Will Vacant Retail Space Fuel the Next Real Estate Bust?

Five years ago I moved from Boston to Southeast Georgia and was immediately plunged into shoppers� hell. Not only was there no Costco (70 miles to the closest one) or Crate and Barrel (five hours away in Atlanta), there wasn�t a major retailer of pet supplies, a decent department store, or even a whole foods market. UPS became my lifeline to the real world of consumption and catalogues flooded my mailbox.

Recently this has all changed. Within the 18 months a big box mall has attracted Target, PetSmart, Lowe�s, Old Navy, Office Depot, Michaels; several regional retailers such as Ross, and hundreds of smaller stores that have sprouted like mushrooms under the shady umbrella of the big stores. We were probably the last town in America to get a Starbucks � and now we have two of them.

A recent drive near the oldest and largest and not very successful covered mall in town revealed five new strip malls, each probably totaling 40,000 to 60,000 square feet. Two were totally tenanted, two, while complete, were still vacant; the last fell in the middle, perhaps 25 percent leased. There were another four small strips of about the same size under construction. This is going on all over town. My best guess would be that some 300,000 square feet of small strip commercial space has been constructed here in the last two years while owners have invested money to upgrade at least that much more of previously neglected space.

So what?

I don�t make the mistake of thinking that my town is necessarily typical but many areas have seen similar explosive growth in the last few years. I suspect that one thing is true here and elsewhere; owners of retail property are being set up to take a very big fall.

Not only are consumers spending less than they did when possessing apparent wealth from exploding home equity. With rising energy and food costs, consumers have less discretionary income for non-essential purchases such as clothing, jewelry, and home electronics. The pattern of their shopping has also changed with customers relying more on clicks to order on-line rather than rushing from store to store. Not only is the Internet a convenient way to shop, it uses far less gas than a traditional shopping trip, especially when the customer must browse to find the perfect gift.

And retailers are beginning to show the strain. Earlier this year the National Retail Federation held its annual convention where two retail consultants offered a discouraging forecast for the industry. One said that the only categories of consumer products that were getting an increasing share of the consumer dollar are food (and this is largely due to rising prices) and pet supplies. Department stores such as Saks and J.C. Penney will survive and even improve because they have upgraded their product lines and drug stores like CVS are thriving because they have added better brands of cosmetics and services such as walk-in clinics.

Since the first of the year a number of national retailers have announced large scale store closings; Ann Taylor will be closing 117 of its 921 stores over a three year period; Liz Claiborne has given up on 54 of its upscale Sigrid Olsen stores, Talbots is abandoning its men�s and its kid�s lines and closing 22 stores. More recently, Foot Locker announced the closing 140 stores; Zale�s Jewelry, 100 and Starbucks is cutting way back on its expansion plans and is closing some of its less profitable outlets. Mervyn�s, a California-based operator of 129 stores in eight western states filed for bankruptcy protection on July 30, following in the ranks of Sharper Image, Steve and Barry�s, and Linens and Things.

In my town Quiznos and Pizza Hut have each closed a restaurant (Quiznos after barely a year in business) and a brand new Athlete�s Foot is sporting a going out of business sign.

The real fallout of these store closings will hit employees, other retail establishments with nearby stores, and the owners of malls small and large.

The big national chains, usually called credit tenants, tend to stand by their leases, paying rent until their lease runs out or until they can sublet the space. Often when a chain is closing multiple stores they attempt to wholesale packages of leases to other chains. Sometimes credit tenants display such loyalty to their landlords to protect their reputation and preserve their ability to obtain preferential lease terms during other lease negotiations; others honor leases because they have to; many savvy landlords require a standby letter of credit from a bank that can be cashed in when the landlord can prove a default.

Even though he may still collect rent from a major tenant, these are the very businesses that make a mall popular. They attract buyers who then patronize the other smaller and/or local stores. When K-Mart closed dozens of its stores some 25 years ago, patrons of the malls they frequently anchored could count on at least one small store a month also closing until the malls were hosting week-end swap meets and auto shows in their empty corridors.

Property owners seldom have much protection when dealing with locally owned single stores. As the saying goes, you can�t get blood out of a turnip and when a proprietor has poured everything he owns into keeping a dream alive, there is little for a landlord to go after when the going out of business sale is over. If there is anything left a bankruptcy filing will terminate the lease and the landlord will have to stand in line for any share of the bankruptcy estate.

As tenants walk, landlords are forced to absorb each closed store�s common area charges such as snow removal, landscaping, and security which are usually prorated according to the square footage of each tenant. Some may be able to pass this additional expense through to the remaining tenants the next year as part of the common area cost of living adjustment, but whether the landlord or his tenants end up eating the additional costs, a bottom line will suffer somewhere.

Pity particularly the landlord who has not yet placed a single tenant in his property or who has seen multiple tenants give it up. He is unlikely to fill those storefronts any time soon. The current economy is scaring many people into deferring their business plans and it is virtually impossible for a new business to obtain any bank financing for store fixtures and initial inventory.

The big real estate developers and mall owners such as Glimcher Realty Trust, and Simon Property Group can withstand negative cash flow, but they cannot do so forever and they have stockholders to whom they must account. The small local builder/developer does not have such deep pockets and, vacant stores or not, the banks still expect payment on their construction loans and mortgages. Commercial property, small strip malls at first, followed by larger ones will start showing up on the foreclosure auction listings, and there won�t be a lot of buyers in this economy.

And if the economy turns around soon � and falling oil prices are taking some of the pain out of the trip to buy back-to-school clothes � will consumers return to their old ways of shopping or continue the new pattern? Buying on line is enormously convenient and could permanently change the way we buy except in those people who consider a trip to the mall to be entertainment as well as bargain hunting. And perhaps we have finally learned that our out-of-control consumer habits are impacting our retirement and will continue to more carefully weigh our consumption of discretionary items.

We won�t know the answers until things improve, but it seems to be a sure bet that retail leasing is in for at least a few months or maybe years that will rival the fallout surrounding residential mortgages.