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Pre-emptive Surgery

As major retailers file for bankruptcy and vacate stores, a domino effect is taking hold across the country. Shopping centers are reeling from the loss of income, and some are so hard-hit that the owners are handing the keys back to lenders and walking away.

Restructuring consultants are guiding both property owners and retailers as they try to avoid the painful slide into bankruptcy. Landlords and tenants who wind up filing for Chapter 11 protection from creditors are hiring advisers to locate essential debtor-in-possession financing to cover their operating costs during and after the bankruptcy process. But credit is so hard to get that the lack of financing has derailed many retailers' restructuring efforts and forced them into liquidation.

“There's very little restructuring debt available today. The banks simply aren't lending,” says Keith Shapiro, former chairman of the American Bankruptcy Institute and now an attorney with the Chicago office of Greenberg Traurig. While retail chains have dissolved in court, property owners' financial crises have primarily been dealt with out of court with their lenders, Shapiro says.

In short, the damaged economy and global credit crisis have created a perfect environment for bankruptcy. The International Council of Shopping Centers (ICSC) estimates that 148,000 stores closed in 2008,- and at least 73,000 will close in the first half of this year. “It appears that a substantial amount of space will become available over the coming 12 to 18 months,” says financial analyst Kyle McLaughlin of New York-based research firm Reis.

In 2008, 27 major retailers filed for Chapter 11, a nearly 400% increase from 2007, according to In the first half of January alone, major retail filings for Chapter 11 protection in federal bankruptcy court reached a seven-year high.

Goody's Family Clothing and 104-year-old Fresno, Calif.-based department store Gottschalks have filed for bankruptcy. And Swiss-based UBS Securities identifies 39 at-risk retailers on its January tenant watch list, including retail icons Macy's, Neiman Marcus, Nordstrom and Borders bookstores.

With a national unemployment rate of 7.6% and still rising, fearful consumers are spending less and choosing discount houses over specialty and department stores. Same-store retail sales fell 1.6% in January, according to ICSC. Given the spate of bankruptcies and store closures, the national vacancy rate is expected to reach 17% by midyear, up from 11.8% at the same time last year, says Suzanne Mulvee, real estate strategist for Boston-based Property & Portfolio Research.

Small shopping centers hit hard

When a retailer catches pneumonia, the landlord shivers, since the health of a shopping center is tied to its tenants. “Smaller owner-operators have had significant problems and have handed the keys over to the lender,” says Stuart Eisenberg, partner and managing director of the real estate group at BDO Seidman. The Chicago-based financial adviser's clients own hundreds of shopping centers, and include such retailers as Barnes & Noble and Jones Apparel Group.

Some larger shopping center owners also have decided that a site doesn't warrant further investment and have returned the property to the lender, Eisenberg says. “Even some [real estate investment trusts] have elected to let go of a property as opposed to continuing to lose money on it.”

The Shops at Atlas Park in Queens, N.Y., a sparkling $200 million, 400,000 sq. ft. center, opened just two years ago. But in February, it was taken over by its lenders, the French banks Société Générale and Calyon, after the owner, Atco Properties & Management, defaulted on its loan.

In Cupertino, Calif., Cupertino Square LLC and Vallco International Shopping Center LLC filed for bankruptcy as its lender prepared to foreclose after the owners failed to repay a $195 million construction loan. A hearing on a reorganization plan is scheduled late this month.

An echoing cry for help

It is no wonder that financial restructuring firms have been besieged with requests for help, as troubled retailers and landlords attempt to stave off bankruptcy or cushion the blow if a filing becomes inevitable.

Hilco Real Estate advises companies on which stores to close, and combs through its database of thousands of names to market the leases of the abandoned stores to wring value from the underperforming locations. Northbrook, Ill.-based Hilco helped Linens 'n Things close 371 stores, and Circuit City, more than 700 stores.

Besides helping firms restructure, Hilco can arrange for liquidations before or during bankruptcy. Advisers can search for a new lender or steer a company away from costly mistakes, such as inadvertently violating loan covenants and triggering punitive actions by a lender.

“In the last month alone, we've had seven new accounts,” says Greg Apter, president and principal of Hilco Real Estate. “All seven are pre-bankruptcy, because everybody's so worried about going into bankruptcy.”

The fate of landlords and retailers is interwoven. Retailers buffeted by waning consumer demand face a real threat of inadequate financing during and after a bankruptcy. Hilco recently launched a program to help companies avoid bankruptcy and liquidation. Too many firms can't recover from Chapter 11, Apter says. “They are unable to emerge, or able to emerge for only a short period of time.”

Taking their medicine

Under pressure from lenders, suppliers and other creditors, retailers are taking bitter pills to avoid or cushion a bankruptcy. The measures vary from pleading for reductions in rent to lopping off weak segments of their operations.

Landlords, in turn, are granting painful concessions such as lower rent, which reduces their income streams but may make the difference between losing and keeping an ailing tenant.

An overriding factor in recent bankruptcy cases is that too many retailers are being crushed by debt. “Because there was so much liquidity in prior years, we're finding that many of these companies leveraged their balance sheets to the hilt. There's no cushion,” notes Bill Lenhart, director of business restructuring services at BDO Seidman. He has aided debtors and creditors in bankruptcy cases, and has been a court-appointed examiner.

Some retailers were bought by private equity firms, which over-leveraged them. Still, too many retailers paid high prices for their inventory, which they later couldn't sell as consumer demand slowed. When credit was easier to obtain, many retailers expanded unwisely, borrowing against store leases and brands.

Retailers can auction the leases of underperforming stores or borrow against leases for healthier locations. Retail leases are often considered assets in a bankruptcy case because they can be sold or assigned. But many retail chains are over-leveraged and have no leases or name brands left to borrow against when they need emergency capital to restructure.

However, as property values fall and rental rates decline, many leases are considered overvalued and find no takers at a lease auction. In a normal market, retailers sell the leases when they shut down unprofitable stores.

Brand names are considered intellectual property, and retailers at times can borrow against them. Hilco and a partner bought the rights to the Linens 'n Things name and plans to relaunch the store brand by this spring.

Shifting bankruptcy laws

Unlike previous slowdowns, when a company could emerge from bankruptcy court as a healthier and leaner version of its old self, the example of more than two dozen high-profile retailers over the past year shows that, more often than not, the path to a bankruptcy filing is a swift and jarring road to liquidation.

When Richmond, Va.-based Circuit City Stores filed a petition in U.S. Bankruptcy Court under Chapter 11 of the Bankruptcy Code last November, executives first shut 155 stores. They kept the doors open at 567 superstores, but those efforts weren't enough. On Jan. 5, the company asked the court's permission to put the chain up for sale.

After two potential investors expressed interest and negotiations started, landlords across the country hoped that the tenant chain might survive under a new owner. But no deal occurred by the Jan. 16 court deadline, and Circuit City took steps to liquidate its assets. Acting president James Marcum expressed his disappointment, saying, “The company had been in continuous negotiations.”

Changes to the federal bankruptcy law in 2005 made it tougher to emerge from Chapter 11, says Shapiro of Greenberg Traurig. The changes reduced the time for retailers to decide which leases to reject.

“They have a very powerful right to walk away from leases with minimal damages,” Shapiro says. Another development is the new clout of junior lien holders such as hedge funds. Some of the liens stem from mezzanine loans, he adds. “In a lot of these cases you end up finding that the junior lien holders have the fulcrum position in the bankruptcy case, and they are pushing for quick sales of these companies.”

Falling dominoes hurt landlords

When stores close and chains stop growing, projects started before the recession may be unable to attract renters, while existing centers can't keep key tenants.

When a big retailer shuts an unprofitable store, the lease agreements of remaining tenants frequently give them the right to pull out of the shopping center without penalty. Called co-tenancy clauses, they can be devastating for landlords and may even push an owner into bankruptcy, says real estate attorney Irwin Fayne, a partner at Holland & Knight in Fort Lauderdale, Fla.

Landlords may persuade the tenant to stay by reducing rent or offering more space. But if one co-tenant pulls out, others may follow, says Fayne. “You could wind up with a house of cards. As one card falls, a few more fall, and eventually there's a collapse.”

For bargain hunters, distressed landlords spell opportunity. “I think this is one of the greatest times to be buying underperforming shopping centers of the last decade or two,” says Brad Hutensky, general partner of Hutensky Capital Partners, based in Hartford, Conn. Hutensky raised $100 million to snap up distressed properties over the next two years, and expects an internal rate of return of 20% to 30%.

Shapiro believes the problems in retail herald a worrisome new phase for other commercial real estate sectors. “I think that later this year you'll start to see more commercial office towers, industrial properties and the like move into a much more troubled state.”

Denise Kalette is senior associate editor.

Get aggressive, advisers tell owners

If a shopping center has lost a key tenant like Macy's or Linens 'n Things and other tenants are threatening to leave, a landlord needs to take aggressive steps to forestall a disastrous exodus and potential insolvency.

“Landlords have to be more aggressive and proactive. When you've lost a Circuit City or a Linens, you've lost a significant amount of synergy and income,” says Al Williams, a principal of Excess Space Retail Services, based in Lake Success, N.Y. The company advises retailers on lease and space disposition issues.

Understanding the pressures retail tenants face helps a landlord in the long run. Retailers are closing weak stores. Their creditors, including vendors and suppliers, may demand cash upfront and cancel previous 30- or 60-day credit agreements, leaving the retailer strapped for credit and inventory.

Scratching for credit

A property owner or retailer facing bankruptcy needs debtor-in-possession (DIP) financing to pay operating expenses while restructuring.

But with credit scarce, many borrowers are at the mercy of their existing lenders, who may be in no mood to issue a new loan to a defaulting client, says Keith Shapiro, former chairman of the American Bankruptcy Institute and now an attorney with the Chicago office of Greenberg Traurig. That's why it's so hard today for a company to emerge from Chapter 11.

At the start of a bankruptcy case, the judge typically issues first-day orders, including interim approval of DIP financing. A liquidator like Excess Space or Northbrook, Ill.-based Hilco may help close unprofitable locations, hiring, say, NAI Global, a Princeton, N.J.-based real estate network, to sell the inventory. NAI Global has more than 5,000 real estate professionals in 325 markets.

Landlords should understand that a retailer has a limited period to accept or reject leases in Chapter 11, normally 210 days, including an extension. Rejected leases can be auctioned, with the sale usually held at the debtor counsel's law office. Interest in the auctions has weakened, however, since few retailers are expanding.

“If you're a retailer and you signed leases two to three years ago for new locations, today those rents are so above market that they have zero value,” says David Solomon, president of retail services for NAI Global.

If dumping leases and chopping costs aren't enough, a company can hunt for a buyer. But realistically, a cash-strapped retailer may make just a brief stop in Chapter 11 before calling it quits.

“If there's no buyer for a retailer, a lot of lenders are now forcing liquidation,” says Solomon. No longer can a retailer make a pit stop in bankruptcy, drop underperforming stores and turn things around. “That playbook has fallen by the wayside.”

Here are five steps owners can take to stay solvent and avoid bankruptcy, based on expert advice from leading financial consulting firms.

  1. Take stock

    Examine your retailer base and determine what steps you can take to assure the center's long-term viability. Try to understand your tenants' needs. Some may be facing bankruptcy.

  2. Renegotiate lease terms

    You may need to bite the bullet and renegotiate a tenant's lease before the current term expires. As consumer spending has waned, many retailers' income has declined. Reducing the rent may keep the space occupied, and less income is better than none.

  3. Offer short-term relief

    Consider a brief rent-free period. This may strengthen the retailer's financial position in the long run.

  4. Fill vacancies quickly

    When a major tenant exits, find a replacement fast. If a remaining retailer's long-term prognosis is poor, line up a new candidate and negotiate for early possession of the space. Anticipate that a retailer in Chapter 11 may reject its lease, and prepare to rent the profitable space.

  5. Talk to the lender

    Negotiate new financing with the lender. “The symbiotic relationship among the three parties — tenant, landlord and bank — has never been more crucial,” says Al Williams, a principal of Excess Space Retail Services.

TAGS: Distressed
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