What retailers are thinking about as they optimize their portfolios

The pandemic isn’t the main reason retailers have become more likely to run deep-dive portfolio analytics, sell excess assets and renew and restructure leases, according to SRS Real Estate Partners COO Steve Dawkins. “There are a whole host of driving factors, but they have to do with the evolution of retail in general. The specifics depend on the type of operator and the particulars of its real estate.” Dawkins has provided consulting to the likes of Carter’s, Walgreens, Lowe’s, FedEx Office, American Girl, Tween Brands, Staples, Zales and Tecovas. SCT contributing editor Joel Groover spoke with the 30-year industry veteran about retailers’ real estate strategies and the effects of these trends on landlords.

What types of retailers are most likely to be rethinking their portfolios right now?

Start with those that are struggling with their historical real estate, such as soft goods tenants at regional malls. In many cases, these operators are dealing with occupancy costs that, in our view, are unsustainable, so they have to think about either substantially reducing those costs or moving out of the mall and also what that means for the stores they will still operate in malls or outlet centers. In addition to different levels of health, retailers have very different strategies, which affects their real estate needs. For example, some that used to be in largely wholesale accounts are now going direct to consumer. They’re trying to figure out what their portfolio should look like as they make that shift.

What guides retailers as they reshape their portfolios?

That’s going to be a function of the sophistication of their internal research and analytics capabilities. For example, we recently had a client in the soft goods category, which is a challenging sector right now, that did not have the means to do a deep analytic dive. We did that deep dive for them by looking carefully at their customers’ demographic and psychographic profiles, market spending patterns, the company’s wholesale accounts and the economics and performance of their existing stores. Part of the process was to develop ratings of between 0 and 5 for each location. If the performance rating is 0, you should think hard about closing that location because you’re never going to make that store sustainable through an occupancy cost reduction alone. For 1s and 2s, you need deep rent reduction without extending the term of the lease. The 4s and the 5s are the best stores. You want to use your leverage to protect those locations. One scenario is what we call “blend and extend,” where we basically add term to the lease in exchange for some significant consideration from the landlord, such as a big reduction in rent, a cash payment or money for tenant improvement.

But even if the plan is to close one of those 0s or 1s, retailers need to understand how to actually do that. Will there be a store relocation opportunity? Do you want to sublease that space directly to another tenant, or would you rather not step into that “landlord” role? If not, you could do a tenant-in-tow arrangement. These typically involve the current tenant lining up a new tenant that wants more term than is left on that existing lease. Based on a pre-negotiated deal structure, the current tenant then buys out of their existing contract at a very low rate, due to the new tenant economics, and the landlord deals directly with the new tenant. These arrangements allow that original retailer to be free of any further obligations involving the space.

Retailers need to be thinking about these options and doing this planning and analytical work all the time. They should be trying to understand their existing portfolio because the right lease actions will become clear from that.

What about retailers launching newer concepts, maybe triggered by shifts that have occurred during the pandemic?

We’re seeing more retailers come up with smaller concepts, but this isn’t necessarily new. More than a decade ago, we worked with a junior anchor in the office supply category to downsize its 18,000- or 20,000-square-foot stores to something more like 12,000 or 14,000. We did this through what we call virtual downsizing, where the retailer never leaves that large space but pays for less square footage. But yes, we are seeing some operators in growth mode that are saying, “We have a great online business. Now we want to figure out how to go into brick-and-mortar.” Or you may have a traditional retailer that needs market planning related to a bigger focus on direct-to-consumer sales.

For traditional operators, it’s a mistake to start acting on this when you’re six months away from the notification date, when you have to tell the landlord if you’re going to stay or go. That late, you don’t have any leverage to do something new. You need to get way ahead of it and look out 24 months. This is especially important for retailers with a lot of scale that will be doing performance-level reviews with larger landlords. Engaging early gives you more time for those negotiations: “Yes, we will stay in locations A and B, but to do that we’re going to have to have a change in occupancy costs at locations C, D and E.” Larger landlords have a lot of leverage, and these can be challenging conversations. It’s good to start them sooner rather than later.

Is it bad news for landlords when retailers focus so much on portfolio optimization, which can mean lower rents?

There are a lot of different opportunities here for landlords. Let’s say the landlord owns a net lease asset. A property with 12 years of term on it has a much lower cap rate than something with a mere 12 to 24 months left, so in exchange for reducing the rent, sometimes substantially, there is an opportunity to negotiate for longer term that increases the value of that asset. Or maybe there’s no rent reduction at all. By extending term, you may have a 200-basis-point spread on the cap rate — we call that cap compression — and the retailer asks for a percentage of that value as cash compensation. Now the landlord is able to go sell that asset at a higher price.

In other words, many occupancy cost changes do benefit landlords. In fact, this drives a lot of what happens in the marketplace. Length of term is particularly important if it’s a landlord sitting on a net lease asset, but regardless, if the landlord can lock in a high-credit tenant or healthy tenant for 10 years, that is very attractive. It’s a big difference from situations where the retailer says, “We’re taking a pound of flesh, and in order to have maximum flexibility, we are only going to renew for a year to two years.”

You mentioned looking to the future. How are retailers’ real estate needs likely to change this year?

Essential retail, such as grocery, managed well during the pandemic and even grew. But what I’ll call restaurant-entertainment went through a really difficult period. Many of these businesses closed. As we look out into the summer and later in the year, we’re likely to finally see that V-shaped recovery that was such a big topic of discussion early on. As a retailer, if you are confident that you have a good, relevant concept, it could be smart to take advantage of the opportunity to get into new locations at very reasonable rates. We still have the pandemic hangover with a lot of vacancies — particularly in markets like New York, Portland and San Francisco where restrictions are still in place — but those restrictions will eventually be lifted completely. If you ever wanted to be in New York City as a retailer, for example, now could not be a better time.