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Retail Traffic

Landlords and tenants have had a trying year, but it is time for the two sides to adopt a joint view of success

For JMW Development LLC, the renegotiation request came rather unexpectedly. The Minneapolis-based real estate development firm had been working with discount retailer Target for several years on its Commerce Hill project in Woodbury, Minn. The chain was scheduled to open a 185,000-square-foot Super Target as the anchor for the 289,564-square-foot mixed-use center some time in 2010.

But at the beginning of July, out of the blue, Target informed JMW that it would not be able to inhabit the project unless it could rework the terms of its lease.

Some commentators have speculated the move could have been due to Target’s lackluster performance in recent months. In June, Target’s net sales fell 2.6 percent, to approximately $5.7 billion, compared to a year ago. Its same-store sales fell 6.2 percent, a bigger decline than the 5.1 percent reported for U.S. chain stores as a whole. Nevertheless, Target expects to open at least five stores in 2010 and might add 25 to that list going forward.

JMW declined to comment for Retail Traffic, but the company appeared taken aback by the turn of events, according to a report in the St. Paul Business Journal that said as recently as June the process appeared to be moving forward smoothly. Meanwhile, a spokesperson for Target said the retailer “remains interested in a location in Woodbury and we’ll continue to work with the developer to find a solution.”

The situation is indicative of a problem currently plaguing the retail real estate industry. Both landlords and tenants are suffering in their own ways. Landlords are wrestling with higher vacancies, falling property valuations and debt loads that are impossible to pay off or refinance in the current credit climate. Retailers have seen sales volumes tank while credit remains limited and their peers continue to disappear. They are holding off on openings, closing stores, entering bankruptcy protection or, in worst case scenarios, liquidating entirely.

Navigating this difficult economic landscape has put retailers and landlords at loggerheads. The retailers are seeking rent concessions whether they need them or not. The landlords, desperate to maintain as much cash flow as possible and facing onerous loan covenants, are loath to grant them. Each side is suspicious of the other. And examples like the one taking place in Woodbury—where a retailer requests changes on a deal before the store has even opened—are not helping matters. Ultimately, however, an adversarial relationship hurts both sides. Retailers and landlords need each other to survive. That means they have to find a way to handle concession requests more amicably, while at the same time working together in areas like marketing and advertising to benefit both the center and the tenant. With everyone short on cash, this will not be easy. But as more and more tenants face the risk of bankruptcy and as an increasing number of malls and shopping centers face foreclosure, cooperation will be the main route to survival.

Next page: Balance of power

Balance of power

Despite both sides facing challenges, it’s difficult to dispute the notion that retailers have gained the upper hand in lease negotiations. As the list of potential tenants shortens and vacancies rise, landlords have had to get used to a new world order, says Patrick C. Maxcy, partner in the corporate reorganization and bankruptcy practice of the law firm Sonnenschein Nath & Rosenthal LLP.

In the second quarter, the national vacancy rate for neighborhood and community shopping centers reached 10.0 percent, the highest level on record since 1992, according to Reis Inc., a New York City–based research firm. The vacancy rate for regional malls moved to 8.4 percent, the highest level since Reis started tracking regional mall statistics in 2000. Meanwhile, the number of stores U.S. retailers plan to open over the next two years has declined to 64,926 from 68,854 in January, according to research from RBC Capital Markets and Retail Lease Trac. Most of those still planning on expansion, including Quiznos, GameStop and Anytime Fitness, are small shop operators.

“It’s a tenant’s market out there and landlords are truly concerned, if not downright scared, about what happens if they lose one of their tenants,” Maxcy notes. “There was a time in the early 2000s when a lot of landlords couldn’t wait to get the current tenants out and get someone else in.”

Back then, retail leasing was almost an order-filling business. Retailers enjoyed booming sales. In addition, retailers faced pressure from investors to expand. ICSC Dealmaking events were marked by rushed meetings between tenant reps and landlords. They flipped through leasing books and devoured vacant sites. That created a huge demand for new shopping center space—a demand developers were happy to oblige with construction of new projects or expansion of older ones. “The market has changed and it has changed drastically,” Maxcy says. “Home Depot isn’t looking to rent space on every corner in America.”

Times are tough for the retailers, he adds. U.S. chain stores have not posted positive year-over-year same-store sales growth in nearly a year, according to ICSC. In June, the Total U.S. Traffic Index, which measures the number of people visiting both individual stores and enclosed malls, fell 12.2 percent compared to the same period last year, reports ShopperTrak, a Chicago-based retail intelligence firm.

The bleak outlook for sales growth over the next few years has put pressure on retailers to cut operating expenses wherever they can. Most have postponed new store openings. Some have had to close underperforming stores. Many have started asking for rent concessions on existing leases, whether in the form of outright rent reductions, freezes on scheduled rent increases, lower common area maintenance (CAM) charges or changes from base rents to rents based on percentage of sales.

Though both tenants and landlords have made efforts to cooperate, these negotiations can be tense, says Henry D. Finkelstein, partner in the real estate practice of Greenberg Glusker, a Los Angeles-based law firm. Landlords think retailers are trying to take advantage of the environment rather than asking for concessions they really need. Retailers think landlords are being too slow to recognize how difficult the retail environment has become.

Negotiations get especially tricky in cases involving large national anchor tenants because regardless of whether they actually need concessions, they have the added bargaining power of co-tenancy clauses. In some centers, the exit of an anchor gives remaining tenants the right to switch to a lower rental rate or to a percentage of sales rent for a period of time, typically a year. At the end of the year, the tenants have the choice of returning to the original rental rate or leaving the center. In others, the lease allows them to move right away.

“I am seeing a lot of threats of going dark if the landlord doesn’t give a concession and that’s very problematic because even if the owner collects the rent, he has a black eye on his project,” Finkelstein says. “That’s the main point of leverage that the tenants with the strong balance sheets are using.”

In today’s environment, leverage seems to be the operating word. Though publicly landlords continue to insist they will only grant concessions to retailers that can prove they really need them, many smaller, struggling firms no longer bother to fight when presented with concession requests, says Rick Burke, president of Lease Administration Solutions, a Marblehead, Mass.-based lease administration and auditing firm, and one of the founding members of the National Retail Tenants Association (NRTA). They are too nervous that tenants are going to make good on their threats to leave, especially in cases involving big-box operators. It seems more productive to cooperate.

“I don’t think there is a real meeting of the minds going on,” says Burke. “Both sides try to negotiate as hard as they can. The landlords are trying to survive right now and the ones who are strong are going to try to [fight]. It’s all about who has leverage.”

That’s not to say that tenants are necessarily trying to take advantage of the situation when they fail to provide proof of distress. Many local, family-operated chains know very little about real estate negotiations, says Tom Lackman, cofounder of Reduce Your Rent LLC, a network of real estate professionals who represent tenants in renegotiation requests. They often need help in understanding their existing lease agreement, presenting their arguments and putting together the package of documents a landlord needs to consider their case.

Next page: Role Reversal

Role reversal

The change in market dynamics hasn’t been easy for landlords. As recently as April, many property owners claimed they fulfilled only a trifling number of concession requests. For example, during the company’s April 24 first-quarter conference call Developers Diversified Realty, a Beachwood, Ohio-based REIT, said it had received 627 rent reduction requests and only granted 20 of them. Everyone insisted renegotiations would only happen if retailers presented proof of financial distress and were willing to take direction on how to improve their business. What landlords have tended to forget is that a lot of retailers signed extraordinarily expensive leases at the market’s peak, when their sales were 20, 30, 40 percent higher than they are today, notes Lackman. The problem is particularly thorny when it comes to new developments. “Landlords that took advantage of low cost credit to build new centers are very difficult to work with because they are highly leveraged, they have certain loan covenants and they are afraid of [defaulting],” he says. “So their first reaction is just to say ‘no.’”

But the picture is changing. Burke estimates that today his retail clients are able to successfully negotiate concessions in up to 25 percent of cases, especially if they agree to lease extensions. With rents in a steady downward spiral, the landlords are realizing they don’t have many bargaining chips left.

“If landlords can get a quality tenant in there, then anything is negotiable right now,” Burke says. “They just want to keep the boat floating till the recession is over and it’s a fantastic time for tenants.”

And that truth is not limited to weak centers with low occupancy levels. Maxcy, for example, was recently involved in a case that concerned a high-traffic location in New York City. The tenant, a regional operator, was on the verge of bankruptcy, but received a buyout offer that was predicated partly on it being able to lower its real estate costs. The tenant approached the landlord and ended up walking away with a 20 percent rent reduction effective for two years, Maxcy says. “Even though it was a high-profile area of New York City, the owner was concerned enough about finding a replacement tenant to agree.”

In fact, one of New York’s (and the world’s) prime shopping districts, the stretch of Madison Avenue from 57th Street to 72nd Street, saw a 31 percent decline in asking retail rents in the second quarter of the year, to $745 per square foot, according to research from brokerage firm Cushman & Wakefield. Owners of Madison Avenue properties started offering existing tenants rent discounts as long ago as February.

Meanwhile, nationwide market conditions are such that some owners have been approaching tenants about lease renewals well in advance of lease expiration, hoping they’ll have more bargaining power if they plan ahead. Jonathan Gould, CEO of Stonemar Properties, a New York City–based real estate investment and management firm, says his team has been working on lease renewals and extensions for the past 18 months. By now, the firm has renewed or extended approximately a quarter of all leases in its 1.5-million-square-foot shopping center portfolio. “There were a lot of modifications coming into place anyway, so there weren’t as many surprises,” Gould notes.

Next page: At the Controls

At the controls

Some tenants, however, aware that they may have a short window of opportunity to rework unfavorable lease terms, are driving hard bargains. Today, one of the biggest sources of conflict in landlord/tenant relations has to do with demands by some retailers to get rent reductions in the absence of any proof of distress, according to Paul Kinney, executive director with NRTA. When that happens, the big REITs and the well-positioned private players have the power to decline the requests and often do. “A lease is still fundamentally a contract and while this is the worst economic downturn we’ve seen, you are not making a commitment for five months,” says Gould. “You are making a commitment for 5, 10, 15 years.”

Smaller operators, especially in battered markets like Nevada and Florida, might feel pressure to grant even unreasonable requests from large tenants because there are few alternatives. At times, it also makes more financial sense to give in.

Landlords nationwide have also become more flexible in taking on temporary tenants, so-called pop-up shops that allow a retailer to sign a lease for up to six months in a new market so the company can take advantage of a particular shopping season or do a test drive before committing to a permanent store. (See related story on p. 84.) The pop-ups generally pay half the rental rate of existing tenants at the same center, plus up to 8 percent in percentage of sales rent, according to Jerry Welkis, partner with Welco Realty Inc., a New Rochelle, N.Y.-based brokerage firm and member of the national X Team retail services network.

Meanwhile, the landlords’ obvious anxiety about vacancy rates has made permanent tenants bolder. For example, Finkelstein is currently in the middle of negotiating a case where a national tenant with only two years remaining on its lease gave the landlord a choice: agree to a reduction in store size to 10,000 square feet from 15,000 square feet or cut the base rental rate by 30 percent in exchange for extending the lease agreement. The retailer is claiming the store isn’t profitable at its current size, but has never provided hard data to back up that assertion. The company also happens to be in the midst of reworking its store prototype into a smaller format and had talked about reducing its space three years ago. That has made Finkelstein’s client think the issue has less to do with financial need than with taking advantage of opportune timing. But after adding up the costs of creating an additional storefront for the leftover space, putting in a new bathroom and working in the price of a tenant improvement allowance for a new tenant, the transaction would result in the loss of three years’ worth of rent. Under normal circumstances, the landlord’s answer would be a resounding no. But given today’s environment, the landlord is seriously considering simply reducing the current tenant’s rent in exchange for a lease extension.

Moreover, some tenants are trying to hold up lease agreements with other retailers as a ploy to get more perks, says Finkelstein. He mentions an owner of a regional shopping center who needed consent of several anchor stores to fill a dark space left by another anchor. In response, the existing tenants asked for tenant improvement allowances and other financial aid that had nothing to do with the potential changes. Nevertheless, they got their way.

Next page: Honey vs. vinegar

Honey vs. vinegar

Both sides have to keep in mind, however, that their relationship is a long-term one. For landlords, that means letting go of the victim mentality and realizing that in many cases, retailers are simply exercising their rights under existing lease agreements, Maxcy notes. When the document was signed, five years ago, neither side might have expected that co-tenancy provisions would ever need to be put into effect. But that doesn’t take away their validity.

“I think landlords always think they are being taking advantage of, and I say that as someone who represents landlords,” says Maxcy. “We are a long way from being out of the woods and there will have to be an understanding that the concessions you make aren’t going to be for forever, but it might make sense to help your tenants through a tough period.”

For tenants, creating a cooperative atmosphere means accepting the fact that landlords might not be in a position to offer rent relief, at least not in the form of outright rent reductions, says Kinney. He advises retailers to abstain from starting concession negotiations from an adversarial position. That tactic tends to make landlords angry and in many cases, the ultimate decision might rest with the landlord’s bank anyway.

Instead, tenants should think in terms of an exchange. Lackman, for example, recently worked with a restaurant client at a shopping center where one of the anchor stores went dark. According to the lease agreement, Lackman’s client had the right to leave because of the resulting drop in shopper traffic. But the restaurant’s owner felt it wasn’t overly reliant on the anchor, so the restaurant offered to give up the co-tenancy clause in exchange for a temporary rent reduction. The landlord was more than happy to agree.

Cooperation also means being willing to accept adjustments in the terms of the leasing agreement in lieu of adjustments to base rent. For example, tenants can ask for a cap on CAM charges, Burke says. Or they can try to revoke an exclusivity clause that prevents them from selling an additional line of products. Or they may request financial assistance from the landlord in the form of marketing and advertising fees rather than in the form of a rent cut.

Tenants have already started developing closer working relationships with landlords when it comes to marketing initiatives—many owners are reporting that whereas before tenants preferred to concentrate on their own store promotions, they are now approaching them about working as a team to drive up sales for the entire center. Some retailers, for example, are now willing to provide free goody bags for shoppers as part of center-wide charity drives, while others offer store discounts for customers who spent a large amount of money at the center. For both tenants and landlords to survive, that spirit of cooperation needs to be translated to leasing.

“The whole idea is that the landlord doesn’t get hit hard, but the tenant saves money as well,” Burke says. “So it’s about being as creative as you can.”

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