By Harold Bordwin, Principal & Doug Greenspan, Manager, Keen-Summit Capital Partners LLC
In 1Q 2017 and into 2Q 2017, news of retail store closures and bankruptcy filings had become commonplace, with no sign of abating. Shifting consumer shopping habits and competition from fast-fashion retailers and e-commerce have led to a more competitive marketplace and, in general, decreasing profit margins for retailers. To survive this market, retailers need, among other things, an articulated real estate strategy to use their footprint more effectively and to mitigate the cost and distraction of unproductive stores.
After retail sales in 2009 sustained their largest decline on record and, concomitantly, consumers increased their savings rate, a May 2010 JCR article pondered whether the prerecession consumer spending highs were sustainable. In fact, they were: U.S. consumer spending returned in a big way, reaching an all-time high of about $11.66 billion in 4Q 2016(1). Nevertheless, while overall spending has returned, how and where consumers are spending their dollars has, in fact, changed.
Online sales account for a larger percentage of consumer spending every year, and the rate of growth is increasing faster than many expected. The National Retail Federation recently predicted that online and nonstore sales will grow between 8 and 12 percent in 2017 as compared to a projected growth rate of 3.7 to 4.2 percent for the retail sector as a whole (excluding auto, gas stations, and restaurants).(2)
As a result of these rapid changes, almost every retail business has too many stores. Historically, retailers were pressured by Wall Street to grow their store bases as a way to increase top-line revenue growth. Opening new (as compared to good) stores was easy when a retailer financially incentivized its real estate department and real estate brokers to do so.
In addition to having too many stores, many retailers are finding that their stores, individually, are too big. Retailers were also historically incentivized to create big box category killers so they could take advantage of economies of scale and complex distribution networks to drive down marginal costs. Examples of this include Barnes and Noble and Borders book stores; Circuit City, Comp USA, and Best Buy electronics retailers; Staples, Office Depot, and Office Max office supply stores; Linens & Things and Bed Bath & Beyond home goods stores; etc. It is likely that this trend has reached the end of its life cycle.
Retailers are reimagining what their retail brick-and-mortar store portfolio should look like and with this, there is a shifting mentality toward doing more with less. One way to increase a
retailer’s financial metrics is to reduce square footage. All things being equal, store performance on a per-square-foot basis increases with a smaller footprint.
Developing a Plan
For discussion purposes, the following serves as a hypothetical case to examine some of the challenges a retailer may face and its restructuring options. A specialty retail chain has 200 shopping center stores, with an average store size of 6,000 square feet. Its average base rent is $40 per square foot, and average additional rent is $25 per square foot. Average annual store total occupancy cost is $390,000. The chain’s average store sales are $275 per square foot, or $1.65 million annually. Average occupancy costs as a percentage of sales are 24 percent. On a four-wall basis, 40 stores (20 percent) lose money, 120 (60 percent) make less than $50,000 per year, and 40 stores make more than $50,000 per year.
For most specialty retailers, there’s no way to make money when occupancy costs are 24 percent of sales. To improve this ratio, this portfolio of stores needs to grow sales and/or decrease occupancy costs. For purposes of this hypothetical, it is assumed that the retailer is doing everything that it can to grow sales and is now looking at its occupancy costs.
This set of facts raises the following questions and observations which, as answered, can lead to the development of a restructuring plan:
- How much are the 40 money-losing-stores losing? When do these leases expire? Are there any kick-out rights tied to sales or co-tenancies? Can a lease termination agreement be negotiated for less than the losses? Is money available to pay landlords for lease buyouts? Are these losses significant enough to push the company into bankruptcy? Is the tenant
on the leases the operating company or are any leases signed by single purpose entities?
- What’s the trend for the 120 marginally protable stores? Can they be stabilized? What’s the growth potential? What would be the impact of negotiated occupancy cost savings? When do these leases expire? Are there any kick-out rights?
- What’s the optimal store layout?
- How many stores can physically be demised to the prototype layout, and at what cost? Is there sufficient lease term remaining to amortize the costs of:
- demising the space (demising wall, new frontage, split utilities and HVAC, new bathrooms, loading dock access, etc.), and
- carrying the space while vacant, paying a brokerage commission, and providing the replacement tenant with a market level of tenant improvements and free rent?
What do the leases say about the tenant’s rights to alter the premises, signage, change of use, and percentage rent? What approval rights does the landlord have?
- Are there any reasonable store-within-a-store options? What will be the leasehold implications as they relate to signage, percentage rent, use clause, etc.?
- When considering store closings, what are the revenue transfer possibilities? What are the impacts on SG&A, advertising budgets, distribution centers, and regional managers?
- What is the financial health of the operating entity? Is it making or losing money? What are the revenue and EBITDA trends? What is the company’s debt burden, and is it sustainable? Are any balloon payments coming due? What if maturities are forthcoming? What covenants are at risk of default?
- What is the financial health of any entity that guarantees the lease obligations?
- What security deposits are in place? How many are letters of credit, and what would be the financial impact if they were drawn upon?
A real estate advisor can help a retailer ask pertinent questions and, based on the answers, develop and execute a lease restructuring strategy.
While considering the needs of the tenant, it cannot be forgotten that all lease restructuring strategies (other than closing stores and rejecting leases pursuant to Section 365(d) of the U.S. Bankruptcy Code) require a landlord that is open to negotiations. Landlords are not in the business of reducing rents or of letting tenants out of leases, and they have to account to their own equity holders and lenders. Thus, a key factor in determining the success of a lease restructuring project is the tenant’s negotiating leverage and messaging.
Whining to a landlord that rent is too high or that the shopping center is not generating sufficient traffic will not persuade a landlord to compromise its position. The single biggest element of tenant negotiating leverage is the legitimate risk that the retailer will file bankruptcy.
In the context of a bankruptcy threat, the landlord faces the possibility of leases being rejected and being stuck with a vacancy and a capped claim, pursuant to Section 502(b)(6) of the Bankruptcy Code, that may be paid at cents on the dollar at the end of the bankruptcy proceeding. Faced with that risk and the costs of rerenting vacant space—down time during the rerental process, tenant improvement allowances, brokerage commissions, free rent, etc.—the legitimate risk of bankruptcy frequently is sufficient to convince a landlord that it’s in its best interest to negotiate rent concessions and lease terminations.
In addition to using the risk of bankruptcy as negotiating leverage, tenants should undertake a market study to determine whether their rent is at market or above- or below-market. Landlords are much more amenable to taking back space if it’s a strong market with little vacancy and the rent in the lease being terminated is a below-market rent.
Moreover, landlords are very sensitive to co-tenancy clauses, which allow tenants to reduce their rents and/or terminate their leases if certain anchor tenants vacate the shopping center and/or certain overall occupancy rates are not maintained. When tenants have co-tenancy clauses, landlords are typically more motivated to negotiate lease modifications to keep a tenant in place rather than risk losing the tenant and triggering co-tenancy clauses in other retailers’ leases and experiencing a cascading effect of rent reductions and/or vacancies.
Without a Chapter 11 or other negotiating leverage, a tenant is in an arm’s-length negotiation in which there is little incentive for a landlord to compromise unless it is getting significant protections. For instance, it is common for a landlord to hold out for a lease extension in return for a rent reduction (also known as “blend and extend”). Where a tenant (without a threat of bankruptcy) is seeking to close a store and terminate a lease, it is common for a landlord to hold out for what it considers to be a risk-free settlement— i.e., payment of all of its anticipated costs associated with terminating a lease. A skilled real estate advisor may be able to help a retailer avoid such a costly settlement.
Given the highly unusual state of today’s marketplace, retailers have what may be a once-in-a-lifetime opportunity not to “let a good crisis go to waste.” Amid this significant market uncertainty, retailers should review their retail store footprints. A real estate advisor can help them understand business trends, identify lagging locations, study leases and markets, and develop and implement a strategic lease restructuring plan. Finding ways to create value from a retailers’ store footprint, while mitigating leasehold liabilities, is one of the best ways for a retailer to stay competitive.
Click here to read the June 2017 issue of the Journal of Corporate Renewal
1. See tradingeconomics.com/united-states/consumer-spending (http://tradingeconomics.com/unitedstates/consumerspending)
2. See digitalcommerce360.com/2017/02/08/online-will-grow-three-times-faster-retail-industry/ http://digitalcommerce360.com/2017/02/08/onlinewillgrowthreetimesfasterretailindustry/)