How the Retail Real Estate Sector Must Change to Survive

In 1838, The Ohio Mechanics Institute sponsored the first exposition held in the United States. Interrupted by the Civil War, expositions resumed in 1869 in Saengerhalle, constructed by a local choral organization.

By 1872, Saengerhalle had been enlarged and was renamed Exposition Hall, and the exposition boasted an attendance of 500,00. A year later, Exposition Hall also hosted a May Musical Festival.

By 1875, the exposition had outgrown Cincinnati’s exposition building, and a local businessman and music lover made the controversial suggestion that the building be replaced by a music hall. In 1878, the music hall was completed. The hall consisted of a simple performance hall with an elevated stage (with a grand organ for a newly-formed Organ Society) and wings designed for industrial expositions. The same year, the College of Music (now Cincinnati Conservatory) opened in the hall.

Over the years, the Music Hall was modified and expanded to accommodate the Cincinnati Art Museum, the Queen City Roller Skating Rink, the Cincinnati Symphony, the Shriners’ circus, and Danceland. And during the Influenza Pandemic of 1918, the Music Hall was a military hospital.

In the 1920s, the wings were modified to become a sports arena, an auto show venue, and a ballroom. During the twentieth century, the Music Hall survived because it continued to adapt to the city’s residents’ evolving needs and demands. A parking garage and adjacent convention center were added. The ballroom had become a multi-purpose room and meeting venue, and the sports arena was transformed into a rehearsal hall and areas to construct and store scenery.

The COVID-19 pandemic abruptly changed what people need from real estate, whether it be a concert venue, a strip center, or a shopping mall. Savvy retail real estate owners who, like the Music Hall patrons, adapt to tenants’ and their customers’ needs will be equipped to survive the pandemic. Retail landlords who do not adapt may not survive.

This article is a series in which I forecast how the pandemic will change real estate investments. In How the Pandemic Will Change Multifamily Real Estate and How the Pandemic Will Change Office Leases, I discussed how the pandemic might change the multifamily and office asset classes. In Reimagining Real Estate for the Pandemic and After, I focused on identifying and repurposing underutilized space. This article discusses how the pandemic is likely to change the shopping centers and malls.

Retail Sector

The retail sector traditionally has covered real estate where a product is sold to consumers on-site. That product might be goods, such as computers, clothing, or groceries. Retail real estate includes shopping centers and shopping malls, big box stores, and sometimes, pop-up stores, lower levels of office buildings in urban areas, and part of mixed-use developments.

Sometimes retail real estate hosts businesses that “sell” an intangible product, such as banking services. And sometimes, retail real estate becomes home to businesses that sell “products” associated with other asset classes.

 For instance, a restaurant, which is part of the hospitality industry, may be housed in a shopping center. An urgent care clinic or dentist’s office, which normally would be considered healthcare, might be in a strip mall. A retail service business, such as a real estate broker, might have its offices in a shopping center rather than in an office building.

Pre-Pandemic Challenges for Retail Landlords

Even before the pandemic, retail landlords faced challenges that threatened their survival. An ICSC report on the shopping center industry’s future described what successful mal owners were doing before the pandemic to remain relevant.

Those owners were finding ways to participate in eCommerce via Amazon hubs or stores. Some landlords established pickup zones in parking lots to accommodate customers who ordered products online and picked them up at mall stores.

Owners also changed their tenant mix to include health clubs, restaurants, and entertainment tenants that sell experiences hoping to make the malls a destination that appeals to millennials. Some malls added free Wi-Fi and workspaces for telecommuters.  Others became mixed-use properties that included hotel, office, or multifamily uses.

How the Pandemic Has Affected Retail Landlords

During the pandemic, in some places, malls were forced to close. Even where malls remained open, retailers deemed nonessential were forced to close. By June, a forecast that 25,000 storefronts, mostly in malls, would close in 2020.

These closures reduced landlord revenue. Plus, during these closures, many customers had no choice but to shop online. And others chose online shopping as a safer option in the middle of the pandemic. The result was a huge growth in online retailers and big-box retailers, like Target and Walmart, with a strong supply chain and existing online presence.

Things did not go as well for retailers without strong supply chains and existing online shopping platforms. These retailers, unable to make up lost revenue online, failed. Many specialty retailers, including Jos. A. Bank, Sur la Table, and J. Crew, are among the many that ended up in bankruptcy. Others, such as Lord & Taylor and Pier 1 Imports, announced a complete liquidation.

Therefore, many mainstay mall tenants are gone forever. With them, landlords are losing rent revenue. More devastating, mall leases may require that the landlord maintain anchor stores or a minimum occupancy percentage. So, tenants that haven’t gone out of business may have the leverage to cancel or renegotiate their leases. And it’s likely that some shoppers, now accustomed to online shopping, may never go back to the malls.

Landlords’ mortgage loan documents may contain similar requirements. Or the loan documents may require a minimum level of financial performance, such as debt service coverage. Landlords that can’t meet those requirements due to tenant exodus or reduced rent from remaining tenants may be in danger of foreclosure.

Merging Landlord and Tenant Roles

As both retailers and retail landlords struggle, we are seeing landlords buy tenants. And we have seen major retail tenants buy entire shopping centers or malls.

The nation’s largest mall owner, Simon Property Group, responded to this challenge by saving its tenants. In August, Simon formed Sparc Group, which started operating Aeropostale and Forever 21, and which by October had purchased Brooks Brothers and Lucky Brand out of bankruptcy.

Mall landlord acquisition of tenants at first looks like a win-win solution. Struggling retailers get a new breath of life. Mall owners eliminate the problems associated with high vacancy rates, such as lender and lease requirements. Other tenants might believe the landlord is artificially propping up occupancy, so tenants can’t get out of their leases due to low occupancy.

As long as the increased occupancy creates mall traffic and helps other tenants’ revenues, there may be no complaints. However, common ownership of both the mall and the retailers may artificially prop up rental rates. After all, affiliate tenants’ rent rates won’t be determined through the same competitive process other tenants face.

While this may benefit the landlords, it may hurt other tenants. Landlords may give their own stores the best locations or promote them more than other tenants. Smaller tenants without bargaining power may be forced into paying rates higher than would exist if the landlord weren’t in control of other tenants. Any increased traffic from the higher vacancy might be more than offset by the artificially high rents.

Tenants that aren’t affiliated with the landlord struggle to pay artificially high rental rates and eventually close their doors, leaving the landlord once again in a high vacancy situation. Therefore, while interesting, mall ownership of retail tenants isn’t a long-term solution to the retail real estate sector’s problems.

Plus, the tenants that Simon has purchased, while major retailers aren’t typically anchors. Anchor tenants are critical to the current retail business model, and other tenants’ leases may require an anchor as a condition to their tenancy.

Reimaging the Anchor

Traditionally, an anchor tenant usually was a major department store in an enclosed mall and a large grocery store in a strip mall. With the development of mixed-use properties, the anchor tenant concept was already changing before the pandemic.

As I discussed in Reimagining Real Estate for the Pandemic and After, Before the pandemic, one older mall owner transformed small boutique shops to micro-apartments for single tenants, allowing tenants to rely upon the mall’s retail stores, amenities, and restaurants for their needs. Another mall already planned to construct an apartment building in place of vacant department store anchor space.

The shopping mall near to me announced that a former Sears location would soon house a fitness club, possibly, with a swimming pool. Other new types of anchor tenants, such as cinemas, office space, and restaurants, also appeared.

These changes were precipitated by struggling department stores that were already struggling. Sears disappeared before the pandemic. The pandemic has sent department stores, such as J.C. Penney and Nieman Marcus, into bankruptcy.

Landlords need to find new anchors. Mixed-use development is one possible solution, but that takes time and money for redevelopment, which can take years–possibly too long for malls to survive without anchors. Cinemas and restaurants are themselves struggling and not likely to take on anchor space. And micro-apartments and even more office space might not be as attractive as telecommuting remains the norm.

Online Retailers as Anchors?

However, despite the pandemic, one real estate sector, industrial, is booming, with demand exceeding supply. The massive increase in online shopping has increased demand for warehouse space and fulfillment space.

One major problem for online retailers is the “last mile” of delivery. Some have used the Postal Services’ SmartPost, but it can be woefully slow for customers accustomed to same- or next-day delivery.

Malls and online retailers could be a marriage made in heaven. Malls have huge anchor spaces vacated by bankrupt department stores. Online retailers need both warehouse space and a way to speed up last-mile delivery. Amazon and Simon have explored that possibility–the use of former anchor stores as fulfillment centers.

Back to the Future?

The merger of malls with online retailers is not groundbreaking. Rather, it is based upon a century-old business strategy.

The Montgomery Ward stores of my childhood were mall anchor stores. Montgomery Ward was started in the late 19th century as a mail-order company. The company continued to be the 19th-century version of today’s online retailer until the 1920s when it opened its first retail stores. Another mall retailer, Sears, was formed as the Sears catalog in the late 19th century, with the first Sears retail store opening in 1925.

Montgomery Ward closed its last stores in 2001. It was acquired by an online marketing company and relaunched as an online company. Sears filed for bankruptcy in 2018 and was sold to a hedge fund in 2019. Sears currently has only a fraction of its mall anchor locations.

As with Sears and Montgomery Ward, consumers will determine whether distribution centers in anchor space save malls. Without customers, even a fully-occupied mall won’t survive for long. And it remains to be seen whether shoppers will shop at a mall with a distribution center anchor.

Cincinnati’s Music Hall predates Sears and Montgomery Ward by decades. Unlike Sears and Montgomery Ward, the Music Hall has survived and even thrived. The Music Hall adapted, even changing its identity from expedition hall to hospital, roller rink, arena, and art museum to draw people.

Mixed-use development and converting mall anchors to distribution centers, residential, or office space are a start and may provide short-term relief. However, like those who guided the Music Hall through its many transformations, mall owners should consider whether, rather than holding on to the anchor tenant model, malls should evaluate whether a different business model might be more effective in drawing consumers to their locations.

© 2020 by Elizabeth A. Whitman

Any references clients and their legal situations have been modified to protect client confidentiality.

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