What a Sears Bankruptcy Means for Retail REITs (and Multifamily Investors)

TL;DR — we are likely to see continued distress and cap rate expansion among B and C malls. This will create multifamily and mixed use re-positioning opportunities over the coming half decade.

Sears filed for chapter 11 bankruptcy last month, after more than 125 years of solvency. It was the largest retailer in the United States until 1989, making the decline that much more dramatic.

Sears is a convenient proxy for retail 1.0 — capital intense, slow to innovate, and digitally deaf.

What exactly does its demise mean for the malls, shopping centers, and sub markets affected by closures?

For Malls (and Mall REITs)

Direct Rent loss: De minimis

Operating Flexibility: Incremental improvement

Co-tenancy risks: Moderate

Cap Rate Expansion: Depends on quality of mall

We continue to hear the perpetuated “retail apocalypse” narrative — that America is over-stored and over-malled. The decline of retail has been sensationalized. Depending on your source, only 10%-15% of retail sales are conducted online in 2018. But it is clear that brick & mortar retail has a tough road ahead, and online penetration will continue.

Class A

We seem to agree that there are too many stores in aggregate, but the real estate community has vigorously defended class-A malls since doubts arose a decade ago. Advocates suggest that these properties are capitalized and trafficked well enough to evolve through shorter-term headwinds. However, this ought to be debated. Consider the market for institutional grade malls (where trades are rare). In 2016, GGP booked a partial sale of its Fashion show mall (250 stores on the Las Vegas Strip) at just under a 4% cap rate to TIAA. In 2017, Unibail Rodamco acquired Westfield malls for a portfolio implied cap rate closer to 5%. Most recently, Brookfield’s buyout of GGP (the second largest A mall operator) was completed at an implied cap rate of more than 6%. We have to take into account private / public market arbitrage and portfolio discounting… but roughly 200 basis points of cap rate erosion is 50% off of 2016 levels, and I haven’t seen any correction downward. Clearly, reservations are being priced into property yields.

For now, let’s assume that A malls are hunky dory though. Credit Suisse expects 25% of malls alive in 2017 to shutter by the end of 2022. A star broker I spoke with believes we’re closer to 40% over-malled today (nationally). If it’s not the A malls closing, that leaves…

Class B / C

It’s reasonable to assume that the majority of mall closures will happen at the periphery — in illiquid markets with limited repositioning opportunities. About 80MM square feet of retail space is estimated to be impacted by the upcoming Sears bankruptcy proceedings alone.

Amazon is conveniently blamed as a homewrecker of Sears and lower tier malls, but there’s a broader explanation for the struggles of these assets.

  1. Distribution is now commoditized. Anchor department stores used to be the gatekeepers of blue chip brands. That changed by the close of last decade. Today, key merchandise is syndicated across many channels (with standard MAP pricing). Instead of launching special products through store partnerships, brands are throttling distribution through direct-to-consumer promotions. Nike and Adidas are leading the way with this, paring back distribution partners significantly in the last three years.
  2. Inventory de-risking pours gasoline on a fire. Inventory is often the largest operating expense for a traditional retailer. When large brands smell trouble with a store group (or specific locations), they will cut back on the amount and quality of product they sell into those stores. They want their stock paid for, and they don’t want their products dumped on the market in liquidation sales. This makes a challenging situation worse for non-core retail, as struggling locations lose traffic-driving merchandise.
  3. Rise of experiential retail… which B / C malls lack. In-store shopping has struggled at large, but two segments have remained relevant and grown since the financial crisis. (1) Specialty, and (2) Off-price. Makeup counters used to be a key traffic driver for department stores that justified large floor plans and carried poorer performing store sections. Today, that frequent shopper goes to ULTA (which sticks to suburban strip malls), or Sephora for a more self-curated experience. Specialty retail has outperformed its competition on a sales / sq ft. basis. Off-price retail hit its stride this decade, even in affluent zip codes. Store counts have grown rapidly, and multiple department stores have come out with their own off-price channels to capture a portion of the growth from Marshalls, TJ, Ross, and Burlington. You’ll struggle to find an off-price retailer in a mall, they’re mainly found in newer anchored strip centers.
  4. Lack of investment. The refi market for regional malls is dry at best. The stores are cash poor and do not have the funding programs to revitalize locations. Regional mall operators question the efficacy of common area improvements, and it’s slowly suffocating the B / C malls.
  5. R.I.P. Brands. The market for products is significantly more transparent today. Price comparison is real-time, and reviews give buyers more confidence in item selection. Brands don’t serve the same purpose that they did a generation ago, when store-brand cereal tasted terrible, and the private label t-shirt fell apart in two washes. White label merchandise has increased in quality by a great deal. That means a brand has to convey a great deal of meaning for the consumer to justify any premium price… and that’s a tall task. Mall based retailers are heavily leveraged to branded merchandise and fell behind on developing their own private labels (Foot Locker is a key example). Result: millennials rely less on brands, and the locations that carry them.

Seven in ten Sears locations are in class-B and class-C malls according to an analysis by CBRE. Their conclusion: closures will cause a flood of short-term distressed sales, especially malls in poorly capitalized financial vehicles (like standalone regional mall opcos). It takes an operator 18–36 months on average to backfill a department store location. Class B / C malls relied more heavily on a Sears box to drive traffic; they had fewer marquis tenants joining the party to begin with. The bankruptcy will trigger co-tenancy breaches that allow piggyback retailers to terminate or restructure their leases. This is already taking place. I was recently on a call with six heads of real estate for national mall tenants. They all had a Sears or hybrid co-tenancy agreement written into their current lease. You can look North to Canada where GAP sued for (and won) the opportunity to renegotiate leasing after a Sears departure. Financially insecure B / C malls are hit both ways. (1) Tenants bargain down rates. They reset from high rents that were negotiated in better times for retail. (2) A coinciding loss of rent and CAM fees from the closing Sears stores.

My conversations with retail brokers suggest that department store backfills could take much longer than 36 months in the case of a liquidation — especially if a large chain other than Sears liquidated in the next 12 months. They’re quick to remind me of the financial troubles for JC Penney and Macy’s (look at their equity erasure and credit spreads). Tougher financing will stunt any store growth ambitions of competitors, and an existing glut of square footage will exacerbate downward pressure on tenant rents. Subdivision is a frequent topic of conversation… while JC Penney, Macy’s, Hudson’s Bay have declined, few large footprint retailers have emerged in their place to fill the demand for as-is Sears boxes. The truth is, A mall operators are licking their chops, waiting for these beleaguered chains to close. They have big plans for remodels and new concepts. B malls are not so fortunate, they have less liquidity to work with, and fewer repositioning options.

There is one bright spot I’ve come across: Warehouse clubs. Costco and BJs (recently public) are becoming more and more comfortable entering malls at massively discounted rents. Warehouse clubs (which I lump into off-price retail) have enjoyed gravity defying SSS comps in recent years. They are proven traffic drivers, and a great fit for department store backfill. I spoke with the head of real estate at a major club retailer, who is actively looking for space in B malls because the old Sears format fits their floor plan needs so well.

What’s unique about the Sears bankruptcy is the preferential status they received as an anchor tenant in previous decades. Sweetheart deals for anchor boxes locked them in at $5 per square foot rents at many malls, while comparable space leases for 3X to 10X above that on the open market. That’s an easy hurdle to clear when locating new tenants… if you can find them.

The press has pointed to repurposing opportunities as a way out for the weakest of malls. Medical centers, fitness centers, community colleges and residential building are potential white knights. Where we see the most opportunity is in class B+ malls that have strong rent rolls. If Sears (and possibly another large retailer) liquidate in the next year, cap rate expansion could become very appealing for yield-starved buyers in the 2020–2023 period, when we confront peak pessimism and a leveraged loan maturity wall. Our premise is that the menu of re-tenanting options is healthy for creative operators (I read of a very successful replacement of a Sears with Top Golf at a class B mall). Looking back to Kimco, they’ve achieved 2.11X across their re-tenanting of Sears locations, with more than a 7X effective rent increase on their most successful conversion.

Class-A malls could see a more immediate benefit of rent uplifts (the public equity markets seem to be buying this story today). Class C malls may never see the benefit of new tenants before running out of cash and financing. For the savvy, patient buyer, we believe that class-B mall property with good receipts will be available at a hefty discount in the next 36 months as the bottom of the market falls out.

New Regulation could Create a Buying Opportunity

The impending wave of mall tenant closures will kick off a series of tenant lease negotiations through the end of the decade. This is occurring at a most interesting time. Effective January 1, 2019, all commercial leases will be moved onto the corporate balance sheet for public companies. Credit agencies have claimed that this reclassification will not lead to a re-rating of corporate debt for retailers, but that doesn’t mean that banks or store chains won’t change their behaviors as a result.

Our thesis is that on-balance sheet leases will incentivize retailers to negotiate shorter leases. The rationale is that a shorter (lower $) lease is less of a liability on the balance sheet than a long one. This will appeal to creditors, underwriters, and potential buyers. It makes sense… in option theory, you command a premium when you afford yourself more flexibility.

As tenant renegotiations kick off, term will be a key subject of debate, not just rates, escalators, CAM, or % sales. This may lead to a very favorable condition for income investors looking to enter the market. For one, shorter leases mean less certain income streams. Not only will mall valuations trade off of lower income, but the shorter term agreements fundamentally change the market structure and should inflate cap rates (all else equal).

Here’s how it could play out

  1. In the event of more retail closures, class B / C cap rates would expand as investors stay out of the mall trade.
  2. The bottom of the market (C malls) will continue to wither away, especially in metros served by multiple malls. Consolidation will take hold and benefit survivors over time.
  3. It seems unlikely that deteriorating retailers will be able to push their maturity walls out much farther, leading to defaults by the early 2020s with limited opportunity to roll over bad debt.
  4. At the same time, any shortened lease impact would be an incremental kicker to cap rate expansion.
  5. Peak pessimism could create very appealing entries on property in good locations with strong repurposing potential.

Enter the Mutlifamily Investor

Despite the headlines, there is a robust market for B mall conversions today. Projects range from retail replacement to more creative strategies.

The average cost to develop multifamily is between $250 and $350 per square foot, depending on market and quality. Mall construction is up to 3 times as expensive on a square foot basis compared to a residential. At the highest level of analysis, partial mall to residential conversions can be done below retail replacement cost, and relieve store oversupply in appropriate markets. We’re seeing mixed use projects hit the market today, as well as full mall teardowns, replaced with single family developments.

We also ask: what is more volatile, housing rents, or retail rents? When you factor vacancy risk and sales volatility, we believe that housing is the safer bet today in terms of cash flow predictability across most US markets.

We’re watching a growing set of use cases convert malls to multifamily in markets with high hurdles for development. Here are a few case studies we can point to:

KIMCO approved to build 179 units in Daly City, CA. Seeking approval for 303 units to create mixed use center in Fremont, CA. KIMCO is seeking to capitalize on residential housing shortage in the bay area. Plans are in approval stage, and apartments will be positioned as up-market luxury.

Brookfiled plans to “Futureproof” roughly 100 GGP malls. Top management intends to turn these properties into mini-cities, with select redevelopment starting as early as 2019. We have yet to see the size and scope of these conversions, but they include multifamily replacement and development on property grounds.

Steiner is spending $500M to create new Columbus “Mall Town” concept.Columbus has lost three of its six malls in the past 20 years. Developer Yaromir Steiner is looking to develop 700+ apartment units, over 250k square feet of retail space, and 300k square feet of office, plus a new hotel at the 90 acre Easton Mall site.

These are merely a few of the many developments in progress around the country, where the largest operators are betting big on mixed use communities.

We are watching this transition closely, and evaluating similar opportunities for smaller syndicates in markets around the country.

To close, a look into the future

For the future of retail, look abroad to China. Their customer experience has leapfrogged American commerce in their gateway markets. Jack Ma (founder of Alibaba) has articulated a vision of the “New Retail” in China: a seamless mesh of product, distribution, services, and quality control.

Alibaba began as an online marketplace, where brands paid media dollars to promote their products. They’ve expanded rapidly into brick and mortar retail with a keystone acquisition of Hema supermarkets. A colleague of mine swears by the Hema shopping experience, which he describes as “10 years ahead of US retail”.

His classic example is ordering lobster, which you do in-store on your mobile phone. You pick your lobster and confirm payment instantly through your device. The listing describes the day your lobster was caught, the fisherman responsible for it, and the exact location it was brought above water. You have the choice to walk out of the store with the lobster, have it cooked for yourself while you continue shopping, or to have it delivered with other groceries at a time of your choice (down to the hour). There is no traditional checkout, and the information and flexibility at consumers’ fingertips is world class.

Ma has pushed the idea of life centers, which apply the “New Retail” concept to services. Life Center describes communities built around Hema stores (within a defined radius) will have every imaginable service available to them, conveniently available through the Alibaba / Hema platform. Examples include haircuts, childcare, home repairs, fitness, and a variety of other modern offerings.

As the mall is re-imagined, we are likely to see closely integrated housing stock within and surrounding surviving malls. It will be interesting to see who takes ownership of this concept: Real estate operators, retail conglomerates (like Amazon and Walmart), or new concierge businesses that are not in existence today.

As retail 1.0 sunsets, we’ll see the next era of the American mall emerge, which will require the work and creativity of opportunistic real estate professionals.