once three to five-year holds are now often projected as seven-year investments. Developers recognize that “if you can hold anything for long enough, you generally are going to be okay.” The key is timing the exit correctly to maximize returns.
For investors considering entering this space, typical returns currently range from 6-9% on cash flow with projected IRRs (Internal Rates of Return) between 16-24%. Investments typically require capital contributions starting around $100,000 to $250,000, with many deals requiring closer to $500,000 or more depending on the scale and type of project.
Despite these challenges, there remains strong optimism about the future of commercial real estate, particularly in growing western states. The migration patterns creating new residential developments will continue to drive demand for retail services. For those with patience and strategic vision, commercial real estate development, especially in the drive-thru niche, continues to offer attractive long-term investment opportunities in an ever-evolving market landscape.