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Turnarounds Amid Disruption: Maximizing Real Estate Portfolios Is an Essential Strategy

The struggles of the U.S. retail sector have been well publicized—so much so that the term “retail apocalypse” is now firmly established in the lexicon. Last year alone, more than 20 national chains in the United States, including names like RadioShack, hhgregg, BCBG Max Azria, Gander Mountain, and Wet Seal, filed for bankruptcy protection.

The typical explanation for the trend centers on another term that has become increasingly commonplace—disruption. It is an imprecise designation that can refer to anything from the rise of the millennial generation to the decline of the middle class to the exponential growth of Amazon and e-commerce generally. It has an air of newness to it, as though profound change were unprecedented in retail and the U.S. economy. The truth is that cyclical changes, even paradigm-busting changes, have always been part of the picture.

Whatever its label, disruptive change certainly is afoot not only among mall specialty stores, junior anchor tenants, and department stores but also in sectors as diverse as hospitals, higher education, and grocery. A Venn diagram charting the forces of change in all of these areas would show considerable overlap. The internet, for example, is a factor in the reduced need for space in the retail and education sectors and in grocers’ pivot toward services like click-and-collect and online delivery.

From the perspective of a turnaround professional, the appropriate response for troubled education and grocery businesses is often quite similar to what has occurred in retail. Along with other measures, it requires an unrelenting focus on optimizing the value and productivity of the client’s real estate portfolio.

In the retail arena, chains are re-evaluating their real estate. Many have decided on smaller footprints and fewer stores. In addition to employing these strategies, Best Buy, for one, also has sought to maximize real estate productivity by doing store-in-store deals with companies such as Apple, Samsung, Sony, and HP.

Across the sector, it is now common for chains’ real estate committees to scrutinize the viability of new sites and stores as never before. Even in today’s improving economy, they are taking it slow compared with past deliberations in an attempt to pick only winners. Landlords and retailers alike, in fact, are now willing to sign shorter leases that keep their longer range options open. A “long-term” lease these days can be less than five years, as opposed to 15 or 20—and even longer for mall anchors—in eras past.

Disposition of Healthcare Real Estate

In nonretail sectors of the economy, real estate dynamics are changing, too. According to research conducted at the University of North Carolina at Chapel Hill, more than 120 rural hospitals have gone out of business since 2005, a trend that has been accelerating since 2010. Dozens of inner-city hospitals have closed as well. Simply put, declining reimbursements and rising costs are shaking things up in healthcare, triggering more consolidation and the need for adaptive real estate strategies.

As part of this transformation, healthcare companies are increasingly expanding into local neighborhoods by opening doctors’ offices, surgical and palliative care centers, MRI facilities, urgent care clinics, and more. It may be an overstatement to assert that the era of gigantic, centralized hospitals is over. However, the demand for medical facilities located closer to customers is undeniable. As healthcare systems open more facilities away from central hospitals, and as they continue to consolidate through mergers and acquisitions, the end result is quite similar to what has occurred in retail—abundant excess space.

In their report “The Hospital Left Behind,” researchers with the Gensler Research Institute cite mixed-use developments as viable alternatives for the glut of hospital space on the market. The adaptive reuse of a typical hospital, they write, could involve bringing in community retail and a public lawn on the first floor and a raft of uses on higher floors—everything from restaurants, co-working areas, and a healthcare center to an event space and garden, hotel, apartments, a learning academy, or commercial offices.

“Scraping” a hospital and starting from scratch with a new project is an expensive proposition, especially in rural areas, where the alternative—simply buying a vacant piece of land—is more viable. However, it does happen. The demolition firm Brandenburg has razed at least 30 hospitals, including the old Memorial Hospital in Michigan City, Indiana, where plans call for construction of new luxury apartments.

In advising clients on disposition strategies for hospitals, then, options include selling the property to schools or to developers of offices, condos, or hotels, either for a new project altogether or for adaptive reuse. When it comes to the latter, one consideration is that older hospitals can be quite attractive, with upsides such as brick construction or soaring atriums. These features, along with their existing wings of patient rooms, make converting them into urban lofts a distinct possibility. One example of this is the Historic Lofts on Kilbourn in Milwaukee, a formerly vacant hospital that was redeveloped into 99 loft apartments.


 
In advising their education sector clients, turnaround professionals would do well to encourage them to think like a retailer.

 


Given the massive demand across the United States for viable fulfillment space operated by Amazon and other e-commerce retailers, industrial reuse is also a possibility for some of the larger basements and other open spaces that are typically part of centrally located hospitals.

If the owner of a hospital is not ready to close the facility outright, a turnaround team could suggest phased disposition of parts of the building via lease arrangements. This would enable the hospital system to gradually relocate various services to the suburbs while keeping the bulk of the facility in operation. One corner of the building could then be converted to a Starbucks outlet, for example, and another to a co-working space or spin studio. The convenient parking typical of hospitals can make such uses quite viable.

The key is to be cautious about lease length. The plan should include a clear vision for the winddown of space. If the facility is 1 million square feet today, how much space will the hospital want to occupy in three or five years? Lease agreements must preserve flexibility. Lastly, due to intense competitive pressures, it is clear that not every attempt to roll out neighborhood surgery centers, urgent care services, skilled nursing facilities, and the like will succeed. Disposition and lease renegotiation for these and other distressed medical assets, over and above hospitals, will be of increasing importance moving forward.

Real Estate Trends in Higher Education

Disruptors are also affecting real estate holdings across higher education. Just as e-commerce made possible by the internet continues to pose big challenges for brick-and-mortar retailers, the phenomenon of online distance learning is among the factors reducing demand for physical space at nonprofit and for-profit schools. Far bigger factors, though, are in play as well. For starters, tighter government regulation of student loans has put intense pressure on margins in the for-profit education sector. One example is ITT Educational Services, which had been one of the largest for-profit schools in the country before it filed for bankruptcy in September 2016 after closing all of its 137 campuses.

At the same time, more students are wary of incurring massive student loan debt given the uncertainties in today’s job market. Simply put, some young people are rethinking the high cost of tuition and lifelong student debt. In December, the National Student Clearinghouse Research Center reported that overall college enrollment in the U.S. had declined for the sixth year in a row. The ramifications for real estate assets in higher education are significant.

With respect to disposition of excess space, some schools are turning to the kinds of creative solutions that have reshaped much of retail real estate. For instance, when for-profit Career Education Corp. needed to dispose of its 54,000-square-foot Briarcliffe College building in Patchogue, New York, it found a taker hailing from the same fast-growing sector that has emerged as a godsend for some retail landlords: craft beer. Briarcliffe’s central business district building boasted high ceilings and red brick construction. That made it a good candidate for the relocation of Long Island’s 20-year-old Blue Point Brewing Co., with its tasting room, restaurant, towering beer tanks, and a catwalk for visitors. Who would have thought that a building once filled with aspiring dental hygienists could find new life as a craft brewery?

In other cases, occupants such as charter schools and churches have taken over space previously used by post-secondary education providers. However, corporate office users are typically the likeliest candidates, because for-profit colleges tend to make heavy use of class B office space, in particular. Turnaround professionals could also pursue a turnkey deal by selling a property to an educational institution from overseas. ITT’s Daniel Webster College in New Hampshire, for example, was sold to a Hong Kong-based bidder for $11.6 million. The Oakdale campus of bankrupt nonprofit Dowling College on Long Island was sold to another international educational institution for more than $26 million.

In advising their education sector clients, turnaround professionals would do well to encourage them to think like a retailer. Schools should routinely review their real estate portfolios with a view toward strategic sales, lease terminations, subleases, occupancy-cost reductions, and the like.

Big Changes in the Grocery Sector

A transformation is underway in how U.S. grocery chains use real estate as well. According to research firm IDG, U.S. online grocery sales will grow at an average annual pace of 18.1 percent over the next five years. If that happens, the firm says, it would represent a doubling in market share for e-grocers, from an estimated 1 percent today to 2 percent by 2022. The industry is watching closely to see whether Amazon’s acquisition of Whole Foods Market will, as some have predicted, drive down costs and lead to millions of people routinely ordering their groceries, with two-hour delivery, on their smartphones.

The long-standing strategy of scaling up through massive spending on both new stores and acquisitions of rival grocers in blockbuster deals also appears to be winding down. Economies of scale continue to matter in grocery, but today’s chains are more likely to make smaller acquisitions by picking off the best stores of troubled independent and regional chains. For today’s grocers, the goal is increasingly to redevelop stores to make them more “experiential” and to invest in click-and-collect and online delivery capabilities.

That trend is abundantly clear from the capital expenditure numbers of top chains. Kroger, for example, plans a 68 percent reduction in new store capital from 2018 to 2020 compared to the prior three-year period. Walmart plans 25 new stores in 2018, the fewest in 30 years. As recently as 2015, Walmart opened 230 new stores in a single year.

From a disposition standpoint, considerations in the grocery sector mirror those in the rest of retail. Like Best Buy before them, today’s grocers face trends that can encourage smaller store sizes. The space-filling packaged items typically found in the center of a grocery store are essentially commodities. Shoppers have every reason to use automatic renewal tools like Amazon’s “buttons,” or, increasingly, voice-activated speakers like Google Home or Amazon Echo to restock these items. It seems more and more likely that it will become common for people to simply have paper towels, toilet paper, cereal, canned goods, and other commodity-type items shipped directly to their homes.

Grocers face competition from smaller-format specialty stores, such as Trader Joe’s, and from dollar stores and other food retailers. If efforts to supplant center-store packaged goods with higher margin fresh items, dine-in areas, prepared food counters, and the like ultimately fail, then even some well-located supermarkets could be forced to shrink their store prototypes.

In the supermarket business, margins are notoriously thin. Small decreases in volume can have a real impact on a grocer’s bottom line. Turnaround professionals, then, will most likely advise clients in this sector to dispose of excess space by closing stores and selling leases. In best-case scenarios, expanding retailers such as Ross or T.J. Maxx will move into these spaces. Among grocery investors, the “flight to quality” is likely to continue. The sector is likely to see a lot of space come online in the years ahead. Clients should understand that in the vast majority of cases, hanging onto underperforming stores is a costly mistake.

A New Reality

It may seem remarkable that assets once considered relatively stable—from hospitals to colleges to grocery-anchored shopping centers—are now under the gun to adapt to rapid change. Clearly, though, this is the new reality of the U.S. economy. Regardless of the sector in question, turnaround professionals should hammer home a simple message to their clients: Real estate is their most important asset, and they need to maximize its productivity down to the last square foot.

Jon Graub

Jon Graub

A&G Realty Partners

Jon Graub is a principal in Melville, New York-based A&G Realty Partners. He is a U.S. retailing veteran focused on advising retailers and other companies on strategies related to both growth and disposition. His client list includes RadioShack, rue21, ITT Educational Services, Career Education, and Zenith Education. Before joining A&G, Graub handled all aspects of store and corporate real estate for a top U.S. fashion chain with multiple brands. He can be reached at jon@agrealtypartners.com.

Topics: 
Retail
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