How to put retail leases in the ‘asset’ column

Retail leases go down as liabilities on the balance sheet, but another option is to see them as assets that can be used creatively. 

That might sound like verbal jiujitsu, but the right approach can help you achieve real-world outcomes like reducing your occupancy costs or reinvesting in your stores. Here are three tips for healthy and distressed retailers who want to ramp up their real estate performance.

Start the conversation — even if you’re healthy

The phrase “out-of-court restructuring” is sometimes used to describe any effort to negotiate higher real estate performance outside of Chapter 11 bankruptcy. When we hear those words, we tend to think of a distressed operator that has managed to stay out of court so far, but is probably headed there.

In fact, the smartest retailers are always looking for ways to generate more value within the portfolio, even if they are nowhere near needing to file for Chapter 11. A programmatic, multi-location push can be the most effective way for healthy retailers to achieve significant savings. Let’s say you operate a coffee house chain with leases expiring in 10 locations. These stores happen to be in need of a refresh: updated bathrooms, modern finishes, and repainted exteriors. Instead of continuing with business as usual, why not walk into those landlords’ offices and start a dialog about the future?

One possible outcome: The coffee chain, having decided that each location needs $150,000 in reinvestment, asks landlords for tenant-improvement (TI) allowances of 20 or 30% as well as two-year lease extensions at flat rent. Taken together, the rent savings plus that TI allowance translate into $50,000 kicked in by the landlord. That means the retailer is able to save $1.5 million across the 10 locations.

There are many different possible permutations. The key is to take the initiative and engage in those discussions.

Take a second look at your store footprint

Shopping habits have changed dramatically since the pandemic. Many operators are doing much more business over the Internet. Some stores need far less inventory as a result and are long-overdue to be right-sized.

By way of example, carving out 1,200 or 1,500 square feet of useable space from oversized locations can be an effective strategy for healthy and distressed operators alike. Once again, the key is to engage with the landlord to explore the possibilities.

In many cases, landlords are able to use that clawed-back space to create another storefront and bring in a new tenant with good credit and an attractive rental rate. Making such a move can add diversity and interest to the landlord’s center as well.

The original retailer benefits by reducing real estate costs on its profit-and-loss statement: A 30% space reduction translates into 30% lower gross occupancy costs, due to the reduced base rent for that now-smaller space. Right-sizing also can allow retailers to keep less inventory on hand or even reduce head count.

Utility bills tend to go down, too. In a market where there is little to no new development, this creates a win-win for the landlord and the retailer. Right-sizing while maintaining your existing revenues can yield substantial, across-the-board savings.

Be transparent about your challenges

All retailers have a few “problem children” in their portfolios. By being transparent about the financial situation at those locations (and possibly within the broader business), you stand a better chance of negotiating a solution.

Sometimes that means persuading the landlord to “reset” the lease and negotiate a permanent rent-reduction, in acknowledgement that sales and traffic patterns are no longer what they once were. Short-term rent abatement could help a retailer get through a difficult stretch (Covid lockdowns are a classic example).

Cutting the lease term, perhaps to a date that is 12 or 18 months away, can give both sides more time to improve the situation while providing a concrete endpoint for those efforts: “You work on finding your next tenant, we’ll do everything we can to improve performance in the interim.”

When distress is part of the mix, it is important to understand that landlords are wary of Chapter 11 bankruptcies, which are increasingly leading to outright liquidation. Last year alone, the list of failures included Rite Aid, Party City, Joann, Forever 21, Big Lots, Rue21 and Bargain Hunt.

Landlords know that in bankruptcies the leverage is almost entirely on the side of the retailer, which enjoys broad leeway to accept or reject leases. Yes, in some cases the landlords are eager to get spaces back to pursue better options. But most of the time, they are highly motivated to work with struggling tenants before the problem gets worse. The entire center suffers when tenants are unable to make rent — from deferred maintenance to yellow “Going Out of Business Signs” in store windows.

These dynamics are part of what enables third-party real estate advisors to generate hundreds of millions of dollars in savings for retailers even in out-of-court situations. While your accountant can’t literally move your leases into the “assets” column, a little creativity can go a long way when it comes to getting the most out of your real estate.