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Retail Property -- Overview
September 12 | 2013

Retail Properties

At RealtyMogul.com, we generally focus on commercial real estate investments – although we also look at debt investments involving single-family residences (usually fix-and-flip projects).  In earlier posts, we’ve reviewed certain kinds of commercial properties (such as mobile home parks or triple net leases) as well as the risk classes into which property types are often classified.   This article reviews a particularly important sector of commercial real estate -- retail properties, considered one of the four “core” commercial real estate asset classes.

Retail properties represent more than 25% of all investment-grade commercial real estate in the United States.   Consumer spending represents nearly two-thirds of the domestic economy, and the U.S. has more retail space per capita than any other country.  Although internet sales have had an impact on some retail sectors (notably electronics and books) by moving some of the related business online, in some sectors online retailers have begun opening up traditional physical stores.  Preferential sales tax treatment previously given to internet-based retailers has now ended.  The vast majority of consumer purchases still take place in physical stores, and studies show that most consumers prefer the “touch and feel” aspect of shopping -- indicating that physical retail centers will likely remain the dominant means of consumer purchasing in most sectors for the foreseeable future. 

The retail sector includes everything from smaller neighborhood shopping centers (encompassing, for example, a small grocery, pharmacy and a few restaurants or clothing stores) to large “super-regional” malls that have entertainment activities and can draw shoppers from a great distance.  In the remainder of the spectrum are community shopping centers, fashion or specialty malls, outlet malls, and “power” centers with a “category-dominating” anchor tenants. 

Special Economics

Retail properties have their own set of growth drivers, on both macro- and micro-economic levels.  The sector is most broadly influenced by the state of the national economy generally, especially such indicators as employment growth and consumer confidence levels.  More locally, the many important factors include the property location and its traffic flow; population demographics; and local household incomes and buying patterns. 

Shopping center operators must work not only to keep their properties fresh to attract consumers, but also to stay abreast of their tenants’ own competitive pressures.  A retail property may not only be at risk of physical obsolescence (an aging facility may need a major structural overhaul), but also of becoming obsolete competitively (for example, if a significant tenant is suffering in the face of larger or more fashionable rivals).  A property’s layout can also become a functional disadvantage; popular retail formats can change, and the configuration of existing store sizes may no longer satisfy modern tastes. 

Unique Rental Characteristics

In earlier posts we’ve discussed triple net leases and the particular aspects of due diligence applicable to them. A triple net lease shifts to the tenant the responsibility for paying some or all of the property’s pro rata real estate taxes, insurance, and common area maintenance.  In the retail world many tenant leases are of this type, or some variant thereof. 

Most shopping centers have larger “anchor” tenants that are a major draw of consumer traffic to the center generally.  For neighborhood centers, a typical anchor store might be a Safeway, CVS or Walgreens; for larger malls, perhaps a department store like Macy’s, Target, or Nordstrom.  Because these tenants serve to draw much of the center’s traffic, they often get special incentives on the rent -- they generally pay based on a percentage of their sales, and sometimes only over some threshold amount.  Smaller “in-line” or specialty tenants are often responsible for the bulk of the overall rent roll -- a price they are willing to pay because the anchor tenant is perceived to be driving much of the customer traffic to the center.   

Many tenants will also be required to pay “percentage rent” based on their sales volumes.  The idea behind percentage rent is that the structure acts to align the interests of the landlord and tenant; the landlord has an incentive to maximize the tenant’s prosperity, since the landlord shares in the tenant’s success by gaining increased rents if the tenant enjoys better sales.  Usually, landlords and tenants will negotiate a threshold or “base” sales amount; then, if the tenant store’s sales are below that threshold, it will pay only the base rent, but if the sales are above that figure additional percentage rent will apply.  Percentage rents are typically in the range of 4-8% range of the tenant’s sales over the agreed “breakpoint” threshold amount.

Because tenants establishing a retail business (or branch store) have their own set of start-up expenses -- and sometimes require particular improvements to a space -- they often negotiate leases of relatively long terms, usually also with renewal options.  While these leases will still typically have escalation clauses tied to the consumer price index or some other rent increase schedule tied to inflation, their longer term gives the tenant some assurance that its business will have adequate time to establish itself.  For property managers, such leases bring some security, but also a degree of risk; the rents under longer-term leases can, over time, begin to lag current market rates.  A landlord may have to wait quite a while before being able to take advantage of any step-up of space’s rent to a level more in line with market rates.

Another factor with retail leases is the brokerage commission that typically applies.  Unlike with residential properties, where a manager either handles rentals to prospective tenants directly (or retains a management company to do so), retail properties typically require specialist professionals to broker leases between prospective tenants and landlords.  These brokers have contacts with large retail chains and other sources of potential tenants and can be very useful to a landlord’s efforts to fully lease a center.  Their fees, however, are typically paid by the landlord, and their commission rates are generally based on the aggregate base rent figure.  The landlord must thus negotiate with brokers as to whether all of their commission is due up front, or whether their fees can be paid on an “as collected” basis over the term of the lease.

Another feature of retail rental negotiations is the issue of how to handle any necessary improvements to a retail space.  Plumbing fixes, repainting, and other basic “habitability” repairs are clearly the landlord’s responsibility.  Often, however, a tenant may want specific improvements that contribute to the “look and feel” of its business.  If such improvements may not be readily usable by a subsequent tenant, a landlord might resist paying for them.  Usually both sides bring money to the construction issue, but leases vary widely as to how the costs of tenant improvements are shared. 

In future posts, we’ll drill down into some the due diligence required with retail properties and some of the factors surrounding their assessment and valuation.

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