Woodmont's Fred Meno on planning for the unknown
Much has changed in the retail real estate industry over the past several years. After a decade-and-a-half of having too much retail gross leasable area chasing too few retailers, COVID, as well as other market factors, initiated a purge that helped the industry remove a lot of that excess GLA. That survival-of-the-fittest cleansing has allowed strong-performing properties and retailers to become stronger.
Yet physical retail’s societal role in the fast-changing 21st Century remains in flux. After emerging from a complete shutdown, we find ourselves confronted by high inflation, escalating interest rates, and destabilizing geopolitical events. We remain challenged to create a sustainable long-term plan for positioning shopping centers to best attract and satisfy a new generation of consumers.
Let’s consider the present situation. We anticipate that landlords will seek higher rent bumps during this inflationary period to account for increases in center-level operating expense as well as to provide a commensurate return on capital, given our current interest rate environment. Historically, pro forma rent increases in the 2%-to-2 ¾% range have been the standard. But going forward, we are anticipating rent bumps of 5%-to-6% until inflation dissipates. The occupancy cost sweet-spot for retailers has generally been in the 10%-to-13% range, but higher rents, absent a corresponding increase in tenant sales, will drive occupancy costs up.
That said, certain sectors of physical retail are steadily advancing. For instance, grocery-anchored centers did well during the pandemic and continue to flourish. Grocers themselves have done an excellent job expanding their concepts to offer a wide variety of price-point options and to better cater to different demographic shopper segments—at the same time maximizing omnichannel opportunities.
Outlet centers, too, are doing well, and they will continue to be resilient during times of economic contraction. These centers have typically been located 40 miles or so from a population hub. Newer outlet centers are now positioning themselves closer to population masses and seeking more local traffic with a heavy concentration of unique, locally owned tenants.
Regional malls continue to be challenged. Eighty-five percent or so of distressed mall loans that have gone back to lenders have been sold and cycled back out to the private sector during the past 10 years, and many of these malls will need to be redeveloped. Active buyers of distressed regional malls have now become sellers themselves as they look to raise capital to acquire the next distressed real estate product type-CBD office buildings.
Which malls stay and which go often is dependent upon the property’s debt structure and the ability for that debt to be restructured or re-financed in an environment of declining mall valuations. Whether you’re a mall REIT or a private investor, you may have a property with a loan maturing in a year and you may be underwater on that loan. The mall owners/borrowers then have to make a choice: Do they consider that mall to be a viable core property worth ongoing capital investment? If not, the likelihood of the property going back to the lender is far greater, especially if the loan is non-recourse. Tenants have become sensitive to committing long-term to properties in distress.
For malls to survive, landlords need to be committed to a level of capital spending that maintains the integrity of the property’s physical plant, attracts synergistic tenants, creates and maintains an inviting shopping environment, and is advertised and promoted to best compete with other shopping venues. Unfortunately, over the past 10 years many buyers of distressed regional malls have been taking the exact opposite operating approach by bleeding the property’s cash flow and not re-investing in the asset. We are now starting to see anchor tenants that own their own parcel within a distressed regional mall looking to protect their brand image and their investment by considering an acquisition of the mall itself to avoid being held hostage by a buyer that lacks the ability and the intention of improving the property’s operating performance.
The retail industry today is truly a “Tale of Two Cities,” full of haves and have-nots. To paraphrase Dickens, “It is the best of times, it is the worst of times.” There are great challenges, but also great opportunities. The operators that emerge successfully will be the visionaries who are best at planning for the unknown.
Frederick J. Meno is president & CEO of Asset Management and Asset Services at the Fort Worth-based Woodmont Company.