Why Lenders Must Account for Mall Trends

By Chris Nebenzahl, Senior Analyst, Yardi Matrix

The rise of smartphones and online retailers such as Amazon has clear implications for retailers, as technology has changed the way people shop. However, changing trends in shopping also have a significant impact on the institutions that finance retail properties.

As consumers increasingly shop online, malls and retail outlets have taken a major hit in revenue and traffic. That has not only led to the bankruptcy of retailers such as Sports Authority, Radio Shack and Aeropostale but has also reduced the impact of anchor stores such as Macy’s and Sears on regional malls. The result is that performance of malls that serve as collateral in CMBS pools is growing much more bifurcated, according to a Moody’s Investors Service study released last week . Malls have a tendency to face steeper losses in the event of failure or default; therefore staying relevant and profitable is even more important than in other real estate sectors.

In order to keep malls afloat, owners have to adapt to new consumer demands. Rather than going to a mall primarily to shop, consumers today seek experience-based shopping. Fast-casual and upscale restaurants have replaced chain-style food courts as the main dining options at many malls. Movie theaters are becoming part of the mall landscape as landlords look to fill vacant space with entertainment and socialization to attract visitors.

The Moody’s study, “Separating Winners from Losers in the Emerging Mall Landscape,” found that the loss severity on malls within CMBS portfolios is often much higher than other types of loan liquidations. The average loss severity on CMBS-held malls that have been liquidated in the past eight years has exceeded 75 percent, while the loss severity for all CMBS loan liquidations averaged 45 percent, according to Moody’s.

In other words, when malls fail and are forced into liquidation, the property value is significantly less relative to the outstanding loan, compared to other real estate types. That is because retail— unlike other real estate sectors—is highly dependent on key tenants. Occupancy and revenue in an office building generally does not depend on one or two tenants, and neighbors moving in or out of an apartment typically doesn’t result in the entire tenancy turning over. However, occupancy in malls is tied to the presence and performance of an anchor retailer, historically large department stores such as Macy’s, Nordstrom, J.C. Penney and Sears. Shoppers were drawn to the mall for the convenience of the department store, then stayed and shopped at in-line retailers occupying smaller storefronts.

So how can a mall remain solvent and profitable through the ever-changing retail environment? When assessing the potential for long-term solvency for retail locations, the Moody’s study noted that a few factors generally predict success:

Demographic makeup of the mall’s location. Unlike other forms of real estate, malls carry additional risk because they can’t be easily repurposed like offices and apartments. As a result, location becomes an important factor that will help determine profitability and solvency. Similar to other real estate types, malls are experiencing demographic changes as shoppers are interested in urban and public transit-accessible retail locations. There is a shift away from suburban areas with sprawling parking lots, and shopping centers are popping up in densely populated neighborhoods with high discretionary income. Multi-use areas that provide patrons access to shopping, dining and entertainment gain a competitive edge over malls with one specific focus, located far from the urban core.

Given the uncertainty of occupancy and revenue, it is becoming harder for individual mall owners to secure the financing needed to keep their property in operation. For the smaller players, the risk of losing anchor tenants becomes even greater. Not only do landlords lose revenue when anchor tenants leave but many in-line retailers have leases tied to anchor stores. Co-tenancy clauses are common and allow smaller tenants to reduce their rent or terminate their lease in the event of a key tenant vacating the property.

Sales per square foot of in-line retailers. The strength of in-line tenants is also a key influence on a mall’s overall performance. If in-line tenants routinely produce sales of $300 to $400 per square foot, then the mall will have a better chance of keeping its doors open. As sales dip below $275 per square foot, however, the mall will likely struggle to stay profitable. A cascading effect can occur in a very short time period, leaving a mall with high vacancy, reduced profitability and the inability to service its debt.

Prevalence of national tenants rather than local tenants. Size and financial strength of ownership and tenants play a significant role in a mall’s overall ability to remain profitable. National sponsors have sufficient capital to continuously repurpose their properties to meet shopper demands, while local owners may not be able to turn over their storefronts fast enough to compete. Large REITs and national mall owners also have more flexibility to obtain financing and maintain an operating budget, as a struggling mall with weak revenues can be offset by a stronger mall in the sponsor’s portfolio. Similar to national sponsors, large national brands improve malls’ sustainability. Brands like Dick’s Sporting Goods, REI and Bass Pro Shop offer experiential shopping in the form of indoor driving ranges, rock climbing walls and fishing ponds.

National versus local sponsorship. Not only can shoppers try out merchandise in authentic settings but amenities provide an exciting reason for consumers to go to the store. In addition to the higher foot traffic, national brands can increase a mall’s strength and viability because of the deep resources and balance sheets of their parent companies. If a national brand is seeing weak performance from one location, the parent may choose to invest capital in the location in hopes of boosting sales. A local brand may be forced to close because it does not have the funds to improve a given location.

Beneficial lease structure. Finally, a mall’s leasing structure can be a good indicator of its future profitability. Malls with the best chances for long-term operations will maintain a strong majority of their leases as triple-net, under which the tenants are responsible for taxes, insurance and maintenance of their stores. Triple-net leases shift the variable costs of the property to the tenant and allow the mall owner to better understand and forecast its cash flows. On the contrary, a mall with many gross leases may indicate a weaker tenant pool that does not have the financial ability to fulfill the terms of the lease. Without having to pay insurance, taxes and maintenance, it’s easier for a tenant to close its doors and fall delinquent on its lease obligations.

There is likely no turning back from the online-oriented trajectory of retail; however, malls and their owners can stay competitive by adapting and embracing the change. Attracting national-brand retailers and a strong, diverse group of in-line tenants will boost revenue. Negotiating lease agreements that work in the mall owner’s favor will increase the likelihood of steady and high occupancy. Adding experience-based tenants rather than only catering to those that are consumption based will attract higher foot traffic, and positioning malls in key demographic areas will transform them from the big-box shopping centers of the past into a new in-demand social setting of the future.