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Leasing on the Dark Side

The nation's shopping center owners and retailers are wrestling with 300 million sq. ft. of surplus space.

But how can a booming economy produce so much excess space?

In several retail categories, empty space appears to be a byproduct of economic growth rather than a mark of failure. Consider the grocery store business, for example. Top-of-the-line chains, thriving in the current economic climate, have begun a nationwide move into spaces 50,000 sq. ft. and larger, vacating their traditional 30,000 sq. ft. stores.

Widespread issue In the drugstore industry, major chains have discovered that customers like drive-thru convenience. The new drive-thrus, however, have left 8,000 to 10,000 sq. ft. holes in several centers.

Likewise, cinemas have fallen victim to new ideas. New stadium-seating theaters attract throngs of people, but leave traditional cinemas begging for patrons. Industry observers expect the next few years to yield a number of traditional theater closings, creating surplus space that may be difficult to re-lease.

Still other categories throw off surplus space as well.

Scott Shillings, a director at Boyd, Page & Associates in Houston, has witnessed an eruption of big-box surplus space. "Since 1997, eight retailers have closed 34 big boxes in Houston, leaving more than 1 million sq. ft. of retail space," Shillings says.

In evaluating the reasons behind these big-box vacancies, Shillings tracked 40 retailers in 150 Houston big boxes, exclusive of grocery store and home improvement store chains. His study indicates that "most big-box categories can support no more than two dominant retailers in an area."

In short, the big-box categories in some cities may have overstored themselves.

Shedding light on reasons Like many brokers, Shillings looks at surplus space as the "dark side" of the current economic boom.

What does this dark side mean to shopping center owners?

Depending on the circumstances, a landlord may or may not find a satisfactory solution to vacancies created by exiting retailers. Surplus space arises in one of three ways: lease expiration; bankruptcy; or the decision of a solvent retailer to leave for a variety of other reasons.

The first case is more or less routine. The lease expires. The owner remains in control and sets about looking for a new tenant.

Crowley's, a case study The second case, bankruptcy, offers a different category of problem. Ludwig and Karas Inc. of Farmington Hills, Mich., is currently disposing of space created by the bankruptcy of Crowley's, a small department store chain that operated about a dozen stores in southeast Michigan.

According to Steven L. Karas, who is president of Ludwig and Karas, the most attractive Crowley's sites were taken by Value City, which purchased the leases in bankruptcy court. Karas is handling one of the properties for which no bids were received.

"The property I have is in a 150,000 sq. ft. strip center," Karas says. "(The former Crowley's site) totals 81,000 sq. ft. Unfortunately, the space occupies two floors, a main floor and a full basement. The issue is what to do with the basement. I don't know of any single users of approximately 80,000 sq. ft. willing to take this type of location in a neighborhood center."

When an anchor leasing more than half the square footage of a 150,000 sq. ft. center goes vacant, the center, of course, suffers. Because this center serves an affluent community and remains fully leased except for the anchor space, it does seem possible to turn the situation around. But the thriving retail in surrounding centers limits Karas' options.

The major retail power center in the region lies just one mile away, limiting big-box options.

Karas is also weighing the idea of dividing up the space, which makes sense in light of the two floors. But who wants a basement location in a suburban strip center?

The third option is to raze the building, fill in the basement and start over. "That would reduce the square footage," Karas says. "I could get up to 55,000 sq. ft. out of a reconfigured space."

That might work for a new large-format grocery store. But this is a center that has never had a grocery store. Does that matter? Maybe and maybe not. Whatever happens, the center owner will probably face a reduction in rental income.

Caught between a rock and a hard place A third surplus-space scenario unfolds when a solvent retailer closes unprofitable stores or moves to a more profitable space. Depending on what happens next, owners must contend with problems over which they have little, if any, control.

The departing retailer, for example, may sell its lease, in which case the owner may end up with a tenant that doesn't fit the center's leasing strategy. Alternatively, the retailer may continue to pay rent on the unoccupied space, preferring to limit competition in the area. Income continues to flow to the owner, but a major vacancy can fray the reputation of the shopping center and lead remaining tenants to consider their options.

First Commercial Realty & Development Co. Inc. of Southfield, Mich., recently encountered this problem at several of its centers, representing 20% of the company's shopping center portfolio.

"Auto Works had taken space in each of four centers as well as in a freestanding building we had put up for the retailer," says Warren Terrace, a partner with First Commercial. "Auto Works was not an anchor, but it did represent a substantial tenant at each of the five properties. It was a problem, but we came out of it pretty well.

"In one location, Advance Auto bought the lease from Auto Works. We had no control over that. In three locations, Auto Works bought its way out of the leases under a negotiated deal. We used the income to rebuild the space, dividing it up into smaller spaces that are leased up. The freestanding store is still unoccupied."

No-win situation Replacing a solvent anchor can prove more challenging. "If you're a landlord, an anchor vacancy obviously hurts your center," says Howard Makler, chairman and COO of Excess Space Disposition Inc. of Lake Success, N.Y., a national company specializing in surplus space disposition. "More likely than not, you'll continue to receive rent. But you're probably not in a position to terminate the lease because you need the income to pay the mortgage. It's a challenging situation where you can be damned if you do and damned if you don't."

Shouldn't an owner in this position negotiate a buy-out with the retailer? "Maybe," says Makler. "But your lender may tie your hands. Suppose you have a lease with a solvent national retailer that literally guarantees payment every month for the term of the lease. The lender may have the right to approve anything that would affect your income stream, especially if it involves your anchor. You can go to the bank, explain that you want to terminate the lease and use the buy-out money to redevelop and save the center. But the lender may insist that you keep the existing lease to ensure payment of the mortgage. It's totally unreasonable. But that's the way it is. You can't do much about it. Game over.

"There is one way to solve this problem," Makler continues. "Replace one national tenant with another. Does this happen? Every day. But for every case that works out, two or three others don't."

A&P departs Atlanta When matters do work out, it's largely the result of good fortune. In the Atlanta market, for instance, A&P decided to pull its stores in May. Prior to the announcement, it sold leases for its more high-profile locations to Publix and Harris-Teeter.

The balance of the properties, 20 or so, were listed with an Atlanta brokerage company, The Shopping Center Group. Ruth Coan is a partner along with Gail Fargason. According to Coan, the Atlanta market currently counts several million sq. ft. of vacated space that requires disposition.

Many centers with departing A&P anchors not covered by the initial agreements with Publix and Harris- Teeter will be readily leased by replacement tenants. But not all.

"Publix only recently entered this market," says Coan. She explains that its initial strategy was to roll out a prototype developed for the Atlanta market and that the giant grocer was interested only in new construction.

"The grocer found sites with relative ease in outlying communities. But when it comes to close-in and downtown locations with strong, attractive demographics, there is no land for new construction. Still, the company wants into the market, and so it may consider smaller existing vacancies not perceived as ideal," says Coan.

"I'm not sure how this will shake out, but I do know Publix is happy about being able to lease existing sites in affluent, highly educated consumer markets with high population densities.

"Both the center developers and Publix benefit from the fact that A&P is relinquishing the entire market. Had A&P retained some stores, Publix would probably not have been given the option by A&P of leasing at these close-in locations," concludes Coan.

Matter of perception Like every issue in the shopping center industry, surplus space represents both a problem and an opportunity. Space in the New York, New Jersey, Connecticut region commands a premium. "The market here is very vibrant," says Charles Aug, chairman of Garrick-Aug Associates Store Leasing, Inc. "There is an acute shortage of space in my region. We would welcome a few defunct movie theaters and empty grocery stores here."

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