Lease Lines: The Crossover World of Big and Small Retail Tenants

Understanding Retail Tenants' Leases and Property: Big Chains to SMEs

Join host Gary Marshall as he delves into the concept of retail tenants, debunking the myth that big retailers always own their stores. He explains why many large chains also operate as tenants and discusses the historical shifts from owning freehold properties to the sale and leaseback model. The episode covers the financial strategies, the impact of leasing on retailers' profitability, and the common challenges faced by both large retailers and small, independent businesses in negotiations with landlords. Gary emphasises the importance of effective lease management, the role of estate managers, and the nuances in leasing dynamics for different types of retail tenants.

00:00 Introduction to Retail Property
00:16 Understanding Retail Tenants
01:01 The Evolution of Retail Ownership
02:37 Sale and Leaseback Model
03:36 Challenges of High Rents
04:50 Big Retailers as Tenants
06:43 SME Retailers and Lease Management
08:14 Comparing SME and Large Retailers
17:18 Location and Measuring Prime Pitch
20:12 Conclusion and Key Takeaways

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Transcript

0:00

Welcome to that Retail Property guy with your host, Gary Marshall relating to the retailer as tenant sharing stories and insights through Gary's unique lens. We hope you'll be entertained, enlightened, and may be a little inspired. A question I often get asked by people outside the normal bandwidth of retail estate management relates to the understanding of what a retail tenant is. They might ask, but don't big retailers own all their stores? Surely they're too big to be tenants. Why do you talk about big chain stores as tenants? And if I take off my property hat, I can see why they might ask. The term tenant seems to define an underdog in a relationship with a domineering landlord. While these big, multiple retailers with a bricks and mortar presence in every high street in every retail park seem, well, two powerful to be an underdog. So let's discuss this, starting with the journey to now. In another episode, we discuss why many national and regional retailers who operate large chains of stores. Ever got into the landlord and tenant business in the first place? In some cases, this goes back several decades when a lot of retailers, whether small independents or national multiples, actually owned the freehold of the stores they traded from. They owned it outright and owning the freehold was a status thing, a wealth thing, a solid balance sheet kind of thing. Owning property meant stability, permanence. But over the years, this made for some difficult management evaluations. There was always a possibility that the value of the building was out of kilter with the trading profit value from the store. Were they running a profitable store or a massive loss maker only propped up because it was rent free. So a lot of retailers developed a second accounting level where they would apply an estimated rental value known as an ERV to each trading store in order to assess its profitability against market forces, for example, to compare it with another store nearby. Certainly, some realized at some point that they could make more money by selling the property or leasing it to another retailer than by operating a retail business. I. Well, for some retailers, that was the end of the retail line. They moved into the landlord business, not the tenant business. Other retailers figured that there was financial treasure tied up in the value of their building as a freehold property. I. But they could cash in on that value by selling the freehold to an investment company and taking the lease back so they could continue to operate as a retailer in that established location. The Salem Lease Bank model has been fairly popular for decades. It's often referred to as selling the family silver, recognizing that they were selling their primary assets for a quick cash return. The freehold value, which had sat on their balance sheet making the company look very successful, or at least asset rich moved off the balance sheet and was replaced by rent, which was a deductible revenue expense. Meanwhile, all the shareholders had parties and celebrated their windfall payouts, but of course, windfalls don't payout every year. So in successive years, those same shareholders saw the other side of the deal sometimes in much reduced profits. Because the retailer was now paying huge rents that they'd never paid before. The sale and leaseback model also led to some difficult circumstances when retailers signed up, sometimes joyfully, sometimes reluctantly, depending where the strings were being pulled to leases for 20, 25, 30 years or more, which seems almost unimaginable today. And with rents, which were higher than their business model could actually afford to pay. There was a logic to this. The higher the rent and the longer the lease they took back, the bigger the cash back that they received for the benefits of their shareholders or for the parent company, depending who was pulling the strings. Generally there was an assumption that inflation would catch up, that the contractually overstretched commitments would soon be overtaken by higher prices, meaning higher profits, and also rising local rental values. So a short term blip of struggling for profitability would soon fade away as a distant memory, but in some cases, that never happened. We discussed retailers we have known, loved and lost, such as Woolworths and Debenhams, who were really affected by these over rented leaseback situations. And we discuss who pulled the strings, who took the big money, who benefited, and ultimately who lost out. But we've digressed. The original point was, are big retailers, tenants? The answer is often, yes, they are. Why is it odd to consider a big retailer as a tenant? If they operate as the contractual underdog of a lease? With a landlord, they're a tenant. A multimillion pound turnover isn't a factor, especially if the landlord has a multi-billion pound turnover. Their business model isn't to be a property owner, it's to be a retailer. They no more need to own their buildings than to own their fleets of trucks. Ah, so you thought they owned their trucks too? Well, no. It's common these days for everything to be leased, so the costs can be put through the books as a deductible revenue expense, although an accounting standard known as IFRS 16 is kind of reversing the logic of those decisions, more on that in another episode. So whether the retailer is a long established business, which survived those leases that were the outcome of Ass Sale and Lease back maybe 30 plus years ago, and which have since been renewed, maybe at lower rents to reflect the modern tone of market value in that locality, or whether they are a 21st century brainchild of a market leading WHI Kidd that got directly into the tenant business from the inception. The fact is, if they operate from a lease. They're a tenant, and even if they are a large, multimillion blue chip operation, possibly considered too big to fail, they are still tenants with a need for advice, support, and protection against landlords and their managing agents. Whatever the situation. The leases create a contract between the tenant and the landlord. Imposing conditions and commitments. It's critical to know exactly what those commitments are in order to manage obligations, to juggle expense and to mitigate risk. And in other episodes, we discuss that key mantra, read the lease. But in another sense, let's consider the smaller retailer as an SME, a small or medium sized enterprise. It might be one shop or a modest local chain. It might be managed by a family firm or a collective of franchisees. It might occupy space in a very flexible arrangement or on a fixed lease. In all senses, we're considering that retail business in the role of a tenant, so dealing with a landlord or their agent, and in that sense, a retail tenant is a retail tenant, whether a national chain or a mom and pop business, or somewhere in between. In most cases, the SME retailer operates a welcoming, dedicated, highly focused, often specialized business. Where the store manager could also be the finance manager, the estates manager, the maintenance manager, the tax manager, the HR manager, and so on. From our specialized landlord and tenant perspective, we could consider that the most important task in that series of roles is the estate manager dealing with the lease, dealing with the landlord, juggling the property costs, including the business rates and the utilities, understanding the extent of their obligations for repair, for payments, understanding the permitted use. Making changes, permissions for alterations, and maybe also disposing of a lease or renewing it. For many tenants, occupier standpoint, the nature of the retailer significantly influences their relationship with landlords, with their lease terms, and with the ability to adapt to changing market conditions. It's important to recognize and consider the difference in perspective of a tenant occupier between a small, independent retailer and a large multiple retailer. These could be influenced by scale, operational requirements, financial capabilities, and of course the strategic goals of the tenant. The SME retailer could have specific financial constraints. Require different flexibility and have a high level of local customer engagement, goodwill, reputation. They might create their own draw for clients. Might be renowned and sought out. So for them, maybe passing trade is less relevant, or it might be highly relevant. Smaller retailers might be located in neighborhood parades along arterial roads or in secondary locations of a market town. While the large multiple retailer might focus on securing prime locations at the highest rent with the highest footfall, so reducing risks in an operational sense and ensuring consistency across all their locations. Smaller retailers might have large institutional landlords or might have small, independent, locally based landlords, possibly themselves not trained or fully experienced in landlord and tenant law. Conversely, large retailers might seek out institutional landlords like pension funds. But still might also deal with local or independent property owners. This mix of perspectives allows us to recognize that wearing our landlord and tenant hats, all retail tenants face similar challenges and can benefit from sharing experiences, knowledge resource. In my experience, a larger retailer in a neighborhood location often becomes a hub, a conduit, if you will, a rallying point for neighboring smaller retailers seeking to unite in a common objective against a common landlord, whether that's in rent review, negotiations, lease renewal, or dispute about repairs and so on. Of course, I'm not saying that larger retailers, estates teams should do all the work and carry their smaller neighbors and incur the costs, and certainly there's a very obvious point at which friendly help and support shouldn't stretch or overreach into formal advice without a corresponding formal understanding of limitations. The extent of liability, the restriction of responsibility. And of course, we should recognize that professional advice might seem disproportionately expensive, but it always helps to collude, to share ideas, to coordinate where possible. In this sense, the last thing anyone wants, whether the large retailer or the smaller retailer is a rogue ill-advised or ill considered rental settlement, which obliges the neighbors to follow suit to their detriment. So let's consider in more detail where some of those differences and some of the overlaps apply. An obvious jumping off point is in the relationship with a landlord when it comes to negotiate a rent or the whole lease, the smaller independent retailer might have or feel they have less bargaining power when the negotiating their lease terms, their landlord might appear to be the dominant partner in the deal offering a case of take it or leave it. Or the smaller retailer might have a limited financial backing or less favorable references and feel obligated to accept standard or maybe less favorable terms. I recall sitting with one small mom and pop team in their lawyer's office. Bear in mind, this was their lawyer being paid by them to give them advice and protected their best interests. When the lawyer basically told them that they should accept the standard local lease, which apparently had been previously negotiated between a cartel of lawyers in the town to supposedly represent the optimum combination of landlords interest and tenants interest. That lawyer was talking rubbish, and the local standard lease was a load of rubbish too. It was an attempted ripoff by inexperienced and arrogant legal specialist who offered a low fixed fee to represent mom and pop and basically didn't want to do any additional work. Needless to say, with a bit of applied pressure, they soon changed their tune. But would an unrepresented mom and pop have achieved the same outcome? And the independent retailer, whether that's mom and pop or a small local chain, may also face stricter lease clauses or higher per square foot costs due to their lack of negotiating leverage. A larger multiple retailer typically might have more bargaining power and more technical advisors who can negotiate from a position of strength or at least be well informed about the decisions they have to take. Their heavyweight bargaining power can drive lower rents. Additional break clauses. Advantageous considerations like rent free periods or capital contributions, whether these are as an incentive to take the lease, generally known as a bunk or a payment towards essential fit out works. Maybe installing a staff toilet sprinklers, air conditioning, her mezzanine floor, whatever. But at the end of the day, let's not forget that smaller, independent retailers can often make faster decisions, take deals that don't fit into a templated corporate expectation. They can be flexible in order to be successful. There's often also a wide distinction between the typical location and space requirements for these diverse sectors. The small independent retailer, perhaps driven by budget constraints, may have to settle for secondary or at least less prime locations or layouts or sizes of units. But their flexibility might just open up opportunities for odd configurations, unconventional locations, tertiary side streets where small specialists gather. Or up and coming areas that are yet to be discovered by the multiples. It's generally considered that the larger multiple retailers typically requires significant floor space, although that's not always the case, there are many nationally represented retailers who intentionally search out smaller footprints or convenience rather than prime pitch locations. High traffic areas, their space requirements might be dictated by standardized shop fitting layouts, commercial practices, stock volumes, and much more. And it isn't unusual for a local neighborhood, convenience location to be anchored by a multiple, whether that multiple is a well-known convenience brand, a betting shop, a takeaway, a service. Or even a charity. And in this sense, of course, even charities can be retail tenants with leasehold obligations, liabilities and responsibilities. The risk of not being able to meet rent obligations might be more immediately pressing for a small, independent tenant, they might have foreseen this and have agreed very flexible lease terms that allow them to exit or downside with relative ease, but they might also have paid a premium rent to secure those flexible terms. So then what happens at rent review, particularly if the lease dictates the hypothetical assumptions on which the review should be negotiated, and these hypothetical terms suggest assume a willing tenant. Now willing doesn't necessarily mean desperate or ill-advised or reckless or underdog. So the conditions which existed in real life when the actual lease was agreed might not apply in the hypothetical lease, which gets negotiated at rent review. Or for rating purposes, and at this point you're not quite sure what I'm talking about with hypothetical willing tenants, rent review assumptions and so on. Well, we discussed these in other episodes, but if it sounds relevant to your position right now, then I urge you to seek advice from a professional with relevant experience in this sector. Consider the costs of failure to understand. By comparison, larger retailers usually have more financial resilience and might be expected to more easily bear the risks and consequences of a downturn. They're often less concerned about short-term local fluctuations because they can absorb costs across a larger network of stores. However, even large multiple retailers still prefer leases with a degree of flexibility such as break clauses or rent freeze, which kick in in the event of a pandemic or other act of God. It might be easy, perhaps too easy to distinguish between SME retailers and larger retailers based on a perception of net worth. It's easy to assume that all big retailers are rich, but of course they have massive overheads that perhaps an SME business doesn't have in terms of head office costs, distribution costs, and corporate responsibility. In some cases this comes to light in terms of talent shop fittings or improvements. Bigger businesses might have a corporate brand or standardized sales floor layout, so need to throw money into a fit out to suit their specific purposes. Conversely, an SME might just shoehorn themselves into whatever space is available, including all those quirky angles and low headroom that big brands might ignore or box out behind Racking. While we are mining this rich seam of comparisons, let's consider location, location, location in many commercial retail schemes, whether that's a small parade. A neighborhood mall, an edge of town, retail park, a regional shopping center, or a destination out of town development location can be a big motivator. Not for every retailer, but for many or most, let's consider it a general rule. Some landlord developers will actively seek out a partner for a new scheme, a big retailer with sufficient presence to exert a gravitational pull, enticing shoppers from far and wide. These prime retail presences are often described as the magnet or anchor for a scheme, and their location within the scheme then drives demand and rents from other retailers. The closer in proximity, the higher the demand, so the higher the rent and so on. This isn't always the case, but the idea of close proximity to the big attraction gave rise to the idea of prime pitch. Describing the ideal location in any scheme or town center may be characterized. Buy that presence of the most powerful retail brand that pulls everyone in. But maybe also governed by factors like proximity to car parking, bus stops, local places of employment, et cetera. Locations that are slightly more distant from the prestigious prime pitch might be measured as 80% of prime or 60% of prime, or as the percentage decreases a secondary or even tertiary as the perception of locations moves from prime to tertiary. So does demand and so does rental expectation. And business rate levels, but not every retailer wants to be in and therefore pay for prime pitch or 80% pitch. Some SME businesses and some larger multiples are happy with secondary or tertiary, especially if they themselves are strong enough in their community to be their own draw, their own magnet or anchor. A good reputation, a strong local presence, established goodwill can all boost a retailer's business almost irrespective of the location. And as we loop back around while wearing our landlord and tenant hats, we might consider a big difference between SME and larger retail businesses is in the extent of their professional representation. Independent retailers might not have in-house estate management teams and might consider external advisors to be disproportionately expensive, so their ability to fully understand lease clauses may be limited, which might put them at risk, or at least at a disadvantage in negotiations. By comparison, larger retailers typically have more experience with complex lease agreements. Maybe have better one-to-one relationships with bigger landlords and can apply some resource to align their business goals with favorable outcomes. So in conclusion, we can say it's a case of horses for courses that there are reasons for and against upsides and downsides to either situation, SME or large retailer. A small independent retailer's perspective might be driven by financial constraints, but they can take advantage of flexibility and swift decisions. Larger retailers might have more clout, but can also be slowed or restrained by corporate process. But one thing overlaps. The need to know your lease obligations, know your rights, understand the rules. Don't risk taking an expensive shortcut or being obligated to follow somebody else's. Thank you for listening to that Retail Property guy. I hope you enjoyed today's discussion and found it both entertaining and insightful. Be sure to like, share and subscribe so you can never miss an episode. For more information, visit that retail property guy.com. Thanks again for tuning in.