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Mall REITs now push for higher fixed minimums

By Dave Bodamer

While sluggish retail sales in 2000 were alarming to shopping center owners, the slowdown did not appreciably affect REIT earnings for the year, underscoring an industry trend that has been building slowly over the past several years: Mall owners are deriving less and less rental revenue from percentage rent.

Lower percentage rent revenue from a drop in retail sales caused only a 1- or 2-cent-per-share decline in funds from operations (FFO) for the year, according to annual results released by the mall REITs in February. The reason for the relatively minor impact is that the ratio of percentage rent to total rental revenue has been falling for years.

For example, Simon Property Group’s percentage rent revenue declined last year by $5.6 million, to $56.4 million, but its base rent revenue rose by $100 million, from $1.1 billion to $1.2 billion. Overall, percentage rent represented just 4.39% of Simon’s total rental revenue, down from 5.05% in 1999. General Growth Properties (GGP) reported a slight rise in percentage rent, from $34 million in 1999 to $37 million in 2000, but as a percentage of overall rent, the total fell from 6.07% in 1999 to 5.46% last year. The breakdown for the two largest regional mall REITs mirrored the industry as a whole (see table).

The numbers reflect a historic shift in mall industry economics over the past 20 years. In 1984, percentage — also known as overage — rent represented 15.5% of total rental revenue for regional malls, according to the Urban Land Institute. By 1992 the ratio was down to 10.6%, and in 1998 the figure was 5.2%.

Exploring alternatives

As the importance of percentage rent continues to decline, landlords are now using other methods to extract value from tenants when renewing or re-leasing space. Those methods include tying rental increases to the Consumer Price Index (CPI), implementing fixed-percentage increases or aggressively renegotiating leases to raise minimum rents by 10% or more.

“I know in our case virtually all of our retailers, maybe with the exception of banks, have a percentage rent component. That’s the way it’s always been,” said Robert Michaels, GGP’s president and COO. “But the difference is that as minimum rents have increased, the level at which percentage rents apply has increased as well. What we’re trying to do is push the percentage rents we’ve collected in years past into fixed minimum rent.”

This has happened across the industry. Although the majority of leases negotiated today do include percentage rent provisions, the level at which they apply has been set higher, and there have been steady annual increases in base rent levels, making overage less relevant in most deals. Only in exceptional cases today do retailers even hit sales levels high enough to activate percentage rent.

The benefit from this shift, obviously, is that it gives the owner a better ability to manage its cash flow. It also protects REITs and other landlords from being hurt if retail sales slow.

Percentage rent is such a small part of Simon’s revenue now that the dip in retail sales last year really did not have an adverse impact on the company’s balance sheet or hurt its FFO numbers for the year, the REIT’s CFO, Steven Sterrett said.

“In a little more robust sales environment we might have expected [percentage rents] to be up,” Sterrett said. “Part of that was that our ratio of percentage rents came down a bit, and the spreads went up. It’s hard to quantify between the two.”

Overage rent is even less of a factor in community centers. For example, Pan Pacific Retail Properties, Vista, Calif., derives only 1 or 2 cents per share of its FFO from percentage rent each year, according to CEO Stuart Tanz.

“Within the strip center companies, we basically don’t look at percentage rent at all,” Tanz said. “If sales weaken, we don’t feel it as much.”

Part of the reason that percentage rent has taken on less importance in the industry is due to a general maturation of the tenant/owner relationship. For example, in a first lease an owner and tenant might have agreed to $100,000 as base rent with stipulations that once sales figures at the store reached a certain figure, the owner would begin collecting a percentage — usually in the neighborhood of 5% — of sales. If that deal resulted in $50,000 in percentage rent revenue, owners would negotiate for subsequent leases to have a base rent of $150,000 before percentage rent kicked in.

Macerich tries tying rents to CPI

Moreover, in some past leases there were triggers to raise base rents once certain sales levels were reached, meaning fixed rent would rise automatically during the life of the lease.

Some leases include annual increases based on a fixed percentage or a flat rise. But now some owners are pushing to use the CPI instead. While every REIT is experimenting with this to varying degrees, one in particular, The Macerich Co., Santa Monica, Calif., is now attempting to structure all of its leases with annual bumps tied to CPI.

“CPI gives us an appropriate starting point and it states our growth accurately each year,” said Macerich Co. COO David Contis.

Using the CPI makes sense for several reasons. For one, it ties rent increases directly to inflation, which both property owners and retailers agree is a fair guide. It also eliminates the accounting tool of straight-lining that most owners and retailers use, which misrepresents rent revenue on balance sheets. Straight-lining means that if a lease is signed for 10 years, with rent rising at a fixed rate starting at $22 per square foot and ending at $32 per square foot with $1 annual increases, the rent is recorded on the balance sheet as $26 in each of the 10 years.

For owners, that means some rents are being overstated in the early years of a lease and understated in later years, while retailers are overstating costs in the early years of the lease and understating them in later years.

“We’re recording the real economic growth and avoiding the fiction of straight-lining. It makes sense for a lot of people,” Contis said.

Macerich has made a conscious effort to make its new leases and renegotiations contingent upon CPI. Contis estimates that 80% to 90% of its deals annually now fit this model.

Industry analysts said that other REITs could follow Macerich’s lead or look to other methods to generate increased rental revenues.

“Mall REITs may continue to attempt to structure new leases with annual rate increases tied to inflation measures such as the Consumer Price Index. This would allow the REIT to avoid having to straight-line rental revenues over the life of the leases,” said Ross Nussbaum, a REIT analyst with Salomon Smith Barney, New York City. “We may see mall REITs continue to attempt to structure new leases with a higher fixed base rental rate and a lower percentage rate component.”.

While it is too early to tell whether this is a shift that will be widely accepted by retailers, Nussbaum said the changes would be positive for shopping center REITs because it would eliminate some of the volatility in earnings caused by fluctuations in retail sales.

David Jacobstein, president and COO of Developers Diversified Realty Corp. (DDR), Cleveland, Ohio, said that some of the leases in his company’s portfolio include tenant options that factor in rent increases tied to CPI when leases are renewed. Those options, however, are usually only given to big-box retailers. For other leases DDR renegotiates and is able to increase base rents at close to 20% over previous deals.

Ultimately, a mall needs strong tenants and strong sales if it is going to be successful. The use of sales per square foot as the industry standard of success testifies to that. But the reality is that from a revenue standpoint, negotiating smart leases that do not rely on a variable percentage rent component makes more sense for a mall owner.

“If you’re collecting percentage rents early in a deal, that means you did not negotiate minimum rents well,” Contis said. “Percentage rents just are not a big part of our portfolio.”

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