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COVER STORY, JANUARY/FEBRUARY 2010
PLAYING THE ADVANTAGE
Times are tough — is a restructured retail lease the answer?
By Jaime Lackey
In every upswing and every downswing of the real estate cycle, someone has the advantage.
At this point in the current cycle, retailers with expiring leases are in a favorable position when it comes to negotiating rental rates and tenant improvement allowances. Those with less than 3 years left on a lease are also in a good position to renegotiate early and lock in a lower rental rate.
“Nationwide, retail rents are down approximately 30 percent,” says Michael Wiener, president and CEO of Lake Success, New York-based Excess Space Retail Services. The company, which specializes in real estate disposition and lease restructuring for retailers nationwide, currently represents more than 60 national and regional retailers.
Wiener believes that retail store closings this year will continue to put downward pressure on rental rates.
He says, “It is likely that 6,000 to 8,000 retail stores will close in the first half of 2010. Additionally, after Christmas, many retailers will be analyzing their space needs and come to the conclusion that they need to downsize, as Internet sales were up while store sales were lackluster.”
Wiener adds, “The downward pressure on rents from the aforesaid [reasons] will likely drive another large wave of restructurings this year.”
He predicts retail rental rates across the nation will stabilize sometime in 2011, but he says, “Rates may drop another 10 to 20 percent nationally (on average) before they stabilize.”
“In the last recession, the first uptick in commercial real estate was 18 months after the first uptick in job growth,” Wiener adds. “It may be as late as 2012 before we see rent increases.”
While retail closures and downsizings due to the economy are the main factors in today’s decreased demand for retail space, retailers’ models are also changing as Internet sales grow.
As Wiener notes, “Many retailers now require less space as Internet sales grow. They may renegotiate the sizes of their boxes or relocate into smaller boxes over time, as Internet sales continue on an upward trend.”
He notes, “Despite the economic downturn, Internet sales saw growth this year, and will continue to grow for years. Retailers will continue to build their Web presences. Free shipping will become more common, and with each passing year, more consumers will learn to use and trust the technology.”
Because of the economy and the uncertainty in the retail industry, Wiener says that he believes it is still in the best interest of both retailers and landlords to consider renegotiating many leases now.
“Rents will likely continue to drop,” he says. “It is good for landlords to be proactive. If not, they are running a risk that retailers will find lower rents in the future in other centers. It is beneficial for landlords to renegotiate early and sign a viable, credit-worthy tenant for an extra 5 years now.”
Retailers, of course, benefit from extending leases with today’s low rates, and they may be able to negotiate remodel contributions in some cases.
Underperforming retailers and those locations that face the risk of closure can benefit from restructured leases that give a rent break during the current economy. This gives them an opportunity to outlast the economic downturn.
Landlords also benefit from working with tenants that face hardships. First and foremost, a landlord doesn’t want a tenant to go dark — especially if related co-tenancy clauses are in effect. Secondly, landlords can benefit by extending a lease or by negotiating some other advantage, such as the right to develop on a pad site even if it might affect the renegotiating tenant’s visibility.
Wiener says that many retailers and landlords are coming to appreciate their symbiotic relationship. Many landlords understand that they must give underperforming stores leeway on rents to help them stay in business or risk further deterioration of their centers.
However, restructuring leases is not necessarily a straight-forward process. “There are not a lot of viable comps,” Wiener says. “It is hard to know what the market is today.”
He adds, “It also depends on the health of the retailer. If a struggling retailer’s losses are greater than the rent, the company may close the store and just pay the rent. However, some leases may have continuous operating clauses, which would perhaps require further negotiation.”
Some leases and mortgage documents require bank approval for changes to leases. In other situations, Wiener says, “a landlord may not be able renegotiate because of debt. A lot of assets will go back to the banks in the coming year.”
“There will be industry turbulence for some time to come,” Wiener says. “Lower retail rents will destabilize retail assets; meanwhile, landlords face a lack of available financing and there are concerns about more retail bankruptcies.”
“In addition, there will likely be changes to leases going forward that no one can anticipate,” he says. For example, retailers may push for shorter leases, there may be more kickout clauses or different thresholds.
On the other hand, Wiener says, it is very rare for restructured leases to add rent to the back end of a lease. “All that does is create enormous pressure on the retailers at the back end,” he says, adding that he has seen it in less than 2 percent of the negotiations handled by Excess Space Retail Services. Therefore, retailers that get a rent break to see them through the down economy should be poised for recovery as the economy improves.
In the meantime, Wiener says, “I don’t think we’re near the upswing yet. We’re still in the eye of the storm and we have to deal with the weather accordingly.”
How Can Landlords AND Retailers Help Each Other?
By Robin Abrams and Jerry Welkis
Tenants and landlords both faced a tough reality in 2009: they’d be far better off replacing their traditionally adversarial relationship with a partnership to assure their mutual health, if not their survival. The name of the game now is filling space. Rather than sacrifice more of their valued tenants, landlords are realizing they have to get creative and offer various incentives, enticements and rent concessions that they wouldn’t have considered at the height of the market just a few years ago.
The deal-making options remain on the table in 2010. Here’s an overview of some of those strategies:
Because shopping center landlords typically have mortgages to pay based on a tenant rent flow, they’re not always in a position to grant steep rent reductions or out-and-out free rent. But what they can offer is free rent, in effect, that’s prorated over several years. This is a win-win for both parties because the retailer is getting the rent adjustment it needs and the landlord isn’t getting beat up from a financing or valuation standpoint.
We also see deals where a gradual step-up in rent occurs. For example, if a landlord wants a long-term “market” rent of $20,000 per month, but the tenant can’t reconcile those numbers under present conditions, the landlord might agree to accept something like $12,000 the first year, $14,000 the next and so on until the tenant is paying the full amount, with standard increases set to kick in during ensuing years. This helps the landlords recoup the shortfall and gives tenants more leeway to build their businesses in tough times and eventually gives landlords the market rent they need.
Every deal is critical these days, particularly as shrinking retail occupancies cause “co-tenancy clauses” to kick in for some retailers. This can start a devastating domino effect where one vacancy leads to another. Once a center gets the reputation of being half-empty, it is a disappointment for the landlord, for the tenant and for the consumer.
It is much better to nip the problem in the bud by offering the would-be departing tenant an alternative of half their average rent for 6 months to a year, which allows them more latitude to re-evaluate their situation. Similarly, many tenants have a “go-dark clause” that allows them to close without reason before the end of their term, even though they’re still obligated to pay rent. In many of these cases, the tenant will agree to keep operating if their rent is reduced. But, as with all partnerships, trust is earned — if tenants are seeking rent breaks, they should expect to open their books to show their pain to the landlord.
Landlords can also offer performance-based deals with tenants. For example, a tenant might agree to pay $22 per-square-foot over the first 5 years of a lease if they can generate $300 of sales per square foot, then pay $25 per square foot if they hit $400 per square foot in sales, and so on. Other deals can be structured so retailers pay a percentage-of-sales rent for 3 years, then permanently lock into the 3-year average when they enter the fourth year of their lease.
We’ve seen some tenants agree to pre-pay their rent at a discount, which is a good solution if the landlord is hurting for cash flow. It also assures that the landlord won’t have to chase the tenant for rent at any point — another win-win.
As for aggressive tenant recruitment tactics, landlords can offer tenants the flexibility to cancel their leases during their term with minor termination penalties. Temporary pop-up stores are another good way for landlords to fill spaces and derive immediate income — and for tenants to test-market their products with minimal risks. Such leases can be structured for longer-term options.
Robin Abrams is an X Team International partner and executive vice president of New York-based The Lansco Corporation. Jerry Welkis is an X Team International partner and president of New York-based Welco Realty, Inc. |
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