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How Retailers Should Think About Risk and Reward in Their Portfolios

May 31, 2022

From the doldrums of lockdown to the record-breaking economic recovery to rising concerns about war, inflation and recession, the pace of change since 2020 shows no sign of slowing. Commerce + Communities Today contributing editor Joel Groover spoke with RCS Real Estate Advisors partner Spence Mehl about how it all affects retailers seeking to balance risk and reward in their portfolios. Mehl frequently negotiates with landlords to reduce retailers’ occupancy costs, restructure their leases and help them open, resize or relocate stores. His firm’s recent projects include guiding Solstice Sunglasses through Chapter 11 bankruptcy; acting as an outsourced real estate department for growing chains Francesca’s, Lolli & Pops and OrangeTwist; and doing a deal to keep Loft, Ann Taylor and Lane Bryant stores up and running in Simon malls.

What’s it like right now for chains trying to optimize their real estate?

It depends a lot on the context. When it comes to open-air strips in the burbs, the word “crazed” comes to mind. I mean, the shift between this year and last has been so dramatic. We went from the world crumbling to a huge uptick in retail sales. Landlords like Kimco and Brixmor have never been busier in terms of leasing activity than over the past six months. Their occupancy rates are also setting records, so they are very bullish on negotiating deals. For retailers, many of which lost a year doing nothing during COVID, that’s translating into enormous pressure to open stores. Their sales are up again. The question is whether that is sustainable.

My personal opinion is that things will be getting a bit softer in sales, and I’m concerned that many retailers are doing new deals at high rental rates, based on the presumption of today’s strong sales continuing indefinitely. In 2020, government subsidies saved many retailers from filing for Chapter 11. All of that is ending now. In addition, consumers’ rent moratoriums have also disappeared. Now, consumers are having to pay utilities and rents again and catch up on all of those expenses. Then you throw in inflation and higher interest rates and things like the Russia-Ukraine war and its ripple effects. So consumer spending will decrease. Most turnaround professionals feel there is going to be a real contraction. Retail leasing always lags the larger economy, so even if things are starting to soften right now, the landlords are not going to really tighten up and get nervous for about six months.

But as I mentioned, it’s all about the context. The suburbs are doing great, but urban areas are still getting the worst of it. New York City is crushed right now in terms of retail vacancies. The office workers aren’t back yet. I was just in New Orleans, Chicago and Atlanta and it’s a similar story in [central business districts] there. For the malls, it’s all about whether it’s A, B, C or D. Landlords at those Cs and Ds, where foot traffic is low, don’t have much leverage right now.

What’s your advice to retailers in those stronger markets?

Be careful. Don’t just look at the market value of the real estate. You need to dig deep into the P&L of that individual store and ask some questions. What happens if your sales contract 5 or 8 or 10%? What if you’re shut down again by a new variant? You have to think about protecting yourself in the event of a shift.

We call it ‘de-risking the portfolio.’ In some cases, we’re encouraging retailers to work with their landlords to take a particular approach to this. Basically, on behalf of the retailer, we’re negotiating a fair floor for the rent. If sales go up past a certain breakpoint, the landlord gets a higher percentage of sales. This gives the retailer some comfort. If their sales roll back, the store is not going to go into the red. Meanwhile, the landlord gets an opportunity to share more of the upside in the event of that tenant’s success. Now, the banks obviously don’t like this. They prefer certitude, but we’re having a lot of success with this. Moving forward, I think there’s going to be a wave of deals structured in this way as things start to soften and de-risking becomes a bigger priority for retailers.

But the key is — and I’m telling this to a lot of my retailers — do not panic. Yes, you’re under the gun, but there will always be another opportunity to open that store. The last thing you want to do is lock yourself into five or 10 years in an underperforming location.

In the end, we need to remember that we are all in this game together. Right now, one big electronics retailer is being very aggressive about letting its lease-renewal options go ahead and lapse. This retailer is calling landlords to renegotiate the option, but the landlords are being tough and telling them, “Don’t talk to me until you pass your option. That’s when we can talk.” That is a dangerous game. If a retailer goes naked on a deal, they can walk away and leave the landlord with a big hole in the shopping center. It’s very expensive to redeploy a big box. So in this situation, someone is going to get hurt and it is unnecessary. Landlords and retailers should be having better conversations. We are each other’s livelihood. If we lose, the purely digital retailers win.

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