By Michael Wiener, President of ExcessSpace Retail Services
Not all landlords agree that tenants have leverage regarding the negotiation of lease terms.
While the future remains uncertain especially due to a number of factors including rising interest rates, supply chain disruption, inflation, and war in Ukraine, the retail sector has continued to see rents gradually rising toward pre-pandemic levels. From a national perspective, when the Covid associated lockdowns began in 2020, overall rents decreased significantly, however, in the first half of 2021 they rose by .1% and then 3% in the second half of the year from the pandemic low. This year, we have seen a continued gradual increase in rents in the retail sector. The good news for retailers is there remains a window of opportunity to take a hard look at their real estate portfolios and create a strategy to reduce expenses, elevate exposure and visibility, and optimize the value of their real estate for the short and long-term.
I think it is important to note that not all landlords agree that tenants have leverage regarding the negotiation of lease terms. In our interactions with retail owners, they contend that inflation is an argument to increase rents, however, in the triple net world, we aren’t convinced that inflation in and of itself is a significant justification for a rent hike. It is imperative to take a micro-level perspective on each local market, understand supply and demand and determine how the triple net pricing is passed through. That is, very often the tenant is fully responsible for the increases associated with NNNs and CAM expenses. The fact is, a majority of markets across the nation have experienced some degree of decline from the pandemic and are in various stages of recovery. That fallout is amplified by the effects of ecommerce that were in play prior to Covid, but which Covid accelerated, leaving more available space as a consequence of retailer bankruptcies and store closures. Retailers are in a sweet spot right now to reevaluate their leases, but not for long. To illustrate, malls are being redeveloped into mixed-use projects, retail is being converted to industrial and multifamily, and big boxes are being broken down for medical and other non-traditional retail uses. Inventory will inevitably get tighter over the next few years.
The good news is, with a robust lease restructuring or renewal program, a vast majority of retailers can take advantage of lower rents as well as saturate new markets and expand in others. Following a few key points on each strategy:
- Lease Restructuring: Creating a situation that provides stability for both the landlord and the retailer is key when renegotiating lease terms. This is most beneficial for stores that are maintaining strong sales and have several years of remaining term while also reworking terms for the more modestly performing stores in the portfolio. A market study is key and will uncover nearby rents and vacancies for potential relocation; new development in all sectors that would impact the area; demographic changes/shifts; and competitor locations, among others. A review of the lease will also identify points of negotiating leverage. While lower rent is always a goal, a retailer can negotiate a number of terms such as free rent; TI allowance; and converting percentage rent into base rent, to name a few benefits. Some retailers may also want to focus on non-economic lease modifications such as homogenize lease provisions across the portfolio, enhance or improve signage, etc.
- Lease Renewals: A lease renewal often seeks to proactivity reshape lease terms, including rent, in order to create long-term stability for a retailer’s portfolio. A market study should be performed for all lease renewal stores to understand market rents and the surrounding market. The retailer should determine the ideal length of term they are willing to commit and the base rent they are willing to pay based on the existing market and the current terms of their lease. All retailers should have a formalized ongoing lease renewal program so the retailer can make decisions and negotiate with landlords far in advance of its lease notice dates.
As we transition from a pandemic to an endemic, and as we navigate a number of domestic and global challenges, all indicators point to a continued dwindling of retail supply over the next couple of years causing rents to inevitably increase. Now is the time for retailers to take action and create value for their retail store portfolios.