Winning with retail real estate in 2016
Occupancy costs are among the largest expenses for any retailer. Total lease obligations can exceed long term debt in many companies, reducing profitability and hindering growth. It doesn’t have to be that way though if operators follow four simple rules of retail real estate.
Properly managing a store portfolio of any size is filled with nuance and minefields are abundant, especially in today as stores play an increasingly important role in many retailers e-commerce fulfillment strategies.. Taking the wrong steps in the form of bad or restrictive leases or poor locations can have negative consequences for retailers that are every bit as significant offering a product assortment or marketing creative that doesn’t resonate with shoppers. To make sure retailers win with stores, there are four core areas that every operator should make a priority for the New Year and beyond. They include:
1. Conduct annual portfolio reviews
While it may sound like common sense advice, it’s surprising how many CEOs don’t review their portfolio annually. For most mature concepts, leases are constantly coming up for renewal, requiring retailers to ask hard questions about how particular locations fit within the company’s long-term view of serving the market. This makes a yearly strategic review of the lease portfolio essential with each location placed in “bucket” that defines how a particular store fits in the portfolio. At a minimum, this essential exercise should involve grouping stores into the three buckets of locations that are winners, those that need a change and those that should be closed.
The definition of winner can vary from retailer to retailer, but generally speaking winner is pretty easily defined as a location that has a 4-wall contribution, positive cash flow, a strong history of stable or growing revenues and a relatively low occupancy burden rate. This desirable combination will in almost all instances indicate that a store location doesn’t need an intervention.
Falling into the buck of locations that need a change are those where losses are less than occupancy costs or locations with less than 12 months to go before an option renewal. Stores may also need a lease adjustment if the location is profitable, but there are less than ten years of “control” remaining. Such leases may require a conversation with the landlord for a lease renewal or restructuring to avoid closure. It might also make sense to negotiate a contribution from the landlord for locations where remodels are planned. Initiating conversations with landlords well before lease expirations or an anticipated project provides time to prepare for any outcome.
Decision about locations to be closed center on whether a store produces negative earnings before interest, taxes, depreciation, amortization, and restructuring or rent costs (EBITDAR) and requires operators make judgment calls about likelihood of future improvement. If a site is generating negative EBITDAR, the firm’s earnings would improve simply by closing and continuing to pay rent. Finding a subtenant can minimize the reduction to shareholder value.
2. Make the right ‘ask’ of landlords
Once the review has identified locations that could benefit from renegotiating the lease, it’s critical the right “ask” is made to landlords. In most cases, landlords will only choose to restructure a lease if they believe it’s in their best interest. Sending a generic request asking for a blanket reduction in rent for the remainder of the lease term is the wrong approach. Build a case tailored to the specific location by creating a fact-based explanation about why the lease should be restructured including details about the location’s financial performance, recent trends and whether the location is at risk of closing without a restructure. Landlords may want added term or percentage rent to share in a potential turnaround, or they may need the tenant’s approval on something that helps the landlord within the development or mall.
3. Conduct thorough due diligence when acquiring a company or property
As with the first point, this may sound like common sense, but when acquiring a multi-site business with significant operating lease liabilities, it’s imperative that all leases are thoroughly reviewed. When assessing the portfolio the key issue is to determine whether it contains enough “winners” with favorable terms and whether the remaining liability on the “losers” is minimal. Knowing if loser leases can be terminated in a cost effective manner and understanding lease run-off schedules play an important role in negotiations, post-acquisition plans and ultimately whether the deal is successful.
4. Establish a lease administration program
A lease administration program is the foundation that supports strategic real estate planning and portfolio management. This is especially critical when a portfolio is large and spread across several markets. Lease administration programs help retailers efficiently control many activities, including tracking lease guarantees and security deposits, letters of credit, rent escalations and lease abstracts; complying with regulatory items; following tenant improvement work and construction cost; and making decisions on key trigger dates, such as option renewal and kick-out dates.
Winning with retail real estate will matter even more in the future than it has in the past given rapid changes in the market place. Following these four basic strategies won’t guarantee any companies’ success, but they will ensure that operators have an essential foundation in place on which to build their value proposition with customers.
Gary Graves is a principal at Huntley, Mullaney, Spargo & Sullivan, Inc., a financial and real estate restructuring firm. www.hmsinc.net.