Retail Traffic

The Gap Trap

For decades now, Gap stores have been mall mainstays — both in terms of traffic draw and financial performance. But now that Gap's sales have slowed dramatically, mall owners are worried about how they're going to make up the lost numbers.

The world of apparel has always been a fickle business, and Gap has been the leading poster child for the segment. Only two years ago the San Francisco-based fashion purveyor was the hippest thing going, with cutting-edge ads and chutzpah galore.

Today, it's red ink that has the retailer worried, not the latest hip color combinations. A few important financial tidbits have mall owners sitting up and taking considerable notice: To help shore up its losses, Gap eliminated 1,600 worldwide headquarters staff positions in August 2001, then it split itself into separate U.S. and international divisions in mid-January 2002. Ken Pilot, formerly head of Gap brand worldwide, will head the international division, but the company is now looking for a new head of U.S. operations to report to president and CEO Millard “Mickey” Drexler.

Gap also put the brakes on its colossal expansion plans, slashing its square-footage growth from a planned 15% to just 10% in 2002 and 2003. It also closed its distribution facilities in Ventura, Calif., and London and is trying to sublease all 283,000 sq. ft. of a new office building it intended to lease for the next 15 years in the Bay Area. Most recently, Gap's overall December 2001 sales were flat, while its same-store sales fell by 11%. That was slightly better than expected, but it still marked the 21st consecutive month of same-store sales declines.

So it goes without saying that malls aren't counting on Gap to draw in the crowds as they once did. And according to industry analysts, they also won't be sharing in rents based on a participation in tenant sales over a predetermined threshold amount, also known as “percentage” rents. Landlords derive an average of 3% of their gross revenues from such rents.

“Gap is a major contributor to percentage rent,” says David Fick, a real estate analyst with Legg Mason Wood Walker in Baltimore. “Gap was also an important player in shoring up vacancies or replacing weak tenants during the 1990s.”

With 4,179 stores around the world, Gap is the biggest U.S. apparel chain and has been the mainstay of malls from coast to coast. Gap now plays an anchor role in terms of drawing shopper traffic, Fick observes. “So if Gap, Old Navy and other Gap divisions such as Banana Republic fail to draw shoppers,” he says, “there is an impact on other tenants, thereby hurting overall mall performance.”

For Fick and other observers, Gap becoming a weak player is a major concern, in part because no clear successor has emerged.

Will all of this translate to lower future rents? “I believe we may see a disconnect between mall owners [REITs] and the tenants in regard to what the former may want to gain from rent increases versus what the latter may be willing or able to pay,” says Ann Melnick, associate vice president for St. Louis-based A.G. Edwards & Sons. “We have already been talked down a bit on same-store occupancies and same-store net operating income growth. I wouldn't be surprised if the expectations are still too high.”

With or without you

One mall developer decided to move ahead with major projects last year even without the traditional Gap stores in place. Bloomfield Hills, Mich.-based Taubman Centers Inc. built four of the nation's 11 largest malls that opened in 2001 — with no Gaps at three.

Publicly, Taubman's official line on Gap's woes does not stray beyond the obvious. “We think Gap is a very good retailer and they are in many of our shopping centers,” says Karen MacDonald, Taubman's director of communications. (She referred all other questions regarding Gap to Gap itself, where officials declined to comment for this story.)

Nonetheless, of the four Taubman properties opened in 2001, only one had any Gap stores, mainly because it was an outlet project where Taubman was not lead developer. According to Fick, Taubman officials believed Gap was throwing its weight around and demanding tough concessions from developers at a time when it wasn't bringing home the bacon.

“Most tenants pay between 12% and 15% of sales in total occupancy costs. Many Gap deals were essentially structured to keep occupancy costs in the 3% range. They were able to demand those terms when Gap was the most important tenant in the business. We believe that in the future mall developers should be more cautious when setting deal terms, and start with the assumption that what's hot today will be lukewarm tomorrow. It almost never fails. What hubris caused developers to think that Gap would be any different? Every retailer eventually stumbles. Starting with this assumption as a baseline will ensure better financial terms and long-term real estate value retention,” says Fick.

Whether Gap's challenges amount to just short-term stumbles, or worse, is still an open question. “First is the question of whether or not Gap's problems are cyclical or secular,” says David Shulman, managing director of equity research at New York-based Lehman Brothers. “If they are secular, then there are going to be a whole lot of empty spaces in more than a few shopping malls. The next question is whether or not Gap's problems are company-specific or more industry wide. If they are industry wide, then the entire rent structure for the mall business will come down.”

Others are a bit more optimistic. “Retailing has a way of reinventing itself and Gap is no stranger to metamorphosis,” says Jeffrey Donnelly, vice president of real estate equity research in the Boston office of Wachovia Securities. “Give them another year or two to identify and close weak stores, reinvigorate the remaining, and call the fashion trend correctly and Gap could once again be a force in apparel retailing.”

Staying up-to-date

One unique challenge Gap faces is the need to differentiate its own product lines. “Gap and Old Navy products have become one and the same and some wonder if Old Navy is an outdated ‘fad’ of the grunge era,” says Donnelly.

Some observers also question if Gap hasn't been a tad too aggressive with its store openings over the past few years (see chart opposite). In the face of a declining sales trend, oversaturation of stores is seen in many camps as a drag on any significant turnaround effort.

According to Michael Beyard, resident fellow of retail and entertainment at Washington, D.C.-based Urban Land Institute, mall owners face their own challenges. They must walk the fine line between differentiating themselves from other centers and providing the predictable major chains, such as Gap, that consumers expect when they go to the mall.

“Ideally, a center will have a mix of local, regional and national chains in an environment that is unique, but that is difficult to achieve because Wall Street demands that most tenants be ‘credit tenants,’ “ Beyard notes. “Gap remains a major draw at malls; however, consumer demands are changing and competition in its market segment is intense. When there is an industry-wide slump in retail sales, the effects of this competition are most keenly felt.”

While the Gap's retailing saga plays out, analysts are now cautioning mall owners to reconsider their leasing strategies. For example, while many developers treated Gap in the 1990s like an anchor, with better lease terms and structures than almost any other tenant, the times they are constantly changing.

“What developers often forget is that today's key tenant may become tomorrow's dog,” says Fick.

Tweaking the tenant mix

So the question remains — will malls do anything unique to alter their future tenanting strategies?

“No, which is not to say they won't waste a lot of time thinking about it,” says Donnelly.

Since most of the largest mall developers are publicly traded companies, their investors have a significant say. And guess what? Most investors think fad tenants aren't always the best long-term investment alternative. “Mall owners have and will continue to spend considerable time thinking about how they can enhance their properties either through re-tenanting or physical improvements, but the simple fact remains that fashion and real estate don't mix.”

“Landlords have a hard enough time picking good real estate sites; I wouldn't want to see them trying to pick future fashion trends to attempt to maximize future rental income,” says Donnelly. “Landlords should and will keep doing what they do best - keeping the property in good condition to attract the best tenants. Let retailers paint the canvas.”

SIDEBAR: Kmart's blue light dims

Gap Inc. isn't the only ailing high-profile retail chain. On Jan. 22, Kmart Corp. became the largest retailer ever to file for Chapter 11 bankruptcy protection.

Kmart stores remain open for now. But analysts say the Troy, Mich.-based company could close from 250 to 500 of its 2,100 retail locations. Kmart won court approval to terminate leases at about 350 stores it has either already closed or subleased to other tenants at cut rates.

The question for the shopping center industry is whether Kmart's ills will eventually lead to a wave of store closings. The retailer plans to review its stores' performance by the end of April and will seek to close money-losing locations.

Already, Kmart has made progress in its restructuring efforts: it received court approval to continue providing wages and benefits to its employees; many of its key vendors resumed merchandise shipments; and it received court approval for a $2 billion debtor-in-possession credit facility.

Nonetheless, it's just too early to tell whether the restructuring effort will succeed, says Chicago-based retail consultant John Melaniphy III.

If Kmart chooses to close several hundred stores, the move could create headaches for shopping center companies with portfolios populated by Kmart-anchored centers. Real estate firms with the most to lose include Malan Realty Investors, Agree Realty and Kimco Realty (see chart).

In January, Kmart's troubles hurt Kimco's stock price, which dipped after Salomon Smith Barney downgraded its rating from “outperform” to “neutral.” Developers Diversified Realty and Glimcher Realty Trust, both of which earn between 2% and 3% of their rents from Kmart leases, also saw their stock prices fall.

Even with a wave of store closings, developers will eventually fill most of the vacancies, analysts say. Likely replacement tenants include Kmart competitors Target and Wal-Mart, notes John Roberts, REIT analyst for J.J.B. Hilliard, W.L. Lyons.

But achieving prior rents is another question. “There are certain Kmart leases that are above market,” says Salomon Smith Barney analyst Ross Nussbaum. “Kimco's average rent from Kmart is $7.27 per sq. ft., and there are a couple of other REITs that have average rents in the $3 to $4 range.”

Another consideration is the effect store closures could have on surrounding tenants, some of which will be entitled to cancel their leases if a Kmart space goes dark, Roberts notes.

Shopping center companies with the most exposure to Kmart

#1 Malan Realty
26% of rents from Kmart

  • #2 — Agree Realty Corp., 24%

  • #3 — Kimco Realty Corp., 13.3%

  • #4 — Ramco-Gershenson Properties, 6%

  • #5 — New Plan Excel Realty Trust, 5.4%

  • #6 — Acadia Realty Trust, 5.2%

  • #7 — IRT Property Co., 4.5%

  • #8 — JDN Realty Corp., 3%

  • #9 — Developers Diversified Realty, 3%

  • #10 — Glimcher Realty Trust, 2.4%

  • #11 — Federal Realty Investment, 1.1%

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