TENANTS GAINING MORE LEVERAGE IN MALL LEASE NEGOTIATIONS

In this podcast, Hilco Real Estate’s Dan O’Brien shares his thoughts on the dynamic between tenants and landlords in negotiating shopping center leases is shifting, and how tenants can capitalize on the opportunity.

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Steve Katz:
Hi everybody. And thanks for taking time out of your busy schedule to listen in on our Hilco Global Smarter Perspectives Podcast. As return listeners know by now, I'm your host, Steve Katz. And if this is your first time with us, well, then welcome. We're glad that you could tune in.
Steve Katz:
Our discussion today is centered around a place that it seems many of us used to frequent a lot, at least a lot more than we do today and that's the mall. Man malls were the place to hang out, to shop, and eat, but things have changed in recent years and accelerated by the pandemic. The dynamic between mall landlords and tenants is a whole different ballgame today than it was in the past. To discuss that evolution and where things stand today for tenants, we have an authority on the topic, Dan O'Brien who's Senior VP of Hilco Real Estate with us today. Welcome, Dan.
Dan O'Brien:
Thanks, Steve. Glad to be here and share some thoughts on what's going on in the commercial real estate world.
Steve Katz:
Well, perfect. Then let's jump right into it. Listen, malls date all the way back to the mid-50s. They evolved quite a bit over the next couple of decades. After that, enjoyed extreme popularity as a destination in the 80s. I myself may have been found in a mall or two in the late 70s, early 80s with my friends. And then they hit their heyday in the 90s. We all remember being in these opulent malls with packed stores, lots of people, elaborate build-outs. Why did malls become so popular? How were they so successful at attracting all those people? And what was the net results of those factors for tenants who wanted to be there and really needed to be there in those days?
Dan O'Brien:
Sure. Yeah, the start of malls really generate the mid-20th century as suburbia exploded and consumers had access to cars, moved from urban cores out to the suburban landscape. They needed places to shop. And so rather than having main street shopping districts located in small towns across America, as suburbs popped up, landlords discovered that you were able to build a much greater nucleus of shopping opportunity by going out to the intersection of a highway and pulling together four or five anchor stores, and then surrounding them with fun places to eat and spend money. And ultimately as time passed, consumers were able to make a day of it. And retailers were able to consolidate the consumer dollar in a one-stop-shop experience. Whether you were eating, shopping for daily needs, shopping for clothing, soft goods, appliances, going to the movies, they wanted to capture you there and get as much of your consumer dollar as possible.
Dan O'Brien:
And the way that translated was the more traffic, the more pertinent and attractive retailers, a landlord could put together that typically resulted in more sales by the tenants and then more rent could be paid to the landlord. As a result, a relatively small number of developers realized that this was a growing class of real estate and decided to buy or build these regional malls, which then turned into super-regional malls.
Dan O'Brien:
And with that, there were only so many malls that could be built and they realized that they could set their own terms with new and existing tenants. This was in large part based on, again, the traffic levels in these malls could enable these stores to achieve optimal levels of performance.
Dan O'Brien:
With that, most landlords then charged base or minimum rents, plus the cost to manage these properties with common area maintenance, accounting for heating and cooling, cleaning, as well as their portion of real estate taxes, marketing, and other fees. And in addition, charged annual increases oftentimes meant to mimic consumer price index increases, but oftentimes grew to 3% to 5%. And so the ability of these malls to drive immense amount of foot traffic allowed landlords to set terms of their deals and put great pressure on the tenants to achieve optimal sales.
Steve Katz:
Yeah, it makes sense. So you've got all this momentum for all those years and the early 2000s rolled around and it seems like there was a bit of a perfect storm. Can you take us through what happened and maybe just give us some details on that? Because I think it really starts to set the stage for where we are today in terms of that landlord-tenant relationship?
Dan O'Brien:
Yeah, it really does. The growth of this property class peaked in the early 2000s as American consumerism was flourishing. We had rebounded from the dot-com bubble burst and this was before the proliferation of e-commerce. So really the main place for retail to drive consumer spending was at these consumerism epicenters, these malls and the malls grew larger and larger with more anchors, more retailers, and more diverse offerings to consumers.
Dan O'Brien:
Not only that, but the areas around these malls grew in popularity, realizing that if you could get your consumer to drive to one area, you could capture more of their spending. So these malls were really the destination to be in most respects. However, as e-commerce then began to be easier for consumers to utilize as Amazon grew from an online bookstore to really an online shopping marketplace, and individual eCommerce sites for the retailers that had brick and mortar presence grew, the omnichannel approach to retail started to change the shopping dynamic.
Dan O'Brien:
With that, then we had the financial crisis of 2008, 2009, and you started to see not only the economy take a turn, but the relationship between retailer and consumer shift in that the demand for value, whether it was shopping in an Amazon or shopping at Walmart or shopping online, really began to drive into the consumer consciousness. And then beyond that with the COVID pandemic, all it's done is make direct-to-consumer opportunities more abundant for consumers to get a better value for their dollar. And so the malls, in turn, these epicenters of consumerism have been struck in that brick and mortar channel was not the only game in town. And therefore, the malls have had to shift the way they were operating in years past.
Steve Katz:
Yeah, it makes a lot of sense. That certainly is a unique time in retail history and that shift away from brick and mortar in a big way occurred and that simpler adoption of e-commerce technology both by retailers and by consumers took place.
Steve Katz:
Okay. So that's the perfect lead into where I wanted to take this next. And let's talk about the shift that's occurred and how new deals are structured then since that time. From some of our previous discussions on this, I know you tend to break it down into three parts. I think you call them New Deal Components. So let's address it that way. Tell us about new deal component number one.
Dan O'Brien:
Yeah, New Deal Component number one most simply put is an equity component. What we like to say typically is downside protection for the tenant with upside sharing with the landlord. With the thought process being that when the tenant does well, the landlord does well. Rather than in years past, the landlord in large part setting a certain rent and certain deal structure, knowing the tenant had to lease space in their mall and really didn't have many other options so that they dictated many of the terms.
Dan O'Brien:
Unfortunately, with those older deals, oftentimes a 10-year commitment was a necessity. And again, with those consumer price increases potentially even 5%, the cost of the real estate, the least real estate far outpaced sales as an omnichannel approach came to be a much more central way the consumers spent their dollar. So the brick-and-mortar stores just weren't seeing as many transactions. Therefore, the sales were impacted where so what we've seen with a lot of tenants over the past 10, 20 years is an increase in the cost of real estate, but really either a flat line or a decline in in-store transactions and in-store sales.
Dan O'Brien:
So what we're trying to do is rebalance that relationship between the landlord and tenant. So really, it's what you're paying for the real estate is more closely tied to your sales where previously there was really no way to self-correct until a tenant went into bankruptcy or had an expiration. What these percent in loo deals that tie a percent of your sales as what you pay to the landlord, it really does better mimic the value that the tenant is achieving in the real estate with what the landlord receives in rent for that, said real estate.
Steve Katz:
Yeah, it makes sense. It's like the pay for performance in business or pay by performance I guess for the real estate. So more flexibility required on the part of the landlord. How about deal component number two?
Dan O'Brien:
Yeah, deal component number two, we'd like to talk about flexibility. And really that flexibility translates to shorter-term commitments. In the last deal component, we talked about those 10-year commitments that were very typical in decades past in these leases in the mall world.
Dan O'Brien:
What we're seeing more is that tenants like to be able to have a shorter-term commitment so they can then understand the marketplace, better shift with the marketplace as consumers do so that if it's shifting to a property or shifting away from a property, that you can be a little bit more or nimble in your business decisions, understanding that, again, if a property is generating sales and you're able to be successful there and earn a profit, then you're more than happy to be there and offer that to a consumer and pay the landlord for that real estate. Whereas if you're locked into a 10-year long-term commitment, or even five years sometimes, the way this omnichannel marketplace works, that can mean that you're committed to a piece of real estate that's losing you money if you don't have the right deal.
Dan O'Brien:
And again, landlords aren't there to give their real estate away, but it's just a deal component that we think is valuable to retailers such that they can, again, remain nimble and work with the marketplace based on what consumers are looking for.
Steve Katz:
Yeah, shorter deals definitely to me at least based on what you said makes sense in this environment for sure. All right. And then how about deal component number three?
Dan O'Brien:
Yeah, deal component number three, we like to look at is a factor of efficiency. With these previous iterations of deals in decades past, not only were you asked to long term commitments at these higher rates and these varied structures paying not only rent, but CAM and taxes and marketing and all these other fees, but there was an expectation, whether that was of the landlord or the consumer, that there was a potentially elaborate, but oftentimes expensive build-out of the space.
Dan O'Brien:
So part of the reason for the 10-year commitment was due to an accounting and an amortization of those costs. And as malls became larger and more opulent and as retailers worked to try to gain their share of the consumer's dollar, these build-outs became more and more intricate, became more and more expensive, and became more and more of a burden on the P&L of those individual tenants.
Dan O'Brien:
So as rent is skyrocketing past your sales and your costs of build-out that you performed three, five, seven years ago, still being amortized across this long-term commitment, it made it very hard for these tenants to make money, especially on the back end of their deals. And so what we prescribe is this idea, and we've seen a to cross the marketplace with retailers, is this idea that the consumers are not demanding opulence in many respects.
Dan O'Brien:
I've seen a lot of tenants, the likes of whether it's Walmart or Costco, or even Apple now where consumers are looking for a product, they're looking for service, they're looking for style, but it doesn't necessarily mean complexity and it doesn't necessarily mean cost. And so with that, pairing that with a flexible rate rent and a shorter term, a lower cost buildout allows tenants more flexibility to then make money and amortize those buildout costs over the length of their lease and putting them in a position to be more successful.
Steve Katz:
Yeah, it's interesting. So when you're talking about that, I'm picturing in my head Apple, and then you mentioned it, but it's true. You walk in there, it's a very pleasing feel for the customer, but it's super simple. It's these light wood either laminate or actual wood tables, whatever they're made of surrounded by shelving, a very clean tiled floor and there's very little build-out. It's extremely appealing and a great experience for the fire, right?
Dan O'Brien:
And not that you would necessarily notice this without being in the industry. But as consumers, we look at a store and we think clean, concise, maybe even stylish, but oftentimes the difference between say even the millwork that goes into building out a store is a huge cost difference versus keeping something simple versus building out something that has to be done by hand done in some specialty can be the difference between making money and losing money. And then another example is flooring. We have seen the flooring where retailers are coding concrete floors, and we don't notice, we don't care versus putting in a wood floor or a full wood floor or some elaborate tile where furthermore, it's all of this build-out are things that only have to be fixed later in their life that ultimately there's cracks or dings or scratches.
Dan O'Brien:
And as a retailer, those are all costs to maintain a presentation of the consumer that they find acceptable. And so keeping it simple and clean and stylish goes a lot longer in the mind of the consumer today versus some of the elaborate buildouts of yesterday year. And again, I don't think landlords fight that, but I think it's the expectation from A to Z that these deals need to be made more efficient, they need to be made more effective, and they need to be overall "cleaner" so that both sides have the opportunity to make money in a very challenging, I said it before, omnichannel approach, they can be successful in that brick and mortar channel that is making a change in today's world.
Steve Katz:
Yeah, yeah. Again, you're talking and I'm picturing like an old Hollister store or something in the back of my mind. Just totally built out, nooks and crannies, all this millwork must have been quite expensive, even amortized over all those years. All right. So I'll take a shot at summarizing it up here since we're running short on time. What we net out with based on these new deals is a more complete partnership between landlord and tenant with more equal sharing of both risk and reward. How's that? How do I do there?
Dan O'Brien:
Growth of the malls' evolution in recent years and the shift in the leverage, it's a much more equitable and beneficial partnership between landlord and tenant, balancing the risk and reward of the relationship. It is a symbiotic partnership. But oftentimes as we all know, when one side of an equation feels a little bit more risk or feels a little bit more pressure, we start to worry a little bit more about our prerogative and that flies in the face of what we really believe what should be the relationship because while landlords create a welcoming environment and they try to assemble the right tenant mix to generate interest amongst consumers, tenants need to pull that traffic into their stores and convert those browsers to dollars. But if the bar is set so high because of expensive builds, because of long-term commitments, because of high rents, there's a limitation to that. And as we've seen as traffic declines in certain properties, it becomes that much more of a challenge for retailers to convert each and every consumer into a shopper.
Steve Katz:
For sure. All right. How can you and the team at Hilco Real Estate assist the mall and other retail tenants in this market?
Dan O'Brien:
Yeah, I think the idea, first of all, is to inform a lot of these tenants of our experience, understanding the shift in the marketplace, the landlord's willingness to create these deals so that they still see the mall as a place where they can do business, knowing that the deal of 10 years ago or 20 years ago isn't a necessity anymore.
Dan O'Brien:
So as retailers look to try to find out where their consumer is, whether it's a street location, or a pop-up store, or location in the mall, they don't just assume that the fixed rent 10-year deals of the past with elaborate build-outs are the only way to enter that space. And so I think we look at the framework of these mall leases and the evolution, it's ever more essential to understand the nature of these deals and the landlord's willingness to balance out that equitable partnership that they're looking for.
Steve Katz:
Great. Great. Well, really good insights, Dan. Appreciate the time. Thanks for joining us.
Dan O'Brien:
Happy to be here. Thank you for having me.
Steve Katz:
Absolutely. And how can people best get in touch with you?
Dan O'Brien:
Sure. Phone number is (847) 504-2475. And email is dobrien@hlico global.com. That's D-O-B-R-I-E-N@hlicoglobal.com.
Steve Katz:
All right. Thanks again, Dan. And listeners, I'm sure you have some follow-up questions on your end. So don't hesitate to reach out to Dan for his perspective. I know he'll be happy to take the call. And we hope as always that this Hilco Global Smarter Perspectives Podcast provided you with at least one key takeaway that you can put to good use in your business or share with a colleague or client to help make them that much more successful moving forward. Until next time, for Hilco Global, I'm Steve Katz.