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Dealing with new realities in “retail” rents

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Back in 1996, I was serving as an expert witness in a mediation related to HVAC billing methodologies in regional malls. The tenant brought in their own expert witness to address water rates. Over the course of two days, the two of us had plenty of time to talk. At that time, in most municipalities, water rates ran 2-3 times sewer rates. He shared that over the next few years, sewer rates would creep up to the same levels as water rates – possibly higher.

I absolutely wanted to discount his prediction because an increase in sewer rates would ultimately affect base rents. But, over the next decade, I saw those sewer rates creep up. He was sharing a new reality, and I did not want to listen.

Though we are fighting tooth and nail, I think we are in the midst of a reality shift for retail rents – much more so for enclosed, regional mall type centers than for open air, community centers. To a certain extent, we all try to apply a kind of ratchet to rents – they can increase but never decrease.  But, tenant mixes are changing significantly. I have a tendency to resist using buzzwords almost out of spite because they are buzzwords. However, a few of them are not just buzzwords anymore and are contributing to this new reality of retail rents – experiential retail and showrooming.

chip cheese

I have quotes above around the word retail in the blog’s title. I have seen so many memes where quotes are used in a way that makes you question whether the user knows how or why to use them. In this case, I am air-quoting the word because, to a certain extent, retail is no longer retail. The language that used to be so prevalent in retail leases about other permitted uses in a shopping center, “… and other similar uses found in first class shopping centers …” no longer has relevance. The days of having specific restrictions against health clubs, schools and other educational facilities, residential, sales and rentals of vehicles, a limit on the number of square feet of office space, gambling, distilleries or even supermarkets (in regional malls) and theaters are going away.

As “retail” changes, many of these formerly restricted uses are becoming desired uses. Vacancy or: A Lifetime or Equinox Fitness? A Tesla dealership? A Whole Foods?  A well conceived multi-family  project? A Main Event or Dave & Busters type attraction? A WeWork coworking office space?

One of my idols in our industry. Henry Faison, passed away a few years ago. I had the opportunity to start working with him in 1990 – a few years into my career but nearly 30 years into his. He developed many successful strip centers before adding regional malls in the mid-1960s. His successes could be attributed to the relationships he developed with anchor tenants over the years. I sincerely wanted to believe that the man did a happy dance when he had gotten commitments from a few anchors and knew he had a center coming. But, what I learned was that his own happy dance was not a physical display but the joy he got from the ability to create that successful center by perfecting the tenant mix. Which tenant would go next to which anchor? How would certain categories be grouped and on what floors? Ultimately, perfecting the tenant mix would optimize sales which would, in turn, optimize rents.

The need to focus on tenant mix has not changed at all. Ultimately, perfecting the tenant mix will optimize the tenants’ successes and the center’s own financial performance. However, the components of the tenant mix have been changing drastically, and the  sales per square foot of a tenant is no longer the exclusive measure of a tenant’s success.

I think it may have been 10+ years ago, I sat at a roundtable at ICSC’s RECON led by Bill Taubman, COO of The Taubman Company. He never came out and used the word showrooming (because it may not have existed as a word attributed to retail at the time), but Taubman was starting to address the concept at the time. They had recognized the need to capture the rental value attributable to a tenant’s increases in online sales in markets where they had a physical location. If you look at the sales of a tenant made at a bricks and mortar location, and let’s say those are $500 per square foot, that might equate to a minimum rent of $40 per square foot. However, if there is a direct correlation to a 30% increase in online sales in a market where there is a physical location, the value is much greater than $40 per square foot. From personal experience, I had not purchased from UNTUCKit until I had the opportunity to visit a bricks and mortar location but have now become a regular customer.

In the case of showrooming, there is value far beyond the sales made in the bricks and mortar location – an opportunity for increased rents.

However, in the case of experiential retail, the flipside may be true. The new reality. The rent ratchet may (or maybe even can) no longer exist. As we rethink tenant mix, we have to rethink the appraisal concept of “highest and best use.” We cannot run our proformas assuming all vacancies will be tenanted at $40 per square foot with a $20 per square foot tenant allowance. We have to consider that these new “retailer” have many different measures of their own successes. We have to understand what types of rents these “retailers” can afford. There may be a sizable spread between what we would like and what a tenant can pay to ensure their long term success.  We have to take time to understand these new types of tenants’ measure of profitability. It may be that, if we want that experiential tenant, we have to accept $15 per square foot instead of the $40. But, ultimately, if that experiential tenant is a key component to our desired tenant mix, we are maximizing value in the long run.

Regional mall values (and the companies that own those regional malls) have already taken their value hits. It’s time to rethink that tenant mix and mine for the new values that can be achieved in this new “retail” reality.

Real estate tax resources

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Back when I first got into the industry in the late 1980s, if I needed information on a property’s real estate taxes, it was not unusual to actually have to go to physically go to a county assessor’s office and access the data on microfiche. Fortunately, those days are long gone. For the most part, municipalities’ tax records can be accessed online.

A friend was looking for information this week related to some of their properties’ land vs improvement value and was lamenting the lack of data on certain municipalities’ websites. As it has been a few years since I could not get everything I needed (tax related) for a property remotely, I was surprised. But, he was not checking all of the available resources.

When I shared my methodology, he, too, was able to get everything he needed. First, determine the county. Then search three terms – 1. (county) tax assessor, 2. (county) tax collector, and (county) GIS. Obviously, you may have to add the state as well if it is a common county name. But, seriously, one of those three sites will typically get you the information you need – even the property’s assessor cards where there are multiple cards for one tax parcel. Use that search methodology for a property you are familiar with and see just how much information is available. My first search is typically the (county) GIS search because I can find a property without even knowing the owner name, tax parcel number or even specific address – you search using a map.

The information is there. You just may need to dig a little.

Real estate tax timing issues

When reconciling operating expenses, timing is often pretty straightforward. The tenants make monthly escrow payments throughout the year. The landlord reconciles the calendar year and applies those payments. An additional billing or credit is applied to a tenant’s account.
However, taxes are a different story. While some municipalities bill taxes for calendar years, many bill for fiscal years – often a July – June period. We have worked on properties where there have been multiple types of taxes with multiple fiscal periods. County, school, village using calendar year, fiscal year 7/1-6/30 and fiscal year using 5/1-4/30. As you can imagine, that can really complicate a reconciliation. There are endless numbers of ways to deal with this type of scenario with the most common being to blend to a calendar year. Essentially, you calculate what taxes would be for say 2018 – 6 months of one fiscal year, 6 months of another – using escrows and occupancy for that same calendar year. Consistently applied, this methodology can work really well.
However, there are certain states and municipalities that really throw a wrench into the calculations – where taxes are sometimes billed either a full year in advance or a full year in arrears. In 2018, in some areas, the tax bill being paid could be for 2019, while in other areas, the tax bill could be for 2017!
What does that mean? If a tenant’s lease commenced on April 1, 2018 in an area where taxes are paid a full year in advance, the taxes for 2018 would have been paid in 2017. Therefore, on the day the lease commences, the tenant should be billed for essentially a full year of taxes – the eight month remaining in 2018 and the first four months of 2019 – and then immediately start making additional escrow payments. When their lease terminates, they would essentially be entitled to a full year’s escrow refunds.
If a tenant’s lease commenced on April 1, 2018 in an area where taxes are paid a full year in arrears, the taxes being paid in 2018 are really for 2017, so there would be no tax obligation for that first partial year. When the lease terminated, they would still owe a year plus of taxes.
To combat this timing complexity, many sophisticated landlords will change the lease language to specifically address timing to something along the lines of “taxes for the year will be taxes paid during the year without regard to the period to which they apply.” With that language, for that lease that started on April 1, 2018, regardless of whether it was in a pay for the prior year, pay for the current year or pay for the next year municipality, the tenant would pay its share of taxes paid during that particular year – using the occupancy information and escrows for that year.
The bottom line on this whole timing issue is absolute consistency – in both understanding the periods being billed and how the escrows are being applied – and sticking with that methodology.
Why this issue this week? We are working on a property where taxes are paid a full year in arrears – so the taxes paid in 2018 are for 2017. But there is a lack of consistency. Some of the anchors are billed taxes based upon the period to which they apply while others are billed taxes using amounts paid during the year, while the inlines and outparcels have similar issues. Some escrow, some don’t. And there are material changes in GLA and occupancy among the years. It’s pandemonium!
Do yourself a favor. Shoot for consistency! (And, spend some time really understanding tax periods and how a seller has applied escrows when you are considering a property for acquisition!)

Unique retail environment

Next week will be back to the regular lease administration blog, but, for now, a little more Mexican retail. One sight in Puebla that does not show up on TripAdvisor is truly “experiential retail” – Container City. Puebla is very much a university town, and Container City is an area designed for those students. It is an area with bars, restaurants and some retail all set up in former shipping containers. While my wife and I were (by far) the oldest people there at 10:30 pm (my son said it did not get really busy until 12:00 am) and were way outside of the target demographic, we absolutely loved the concept – and the experience.

Liability issues aside, it was exceptionally well done.

Buen Fin!

This week, the blog will not be about lease administration. Rather, it is just a few pictures to give you confidence going in to the upcoming holiday retail season.

My wife and I are visiting our son in Puebla, Mexico this week. We happened to arrive during Buen Fin – the Mexican version of Black Friday. Traffic around the city is ridiculous and is attributed to Buen Fin. And, traffic in the malls, shopping center and streets is absolutely unbelievable. While there is nothing scientific about it, I am still a fan of “bag checks.” No. Not the bag checks going in to a concert or sporting event, but the visual bag check of whether or not people were buying. And, yes! They were buying.

For me, these pictures are better than any motivational posters.

(Just a couple of quick observations. If you look at the pictures, you will see that the anchors do not have grand courts. They are flush with the rest of the inlines, and they may online have a 50-60’ front lease line. Instead of having wall kiosks, flush with the front of the anchors, you then have a series of smaller premises (maybe 750-1,000 sf), making it much busier (in a good way) than our US anchor courts. Also, with Puebla being in a much more temperate climate, they had a good portion of the mall covered, but open air (you should see it in some of the pictures), eliminating the expense of mall HVAC in the part of the mall. And, finally, I have never see a food court busier. In the picture, you will notice shoppers sitting and finding space wherever they could, often on the floors and half walls. My son said that the quality of the local food court tenants is exceptional.)

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