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Real Estate Game Planning Takes on New Urgency in Retail Restructurings

Understanding the strengths and weaknesses of a retailer’s real estate portfolio has always been a critical part of the planning process before commencing a restructuring project. However, in today’s highly disrupted retail environment, the need for clarity on this front is greater than ever.

The real estate planning component centers on ascertaining individual store profitability by closely reviewing both the retail company’s present-day financials and future projections. The real estate professionals conducting this analysis carefully study the marketplace dynamics in answering basic questions such as whether particular stores should continue to operate over the short term or the long term. Clear underperformers are slated for closure, while certain “on-the-bubble” stores merit further discussion.

Retail Real Estate, Disrupted

From a big-picture view, the real estate planning process is relatively straightforward. However, the shifting realities of today’s transformed retail marketplace can complicate this picture in ways that require close attention.

Before the stratospheric growth of e-commerce, for example, the profitability equation was uncomplicated: If the chain’s annual sales per store averaged, say, $1 million, the team might recommend that any location with annual sales below $800,000 be considered unacceptable. For example, a profitable store with $800,000 in annual sales could be kept open for the short term, while a location grossing just $600,000, even though profitable, would go on the closing list.

But e-commerce adds a new dimension. These days, in addition to looking at sales completed in individual stores, real estate professionals need to work with the retail chain to determine what role particular physical store locations play in that retailer’s omnichannel operations. If the store is a popular destination for online returns by customers in the trade area, how would closing it affect the chain’s e-commerce strategy? When customers buy items online that are then fulfilled at a store for home delivery or in-store pickup, does the retailer count those transactions as store sales or e-commerce sales? The real estate team needs to know those numbers.

Studies show that up to 35% of customers who cross the threshold to make returns or pick up online orders in a physical store buy something else as part of the journey. This is a big part of the reason that Nordstrom Local has just started accepting returns from Macy’s and Kohl’s. Along the same lines, Kohl’s now allows Amazon shoppers to make returns at Kohl’s stores as well.

The real estate team needs to do a deep dive with the retailer to understand any applicable e-commerce dynamics. To be sure, some retailers have yet to launch significant online operations, in which case the analysis will be more conventional; others are massively invested in e-commerce and their brick-and-mortar locations function as much as showrooms and fulfillment centers as they do traditional stores.

Owned, Leased, and Everything In-Between

Another potential complicating factor could come in the form of mixed real estate portfolios. While some chains lease all of their stores from retail landlords in a straightforward lessor/lessee relationship, others lease a portion of their store portfolios while also owning some of their real estate and operating with ground leases here and there as well.

During the go-go years of retail real estate 20 years ago, a company might be willing to sell a box on a ground lease and move a few miles down the road to secure a more favorable location. Today, far fewer retailers see such a move as realistic in a restructuring. But it is important to understand that challenges and opportunities are always intertwined. Some retailers lose sight of the reality that longer-term ground leases—because they locked in low rents years or even decades earlier—still tend to be valuable assets.

As counterintuitive as it might sound, then, the best approach can often be to renew such leases and put them on the market for sale. In other words, even in the run-up to a restructuring project, it often pays to think of leases as assets with intrinsic value, not as unwanted liabilities. This attitude can make a significant difference in the success of the real estate strategy.

Location, Location, Location

While retail real estate has always been characterized by rapid change, the shifts occurring in today’s marketplace require an extra level of diligence on the part of the real estate team. According to Coresight Research, in the first nine months of 2019 even more square footage came on the market as part of bankruptcy-related vacancies—in fact, the retail industry saw 40% more store closings than in the same period the year before. By Coresight’s calculations, approximately 12,000 U.S. retail stores will have closed in 2019 by the end of the year.

Store closures should never be seen as a uniformly negative phenomenon. Smart retailers have always shuttered underperforming locations as a routine part of their real estate strategies. Nonetheless, in today’s retail marketplace the likelihood is greater that vacancies by important co-tenants—some of which have been stable, traffic-driving household names in retailing for decades—could undermine the viability of particular retail locations.

In worst-case scenarios, such vacancies can allow other important retailers to take advantage of “kickout” clauses in their leases that give them the option to close their stores or pay lower rents. In reviewing an individual location, the real estate team should look at store profitability, but it is equally important to scrutinize the dynamics at that particular center and, indeed, in the surrounding trade area. Is the submarket gentrifying or declining? How could prevailing trends affect the viability of the store and the shopping center or district? Factoring in such locational dynamics bolsters the accuracy of the analysis.

Fortunately, retail is no longer a business dominated by guesswork and gut instincts. As in other sectors of the U.S. economy, the data analytics revolution is providing unprecedented clarity, with stakeholders pulling in terabytes of data from sources that provide multifaceted customer insights, such as national retailer databases, trade-area satellite imagery, and geofencing systems.

Third-party real estate firms are now able to enlist such information as part of the effort to identify which assets should be retained or sold. Such data are also invaluable for the due diligence process and the evaluation of new real estate in cases where store relocation is part of the strategy. Retailers are also making increasing use of data analytics to maximize their real estate post-restructuring.

Divided, They Fall

The widespread turmoil and disruption in retail also tends to increase the likelihood of internal divisions at retail companies, often due to high c-suite turnover. These conditions can lead to complications in the real estate planning component of the restructuring as well as in the broader restructuring effort.

When companies yo-yo on their decision making (perhaps because the CFO position is a revolving door), this can lead to inconsistencies in the plan for the real estate. One decision maker chooses to shutter certain on-the-bubble stores, but then the successor moves to keep operating other locations with the same productivity profile. Typically, companies with internal misalignment tend to default to the path of least resistance—namely, to continue to hold on to underperforming stores. However, this attachment to the short-term gain generated by these locations almost always spells trouble.

Consistent decision making on the part of the retail company can be critical to the success of the real estate plan. Store closure decisions tend to be emotional for those closest to them, but third-party real estate experts can be objective about these judgments, which is one of the benefits of engaging them in the real estate planning process. If a favorite store in a prestige market must increase its sales by 65% in three years to meet the threshold for viability moving forward, is it realistic to expect that to happen? Such conversations should be part and parcel of the engagement process with the real estate consulting firm.

Lastly, because there are more tough decisions to be made in today’s environment, there are, unfortunately, more real estate situations in which difficult choices have been severely delayed. Waiting too long to optimize the portfolio and close underperforming locations is all too common. When CEOs are reluctant to face reality, it is more likely that the problems that triggered a restructuring have worsened to red-alert levels. That means the team conducting the planning process must be ready to hit the ground running once engaged.

Ideally, all retail companies would conduct regular, clear-eyed reviews of their real estate to ferret out problems and maximize performance. In today’s hypercompetitive and challenging retail environment, the notion that “no news is good news” is a fool’s maxim.

Jon Graub

Jon Graub

A&G Realty Partners

Jon Graub is a principal in the Philadelphia office of A&G Real Estate Partners. With decades of experience in developing complex real estate strategies, the former Charming Shoppes executive has managed some of A&G’s largest lease-disposition and occupancy-cost-reduction projects, including RadioShack, rue21, Charming Charlies, and Charlotte Russe. Before joining A&G in 2013, Graub provided strategic leadership for Charming Shoppes’ real estate and store development teams, managing growth from 1,000 to 2,500 stores nationwide. He can be reached at jon@agrep.com.

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