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Surplus Real Estate: Causes, Solutions

More than 300 million sq. ft. of surplus retail real estate is currently available nationwide, with several factors contributing to the high volume. By some accounts, there is an equal amount of space in under-performing, obsolete and unprofitable stores still operating and not defined as surplus, but obviously in limbo. Depending upon whether you are a landlord, retailer, entrepreneur or lender, the situation can represent anything from a liability to an opportunity.

Format change acts as catalyst With all retailers constantly chasing the "en vogue" format, changes in real estate are inevitable. Unfortunately, it is difficult, if not impossible, to effectively predict or safeguard against this dilemma because the length of most real estate leases is considerably longer than the typical change in format cycle.

Supermarket chains such as Winn-Dixie, Kroger and Albertson's may often expand their older, smaller stores - typically 25,000 to 40,000 sq. ft. - to their newer prototypes (typically 55,000 to 80,000 sq. ft.). In such instances, retailers typically explore the option of expanding on the existing site before they pursue the more costly alternative of relocating the store.

Most major drug chains such as CVS, Eckerd, Rite Aid, and Walgreens are relocating many of their in-line strip center stores to freestanding locations with drive-thrus. Most movie theaters over 5 years old are now obsolete, as the most popular theaters today feature 10 to 30 screens, all with stadium seating.

Although these changes can be costly to the retailer in a variety of ways - lease terminations and/or subleases, new real estate, fixtures, and equipment - the rewards have generally proven to justify the costs.

Mergers and acquisitions Consolidation continues at a frenzied pace, leaving in its wake many unneeded assets, including real estate. Kroger is acquiring Fred Meyer, which had previously acquired Ralphs and Food 4 Less. CVS acquired Revco. Thrifty Drug Stores and Payless Drugs merged and were then acquired by Rite Aid.

Ahold - a Dutch-based corporation that operates more than 3,600 supermarkets, hypermarkets and specialty stores with annual sales of $30 billion worldwide - has been on a buying spree that so far has included Stop & Shop, Bi-Lo, Giant (of Landover, Md., and Carlisle, Pa.), Tops, Edward's and Finast. Ahold also recently announced its plans to acquire Pathmark.

And the list goes on.

Duplication of market coverage occurs all too often, with stores frequently located within a stone's throw of each other. Additionally, each new merger and acquisition presents unique challenges. Stores may differ in overall size as well as dimensions and layout, all of which makes some of the company's other outlets superfluous.

Issues and opportunities Seasoned retailers are constantly analyzing existing locations to determine if relocations are appropriate. The most common reasons for relocation are an adjustment to shifting demographics to best serve a target customer base; overall upgrading of real estate (visibility, access, signage, etc.); economics (a better deal); and changes in format (size, freestanding vs. in-line vs. mall, etc.).

From the bankrupt retailer's standpoint, surplus real estate falls into two categories: It has value and can be sold (either leasehold or fee); or it must be rejected and therefore goes back to the landlord, thereby becoming his problem or opportunity, whatever the case may be.

If the real estate has value, is being sold, and a potential owner is fast and savvy, it could present a tremendous opportunity. Kimco purchased 89 former Venture store leases as a real estate investment, reselling 49 to Kmart; Staples purchased the vast majority of the former Rickel Home Center locations in the Northeast; and so far Kohl's, Kmart, and Wal-Mart have all announced plans to purchase a significant number of Caldor leases.

A landlord that receives a store back can seize the opportunity to redevelop the project and potentially receive higher rents. That opportunity assumes many variables. One assumption is that the landlord has the money to invest back into the project.

Notwithstanding the rosy stories depicted above, many landlords have been severely impacted by receiving space back, losing the income stream, and not having the resources to properly redevelop or make necessary improvements.

Unprofitable stores are a drain By closing an unprofitable store, an astute retailer will reduce negative energy and improve its bottom line. Customarily, we may be talking about a small percentage of a retailer's stores, perhaps 5% or 10% of the total store count. Although for many retailers this liability does not mean the difference between success and failure, closing unprofitable stores can make a healthy retailer healthier.

And, considering that in most cases surplus savings can instantly go to the bottom line, solving surplus liabilities can be an easy way to boost profits immediately . This is one of the reasons many retailers have a continuous flow of new surplus stores.

Many landlords have successfully capitalized on surplus real estate, profiting well by taking advantage of unique opportunities. Many other landlords, however, have been devastated due to surplus real estate, ranging from the thriving center that seems to die overnight as its anchor moves out (even though it keeps paying the rent), to those that outright lose their needed income stream.

Although some lucky retailers have profited from surplus real estate, it is almost always a liability. Subleasing often requires financial supplementation, not to mention the trials and tribulations associated with being a landlord. And paying up front for a lease termination typically represents a financial liability, requiring substantial resources.

Cost of conversion The current use of the building will determine the magnitude of conversion necessary for an alternative use. Landlords typically weigh the best rent obtainable in an "as is" condition against the sums necessary to convert it to an alternative use. Many specific uses have predictable costs to make space reusable. For instance, supermarkets typically have open trenches due to plumbing for coolers, and lack adequate HVAC, as they originally calculate into their needs the cooling effect of the many store refrigerators and freezers.

Theaters generally cost $15 to $25 per sq. ft. to bring the building back to a "vanilla-box" condition. Doing so often requires major demolition, the addition of a storefront, relocation of the bathrooms from the front to the rear, electrical changes, and leveling of all floors.

Retailer's dilemma: Who spearheads disposition? Retailers typically delegate the disposition duty to the real estate department, finance department, or some specialized in-house department. The real estate department that is focused on new stores is often too busy to devote the proper time to surplus, not to mention the unique nuances associated with, and necessary for, a successful disposition project.

Full-service specialized departments can be extremely challenging, costly and time consuming. Outsourcing part or all of the work can often provide significant cost savings, as well as negotiation advantages. However, you must find an experienced service provider. Be wary of real estate brokers who lack the experience to tackle the complex and sensitive issues associated with surplus disposition, including landlord relations, termination negotiations and lender approvals.

Also be cautious when choosing to use brokers who also represent you on new stores, as the compensation associated with acquisition work usually outweighs dispositions and can negatively affect their motivation to focus on surplus locations.

Evaluating surplus real estate For leased properties, the first step is to evaluate your lease document for all relevant information, such as use restrictions, assignment/sublease language (including any necessary landlord approvals), and any termination rights (co-tenancy, sales volume or other kickout provisions).

Sometimes these clauses are not in obvious places and are easy to miss. Make sure to carefully read the lease, as well as check all exhibits, addendums and side letters.

A proper market valuation of a surplus location is a necessity. Whether owned or leased, you must accurately and honestly assess the value (or more likely the liability) associated with all real estate. An experienced disposition broker or specialist can determine the current market conditions and marketability of your property, as well as determine the highest and best uses and comparable sales or rentals graded against your location. Frequently, the retailer has to accept the fact that it paid $X two years ago when competing aggressively for the location, and can now receive only 70% of $X when it comes time to sublease.

The next step is to realistically determine parameters for dealmaking. On owned properties, determine an acceptable sale price; on leased properties, determine both subleasing rents and buyout budgets. Market rents and sale prices are determined by market conditions and desirability of space, whereas the cost of a buyout depends on many additional variables, including, but not limited to, a landlord's eagerness to cooperate and the availability of alternative tenants.

Marketing the property Even if the ultimate goal is to terminate the lease, most retailers want to mitigate their surplus real estate without becoming a landlord in the process. You should pursue negotiating a lease termination with your landlord while simultaneously searching for an alternative user. From a strategic standpoint, the value and bargaining power of finding a replacement tenant are enormous.

Many leases simply can't be terminated and must be subleased in order to mitigate damages. Retailers such as Consolidated Stores, PetsMart, Heilig-Meyers, Family Dollar, Dollar General and other creditworthy alternative users have utilized surplus space.

Some lucky retailers even generate a profit, especially if they have old, long-term, under-market leases. At other times you need to ferret out creative or unorthodox users, which generally generate less income. Real-life examples include a corporate call center, church and synagogue, car dealership, fresh fruit market, university satellite campus, emergency medical clinic, police station, and various industrial and warehouse uses.

Make certain you and/or your representatives utilize every conceivable medium of communication to get the word out. There is no substitute for exposure, which can be accomplished on several fronts: at trade shows such as the ICSC Spring Convention; in trade magazines such as Shopping Center World; direct mail; fax broadcast; and via an Internet home page. A disposition specialist can clearly assist in this regard.

A strong commitment to advertising has historically proven to generate substantial returns by increasing income and saving time.

Lose a day, lose a deal Time is the worst enemy of surplus. These transactions are disproportionately fragile. They can die as quickly as they surface. If you lose a day, you can often lose a deal. Commit necessary resources, including legal support, so the disposition effort gets priority treatment and fast turnaround. Once you have a plausible deal, even if it is not exactly within projected parameters, it should be seriously considered. It almost always costs you more to wait.

How does that old saying go? A bird in the hand ...

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