Appraisal Matters

As the current recession gets deeper, its effects become more obvious and well known.  We’re used to seeing lots of discount signs in store windows that disappear when things get a little better, only to appear again when retail sales soften. Back and forth, back and forth. Vacancies can increase too.  These are just the obvious changes. Like an iceberg, 90 percent of what’s there the consumer cannot see.

Using the same analogy, 90 percent of the undercurrent of change occurs in second- and third-tier regional malls.  The first-tier malls, those that are relatively new, modern and have all the best major anchors, minor anchors and mostly national tenants, are showing few changes.  If a national retailer moves, the probability of renewal is high because another national retailer usually fills the space… or at least a regional retailer.  Let’s focus on the 90 percent of retail changes affecting regional malls - the second and third tier malls.

Landlord Negotiating Position

Several large national retailers have announced and begun closing some of their anchors.  Others have renegotiated their leases.  Some inline bay retailers have done the same.  These changes occur in the older, less competitive regional malls, those I call second and third tier.  Why?  It’s all about the landlord’s negotiating position.

The loss of an anchor has more effect on a mall than any change short of a disaster.  Unlike newer malls, the design of second and third tier regional malls make the loss far more exaggerated.  A large percentage of these malls are designed based on a dumbbell or double-dumbbell shape.  When an anchor goes dark, the wing suffers a similar fate.  Foot traffic drops, sales drop and some retailers in that wing close.  Those that remain renegotiate their leases.  Temporary tenants are considered to help show other tenants and shoppers that the wing is still viable.  The loss of an anchor also means a large hit to the landlord recouping the common area maintenance of the mall, so profitability suffers all around.

Financial Incentives to Stay

Anchors are in a better negotiating position during down markets… especially when one or more anchors close.  When major anchor chains file for bankruptcy, landlords and managers know this and this helps set the stage for renegotiation.  Anchors in these situations have many options when renegotiating:

• Rent can be lowered for the remaining list or reduced for a specified number of years
• Rent can be abated for a period of time (i.e. no rent payments for a while); this is referred to as “rent relief” in the retail industry.
• Percentage rent can be reduced, although sales breakpoints typically stay the same (these are sales milestones where a different percentage of rent is paid on sales above that amount).
• Exterior renovations to the anchor’s space can be negotiated with the landlord bearing the cost.
• A new trend has been for anchor stores to be able to negotiate a real estate and operating expense cap.  Essentially, any increase in real estate taxes or operating expenses are fully absorbed by the landlord instead of being passed on to the tenant.

What about national retailers and inline bay tenants with lesser credit ratings?  Only some of the above can they negotiate.  Since their rent is many times greater than that paid by an anchor, the emphasis is on a lower rent.  Frequently what the retailer wants is a better placement in the mall - one with more foot traffic.  Perhaps closer or in the central nexus. Maybe next to the highest volume anchor.  The farther away from a dark wing in the mall, the better.

Gifts to Get Them to Come

So when markets are soft, what can landlords offer prospective tenants to get them to commit?  Free rent and high percentage rent breakpoints are the most common.  Even if they don’t make money for a few years and they absorb all common area maintenance, the landlord is better off because the wing is no longer “dark”.  The landlord’s negotiating position is better with all tenants and especially those in the wing that would stay dark.

Although this sounds great, I have to say that it rarely works.  When the anchor tenant’s negotiation position is this good, the market is just too soft for most high- and middle-tier anchors to commit.  It’s expensive hiring personnel and adding stock.  It takes time and lots of management hours, so effort is substantial. Yes, it takes cash at a time when cash flow is the weakest… or it is the thing to be most conserved.  That’s why sometimes a mall will take on an anchor tenant that is of a very different calibre or credit rating than the others already there.  Of course, for this to occur, an anchor store needs to be vacant for an extended period of time or multiple anchors need to leave a mall.

What can the much smaller inline bay tenants get during soft markets to come to the mall? For second and third tier malls, there are few national retailers they can attract. Sometimes vacancies allow landlords to move tenants in such a way as to take two or three contiguous spaces and create space for a minor anchor, such as CVS Pharmacy.  It’s hard to do that when times are good because these spaces are leased and tenants may have not desire to move.

The primary effect is that landlords are willing to allow less than national level credit tenants. If enough vacancies occur, temporary tenants may be considered.  This means more risk, shorter leases and typically fewer options to lease than what national retailers require.  It’s hard to say whether rents differ between national-level inline bay tenants and those with less credit ratings just based on credit; it seems to depend on what industry they are in.

Conclusion

Like most real estate, those properties of a lower investment quality seem to bear the brunt of the recession.  There are many tools available to landlords for keeping tenants, but most of these tools do not translate well into getting new ones in soft markets. There is just no way to fill all the space when supply is greater than demand without compromising a mall’s long term profitability.

John Simpson, MAI