Honey I bought my tenants!

Much has been written in recently years about the retail apocalypse. Earlier this year we shared the mind numbing statistics of retail store closures that amounted to over 10,000 retail stores in the US in 2019. The pandemic clearly hasn’t helped most retail establishments.

On today’s show we’re taking a closer look at what is happening in retail. These days, my email in inundated with listing offers for retail real estate. They aren’t bargains for the most part. I’m seeing  pharmacy locations, banks, fast food establishments, convenience stores, has stations, and automotive service shops like muffler and tire shops. The list is long and varied.

These for sale listings are not bargains. I recently saw an offering for a 21,000 SF multi-tenant property that houses four large restaurants. The asking price is at $588 per square foot. This is well above replacement cost. Remember, these restaurants have been closed for quite some time and the metrics for restaurant dining post pandemic have not been established. It would be very hard for this investor to pay that kind of top dollar with the risk that is inherent in four new restaurants as tenants.

Simon Properties is the largest shopping mall owner in the US. In the past four years, Simon has acquired three of its tenants. Now they’re in discussion with Brookfield Property Partners to potentially acquire JC Penney. JC Penny is an anchor tenant in several of Simon’s shopping malls. When a mall loses its anchor tenants, the mall usually dies.

You see our credit system isn’t designed to handle an economic downturn. There is so much debt in the system that businesses can’t survive a drop in revenue. The businesses have borrowed money to fund their inventory. They’ve borrowed money to advance funds for their accounts receivable. They’ve borrowed money to pay for equipment, or perhaps the equipment is leased. Either way, the fixed costs of these retail businesses are high and these businesses are not resilient to economic fluctuations. The problem is further compounded by the fact that the mall owner can’t survive a long period of economic vacancy.

As a commercial landlord, I frequently face questions from tenants looking for rent concessions to help them with revenue fluctuations.  The massage therapy office that rents from us needs rent relief. The clothing store needs rent relief.

We know that some stores will close as a result of the pandemic. Some stores simply won’t survive.

Here’s the scenario that I believe we will face in the world of retail. Retail space will get repriced, on a massive scale. There will be lots of pain along the way. Even those retail owners with firm leases will find themselves negotiating rent concessions on a large scale.

Let’s imagine that we have a 20% reduction in retail floor space as a result of the combination of the pandemic and the ongoing trend of local retail sales being replaced by online sales.

There might have been already a 10% vacancy rate in the market. Add another 20% and you’re near 30% vacancy. So now some of those properties go into default on their loans and the buildings are sold at a fire sale price, say, 50% off their construction cost in a foreclosure auction.

The new buyer owns these buildings at 50% of their replacement cost. They can charge a lower rent compared with the competition and still make a healthy rate of return. New tenants will flock to the newly available space that is priced 1/3 less than the comparable market. Tenants in existing spaces will renegotiate their leases. They will argue that the move to less expensive space is necessary for business survival. The existing landlord faces a difficult choice. The landlord either offers a rent concession, or they lose the existing tenant and revenue goes to zero. It’s a lose lose scenario for the landlord.