Appraisal Matters

Now we’ve lost one or more anchors from our regional mall.  Pedestrian traffic is down.  The dollar amount of sales drop for certain stores such as those that were synergistic with the lost anchors (the best example being fashion or clothing stores that are synergistic with a major department store).  Tenants are talking.  Who’s going to be the next anchor and when will they come?

Stage 2 - National Tenant Changes

The next stage in the “decline scale” concerns changes with the national tenants.  Some may have moved when the new mall opened up or shortly thereafter.  Not a great exodus, but perhaps one nevertheless.

More important than the potential loss of one or a few national tenants is the increase in negotiation position they have with the landlord.  Leases that are coming up for renewal and options to renew come under a much higher degree of scrutiny.  Should they renew or exercise their option?  Many national tenants have a very professional process they go through to see if they should renew.  If they intend to open a store at the new regional mall they may feel that keeping this store is advantageous because it’s more market penetration.  I’ve found that most don’t leave their bargaining chip on the table - they want different lease terms the first chance they get.

What are the terms the national tenants will likely demand?

• Lower the rent and increase the percentage rent sales breakpoints
• Lower the sales break point percentages paid.
• Counter with a shorter lease term

In my experience, I find that the loss of national tenants is a slow, progressive event.  The number of tenants lost over a several year period is usually not great (generally between 5 and 30 percent).  When it is really noticeable is when your favorite store has now moved to the new regional mall.

During this transition period, what is important to observe is the type and credit rating of the nationals that remain.  How well do they cover the range of necessary goods and services?  Do they only partially cover the necessary industry, as in having too few fashion stores to appeal to the mall’s target market?

Stage 2 - The Effect on Income and Market Value

At this point, the effect on income and market value becomes obvious.  Long-term projections factor higher risk with a lower probability of renewal for the inline bay tenants.  Time to lease increases because the number of nationals interested in leasing a vacant national’s space goes down, often along with the credit rating.  Vacancies go up and contributions toward CAM decline (with the landlord absorbing more of the expense).  Less money is available for the marketing pool (the cooperative advertising done by a mall and paid for by most tenants as part of their lease agreements).  Sales volumes drop for most stores, as does percentage rent paid to the landlord.  All this results in lower income, more owner-absorbed expenses and less net operating income.

The effect on cap rates are also easy to define.  Risk is greater, so the cap rate needs to be higher.  What is not so obvious is that the availability of market derived cap rates goes way down at this point.  There are typically so few sales that fit into this stage of a mall’s “economic life cycle” that you may find no analog.  The typical buyer of a mall at this stage is a company that specializes in turning them around.  They will only buy at a price that reflects a high rate of return given that they’re undertaking substantial risk.  Remember that the landlord has already been marketing anchor space, often for years, and the national tenants that left for the new regional mall are not interested in coming back, which may also have occurred over a several year period.  Essentially, mall space has been exposed to the market for long enough that the risk is high and therefore so must be the potential return.

This creates a quandary for the appraiser.  The cap rate that a typical market participant, a turnaround specialist, will require to buy the mall and what more established regional malls sell for can be great.  With no analog in the market, how can this dilemma be solved?  The answer comes by expanding the market search, examining listings and a willingness to place a material cap rate premium to reflect all these considerations.

By expanding the search radius, the appraiser may find a similar analog in another market.  Using demographics, it’s easy to compare the two markets.  For instance, if Regional Mall A, a mall in another market that is not on the “decline scale”, sold at an 8 percent cap rate and Regional Mall B that was at Stage 2 sold for a 10.50 percent cap rate, that shows the market is paying a 2.50 percent cap rate premium for this level of risk.  Differences in mall condition, quality, location and other factors appraisers adjust for are already considered in the cap rate and net operating income.   Sure, it takes more time to find comparables in these two categories, but the results are supportable.

Comparison to listings can be equally rewarding… especially if the asking price changes over time.  The asking cap rate can form a basis for comparison, with the caveat that the property has not sold at that price and therefore the final cap rate might be higher.  Although I am not an advocate of mathematical models such as the band of investment or mortgage equity technique, adding a material premium to those indicators would be appropriate should they be used.

The next part of this series will focus on the next stage of the “decline scale” - the advent of temporary tenants.

John Simpson, MAI