The Incredible Shrinking Stores

By Keat Foong

Consider these developments: Best Buy has announced plans to reduce the average square footage of its stores and wall off and sublet parts of larger stores to other retailers. Walmart is experimenting with smaller-format stores, such as Walmart Express, which are less than 10 percent of its regular store size. Target is considering testing smaller footprints in urban locations. Staples and Office Depot are also reportedly seeking to launch smaller stores in different markets.

Whether it is a structural or cyclical trend, there may be a movement afoot toward smaller retail spaces that is driven by both retailer and investor preferences. In the short run, retailers may be downsizing their footprints because of weak store sales. Indeed, Reis Inc. forecasts another challenging year for the retail sector. Consumer demand is not increasing meaningfully, noted senior economist Ryan Severino in his latest retail report. Reis reported neighborhood and community center vacancies stayed flat at 10.9 percent in the first quarter.

In the face of lackluster sales increases, “retailers are really looking at their footprints and asking whether they need this space. If they signed the lease in 2002, the economy is at a different place now,” said David Pinsel, managing director for the investment brokerage business of Colliers International. “A lot of retailers took more square footage than they needed at the peak of the market, and they are now rightsizing.”

The downsizing trend may also be more structural and long term in nature, as these companies are announcing long-range plans to reduce their store sizes: Retailers are also responding to changing shopping patterns and the loss of traffic to online shopping. In the Internet-based economy, retailers are not having to carry as much inventory in their stores, noted Randy Blankstein, president of The Boulder Group. For example, retailers such as Best Buy “no longer need to carry certain items, such as DVDs and CDs, which have moved online,” he said.

And of course, many of the retailers are also trying to penetrate new urban markets with smaller-format stores. “Most of America is not under-retailed,” said Dan Fasulo, managing director of Real Capital Analytics Inc. “There is too much retail in most of America. However, most retailers realize that many urban environments are under-retailed. To fit into those locations, they have to tinker with the traditional formats.”

There are correspondingly more examples of net-leased spaces with comparatively reduced square footage changing hands. In the early summer, The Boulder Group brokered the $5 million sale of a single-tenant Best Buy property located in Marquette, Mich., at a 7.8 percent cap rate. The 30,040-square-foot building sits on a 4.8-acre parcel and is leased to Best Buy for a new term of 10 years. Best Buy is moving to a smaller prototype, noted Blankstein. “Their stores are more typically 45,000 square feet, but the newer ones are in the mid-30,000-square-foot range,” he said.

Smaller footage may also be desired by the owners of net-leased retail properties. These investors may be subdividing the spaces or building out smaller spaces. Reasons for possible downsizing among investors include easier ability to rent more restricted space and the higher per-square-foot rents and investment returns that the smaller shops may bring. In addition, subdividing the net-leased spaces may provide a hedge against any one big retailer going under, some experts argue.

Pinsel said that 40,000- to 60,000-square-foot big boxes are being subdivided into two to three smaller spaces by the asset owners in order to have access to a larger renter pool. “This is a great way to attract tenants because there are more tenants in the 20,000-square-foot-or-less range.” When Walmart recently vacated a space in Oklahoma, Pinsel related, Old Jim Customs and Forever 21 eventually moved in to occupy the space. “The owner was able to fill the space much quicker than it would have if it was looking for one large tenant,” he said.

As the pool of potential tenants for smaller spaces is much higher than that for bigger spaces, smaller spaces lease up faster if they are vacated, Pinsel noted. At the same time, owners can charge higher per-square-foot rents for them, since the demand for these spaces is greater. “There are more renters at the 20,000- to 25,000-square-foot range than for larger footprints,” he said. “For spaces measuring 50,000 or 60,000 square feet, the pool of tenants falls dramatically.”

Properties with smaller footprints also have lower sales prices, and in that $5 million-and-under net-leased segment, investor demand is currently “extremely strong,” Pinsel noted. Colliers currently has a listing of almost 100 CVS-, Rite Aid-, Burger King- and 7-11-occupied net-leased properties located in primary, secondary and tertiary markets available for sale. The tenants in these 4,000-square-foot-or-less spaces are typically fast food chains or drug stores such as Rite Aid or CVS, he noted. For stores with square footages just above that range—occupied, for example, by larger stores such as Trader Joe’s or Fresh & Easy—there is still far more investor demand than for the 40,000- to 50,000-square-foot range of assets.

As an example of heated investor demand for smaller properties, Fasulo cited the $10.4 million sale in March of an 11,062-square-foot triple-net-leased freestanding property occupied by Walgreens. Fasulo noted that the price of $937 per square foot was almost a “ridiculous price for Peekskill, N.Y.” The asset, which was sold at a cap rate of 7.3 percent, was developed in 2010 by the seller, Ryan Peekskill L.L.C.

Another trend in the configuration of retail spaces is for stores, especially banks and drug stores, to take advantage of lower prices in the retail downturn to relocate from malls, strip centers or other in-line locations to standalone and street-corner locations, added Blankstein. At these locations, retailers can enjoy their own identities, greater visibility and higher traffic count. At the same time, they remain in the same submarket and are able to access the same proven client base. The retailers can often vastly improve sales as a result of these relocations, Blankstein said.

The Boulder Group recently brokered the sale of a 13,650-square-foot, single-tenanted, net-leased Walgreens property in Chicago to a California-based 1031 exchange investor. Walgreens had moved to that location from a strip center next door in which it was one among other retailers, he said. The property, developed in 2010 and located at 3220 W. 111th St., at the intersection with Kedzie Avenue, was sold by the developer for $7 million, or an 8.8 percent cap rate. Not only are the rents for these freestanding corner locations now lower than they were at the peak of the market, it is also easier for retailers to find these spots today, said Blankstein.

At the same time, Blankstein knows that net lease investors may pay a higher premium for smaller or more visible assets as they begin to realize there is a trend for retailers to prefer these kinds of spaces.

With these changes occurring, certain retail space reconfigurations could drive properties out of the net lease sector, or at least be very difficult to execute under the triple-net-leased format. William Pollert, president of CapLease Inc., said that one complication of multi-tenanted space is that the costs for maintaining the common areas of the asset, as well as taxes and insurance, are shared. If one tenant fails to pay its share, the investor may have to step in, and that jeopardizes the predictable-income-stream nature of the investment. “Tenants have a responsibility to maintain the property as theirs. When the space is divided, it is very difficult to get a truly triple-net-lease structure,” he added.

Fasulo maintained that owners of vacant big boxes always consider subdividing their spaces. “That is nothing new. It usually happens in a down market. There is no structural change in my view.” Fasulo said landlords usually “resist subdividing their spaces, which is usually done in desperation. Everyone likes big tenants.”

Pinsel acknowledged that there can be issues that arise when the spaces are chopped into smaller territories. However, he added that the obstacles are not prohibitive—and certainly preferable to the space going dark.