By Merrie S. Frankel

Consumers are "shopped out," with closets full of clothes, countless electronic gadgets, and a new SUV in the garage. These factors combined with high energy prices, substantial consumer debt, a volatile stock market, and employment worries are crimping the retail sector—impacting both retailers and their landlords alike. Consumer confidence, as quoted by the Conference Board's Consumer Confidence Index, a forecaster of discretionary spending, has declined for the past six months. Simply put, consumer confidence and spending have weakened, as evidenced by disappointing same-store sales in the Department of Commerce Retail Spending Report data: March 2001 retail sales (excluding autos) fell 0.2 percent from March 2000.

However, not all regional malls are alike. It is imperative to make distinctions today in credit judgments between retail property owners. We are particularly worried about malls that are not leaders in their markets. It will be tough sledding for the owners of the lagging malls in submarkets. Thus, we expect a widening of the gap between the good and the not-so-good.

The Trouble with Anchors

Malls have traditionally been anchored by two to six anchor tenants—typically major department stores. These anchors have been key draws for consumers. However, several anchors have been running into difficulty, often severe. For example, in the past year Montgomery Ward, a traditional anchor, and Bradlees have both announced liquidations. J.C. Penney, Sears and Federated (Stern's) have announced store closures. Even Nordstrom is becoming more cautious. Although these anchors are liable for the rents for the remainder of the lease terms, a dark anchor tenant is a distinct negative draw for customers, hurts sales at the in-line, smaller stores that generate most of the rent for mall owners and casts a pall (both economically and figuratively) over the entire mall. Even if the anchors stay, they are often finding it tough.

In these more difficult retailing times, anchors will stay put in the malls that work for them and cut back in the malls that do not suffice due to geographic positioning and demographic statistics. The same holds true for line tenants such as the Limited, Borders, Ames, and Lechters, which recently announced closings. Therefore, the weaker malls will find their positions especially challenged as retailers re-evaluate where to cut and where to invest.

Anchorless Malls?

There has been talk of a newer format—the anchorless mall—often in regional malls that are tenanted in cluster formats by big box or category-killer stores, or even by some of the more prominent line stores. Traditional anchors would not be required. We are skeptical of whether such a format will work in most cases. Such merchandising is not what most consumers seek when they go to a mall. Typically, clusters of big box and category killers tend to be in power centers, or in stand-alone formats, which have worked for them. Shopping patterns at such "big box" stores are much different from those at mall stores. For example, shoppers at big box retailers tend to return to their cars with their (often bulky) purchases, and drive to the next big box at the same center. That talk of anchorless malls is occurring indicates the depth of concern some landlords have about anchors' situations, and the various options they are exploring to address it.

Development Pipelines a Growing Concern

Development poses obvious risks in a softer retail environment. Development exposes REITs and REOCs to cash outflows without inflow and potential interest rate risk, plus the usual risks of problems with contractors and construction delays. Our primary concern at this juncture is the challenge of leasing the space, and the rents that can be obtained.

Cautious landlords are taking steps to address the leasing risk. One is to demand high levels of pre-leasing of both anchors and line tenants. This presupposes, however, that those tenants will be in good shape when the time comes to occupy the space and avoid further anchor consolidations and closings.

In addition, as leases are negotiated with new and current tenants, mall owners are hedging their cash flows by depending less on percentage rent and invoking other methods to extract value from tenants renewing or releasing space—such as tying rental increases to the Consumer Price Index (CPI), implementing fixed-percentage increases, or raising minimum rents to encompass the percentage rent amount. Consequently, as minimum rents increase, the level at which percentage rents apply has increased as well. This shift has provided mall owners with better management of cash flows and protection against downturns in retail sales. Clearly, the stronger landlords have more negotiating power.

Some landlords are also entering joint ventures with partners to help them spread the risk. This choice, however, creates the challenge of managing the partnership, the loss of control one has when one owns the property outright, and unwinding the partnership at some point. Furthermore, most of these joint ventures are highly levered with secured debt, which puts pressure on the ratings of the real estate companies involved. While such actions help attenuate risk, this may not be the best time for development.

Heightened Need to Remerchandise

Retail is a fashion business. Themes changes, concepts wear out, consumers seek something new. As the place where this happens, malls need to stay fresh too. This means not only being able to identify and make shifts in the nature and mix of tenants required for a successful mall, but altering the physical formats of the mall as well. The growth of cinemas, theme restaurants and other entertainment formats in malls are examples. Line tenants also demand wider storefronts and disdain the older "bowling alley" shapes of retail space. Consequently, the new malls being built are often larger than those constructed in past years in order to accommodate this remerchandising and the growing diversity of tenant needs.

The bottom line is that mall owners need outstanding leasing skills and excellent relationships with retailers if they are to prosper—or even hold their own. Furthermore, good landlords must have the ability to reposition, reformat and retrofit their malls assertively. Not all mall owners have these skills, and the better owners—the ones that can successfully coordinate this—should find themselves pulling ahead of the pack. Regional malls are "high-touch" assets, which are supported by the REIT format, with its dedicated management and the capacity to build strong, permanent infrastructures. Malls that are "solo" malls and ones managed by third parties, despite their managers' skills, may not be as well positioned as REITs in their corporatized forms.