Recent global headlines have again raised concerns over the state of troubled department stores as the month saw Sears Holdings file for Chapter 11 bankruptcy in the U.S., while Debenhams reported intentions to close a third of their stores in the U.K. We therefore thought it would be interesting to look further into the department store model, the impact of these brick-and-mortar closures on the listed real estate landlords and some of the likely differences across geographies.
The struggling department store is by no means a new concept. Traditional department stores have been losing market share to other retailers and retail channels for some years now, including discount/off-price retailers; mass merchants such as Walmart, and of course to e-commerce. However, department stores have generally been slow to adopt online channels, invest the capital expenditure required into their stores, or have been hesitant to reduce their footprint via store closures.
Department store anchors are no longer the major traffic drivers of shopping centres, although it is not unusual to have 4 to 5 anchors per centre, particularly in the U.S. Their historic bargaining power allowed them to strike long term leases at low rental levels and has resulted in these anchors taking up a significant percentage of shopping centre space, while only contributing fractionally to the overall rent roll. In the U.S. it has been estimated that anchors are around 10% of net operating income, yet account for around 50% of Gross Lettable Area (GLA). This fact brings opportunity for landlords who are able to fill the space with new and more relevant tenants at levels closer to market rents.
The impact of an anchor closing on a shopping centre or mall will vary depending on a few factors, including but not limited to 1.) How the anchor drives traffic to the overall centre;
2.) How the closing of the anchor will impact the leasing of the surrounding line-shops (who generally pay significantly higher rents per square foot); 3.) If there are any co-tenancy lease provisions (that allow tenants to terminate their leases or pay less rent should an anchor vacate the centre); 4.) How the anchor impacts the financing of the centre since anchor stability is a primary determinant of mall financing; and 5.) The size of the anchor and vacant space required to be let.
The ability to fill the empty anchor space is imperative for defending a mall’s overall value. Lower quality, poorer located centres are most at risk and in the current retail environment will struggle to re-tenant the vacancy, magnified by the effect of losing in-line stores over time through co-tenancy clauses and diminishing foot traffic. High-productivity, high quality landlords, such as Simon Property Group (Ticker: SPG), have proven their ability to re-fill, re-purpose and re-position vacant anchor space with ‘modern’ tenants such as movie theatres, restaurants and new concept/flagship stores at much higher rental levels, thereby improving overall asset values.
Two concerns for landlords over the nearer term are a supply uptick and an increase in capital expenditure. Short term supply dynamics will be negatively impacted depending on the magnitude of these store closures going forward. The greater the number of closings over a shorter period, the higher the overall bargaining power of tenants will be, which will limit the ability of landlords to charge higher rents. Vacancy should also tick up over the short term. Capital spending for landlords is also set to increase over the nearer term as space is re-tenanted in an environment where the balance of power is in the hands of the retailer, meaning an increase in tenant incentives and allowances.
Landlords with poor quality retail assets or a poor cost of capital could potentially find themselves owning dead malls in a few years. Over the longer term, high quality mall landlords could become winners as low-quality malls close and retailer demand for space and consumer spend is redirected to better quality retail locations.
The Sears Chapter 11 (i.e. company restructuring) filing appeared to be largely anticipated by the market in terms of REIT pricing, given the outdated department store model and large number of stores, coupled with high company debt. The company plans to close 142 (77 Sears and 65 Kmart) locations by the end of 2018, in addition to the 48 store closures previously announced and due for completion by November.
The Sears store closings will primarily impact the REIT mall landlords, while the Kmart closings are predominantly stand-alone retail locations across the U.S.
Who owns the Sears boxes will impact the outcome of this process as it may be the case that the adjacent box is not owned by the mall landlord. It is preferable for the landlords to own the boxes as space will simply be returned to them and be available relatively quicker for re-let initiatives. If the box is not owned by the landlord, the space will go to the higher bidder, which may or may not be the adjacent REIT landlord. The final owner of the space may be a competitor or a tenant that is not optimal for the overall tenant mix of the centre, and therefore may impact the long-term viability of the asset. The REIT landlords will likely bid for boxes with the highest redevelopment opportunity.
Chapter 11 also allows for the sale of existing leases. This would be a viable way to monetize existing long-term leases that are significantly below market rental levels. Landlords would largely be unable to control the replacement tenant in this case, although this avenue would benefit occupancy levels. Shorter term leases or leases above market rental levels would command less value. Sears has requested to reject 220 unexpired leases that are mostly related to dark stores where operations have already been shut down, remaining lease terms are short, and rental levels are relatively higher. Chapter 11 allows Sears to expediate this process.
Across the pond in the U.K. Debenhams is planning to close 50 underperforming stores of its 165-store portfolio over the next 3 to 5 years. Unlike the general case in the U.S., the Debenhams CEO has commented that two-thirds of the portfolio is in fact over-rented (i.e. the rent paid per the lease is above current market rents), which does not bode well for landlords needing to re-let the space. High quality landlords, such as the listed U.K. retail landlords, generally have better performing stores and will be less directly impacted by these closures. House of Fraser is set to close half of its 59 stores and while none of the closing stores are owned by the U.K. REITs, the numerous retailer closings across the U.K. will continue to put pressure on rents as retailers rationalize their store counts.
CVAs (Company Voluntary Arrangements) also appear to be on the rise in the U.K. with retailers such as Homebase, Gourmet Burger, and New Look making applications. A CVA is a legally binding arrangement between a struggling company and its creditors, including landlords, to pay a certain percentage on the pound and is a popular insolvency procedure in the U.K. 75% of creditors by value must vote in favor of the CVA, but once approved, is binding on all creditors irrespective of value owed. The eventual outcome may or may not benefit the landlord in terms of the amount of rent ultimately received from the tenant in question.
Intu (Ticker: INTU LN) currently has 3% of its rent roll due from tenants under CVA or administration, while Hammerson (Ticker: HMSO LN) has around 2% of passing rent due and recently admitted to an accelerating rate of CVAs.
In conclusion, there is likely too much department store space across the globe and the space required from these retailers will shrink over time. The magnitude and rate of closures will impact short term fundamentals as landlords deal with the vacancies and re-tenanting the space. Our thesis is that better quality retail locations and management teams will fare best, with poorer quality retail destinations ultimately becoming irrelevant over time as ecommerce continues to capture market share. Based on current fundamentals we prefer high-quality landlords in the U.S. versus the U.K.