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Shopping Centers Today -> May 2001
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LINE OF VALUE: A FORMULA FOR LEASING SUCCESS
By Charles Aug
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After a five-year period of unprecedented growth and high activity in retail markets nationwide, many businesses today are ill-prepared for an economic slowdown or correction. It is no secret that the economy is softening, but there are differing opinions as to how great the effect will be on retail.
This past holiday season was probably the first red flag, and there have been previous indications dating as far back as the last two years. In particular, Christmas 2000 showed a flattening in the higher end, but the season was disappointing for retailers in most market segments.
Therefore, it is important to address ways in which landlords and retailers can mitigate the damage of a softening economy by assessing what may be considered affordable rents for the long run, whether in a mall or a shopping district on a city street. But first, landlords need to understand where retail rents come from and, equally important, retailers must comprehend how much revenue intake is needed to maintain a store’s viability, let alone its profitability. Although there are several ways in which to discern the appropriate amount of rent for a given business, there is a standard “line of value” for retail space that determines a business’s profitability.
As many are aware, the value of a space is predicated on how much product or services are sold per square foot. A surge in sales, or a hyperactive market such as the one we have enjoyed for the past several years, may justify a rent hike. Of course, the opposite holds true, too.
For example, if a merchant with a 2,000-square-foot store sells $600 of product per square foot per year, then an affordable rent would range between $120,000 and $140,000 per year, or 10% to 12% of gross sales. The golden standard is 10% to 12% of the gross.
When landlords understand where rents come from, then applying a percentage of the sales volume per square foot helps to determine the right kind of tenant for the space in terms of product and demographic. It also contributes to a stable tenancy and a more profitable relationship between tenant and landlord.
Also, depending upon the demographics and location, many landlords reasonably opt for a low base rent with built-in percentage escalations relative to sales activity. This type of leasing is most common for retailers in shopping centers, and has the advantage of protecting both the landlord and retailer. Everyone, including the landlord, makes more money in good times, and the parties are better protected in slower times.
Advantages
of sales-based leases
Since
the duration of most retail leases cover fluctuations in economic
cycles, leases that escalate by sales activity make a great deal
of sense.
By exercising a flexible model, we can maintain our businesses. These are measures that landlords can take to diminish the loss of tenants and, thereby, maintain the solidity of the shopping areas. Everyone, in turn, benefits from the maintenance of the shopping centers, not only the landlord and the retailer, but also the consumer and the community. A sure sign of a distressed area is empty storefronts, which can have a negative impact upon the values of residential property, as well as office and other commercial property in the area.
Many store leases in shopping centers build in the escalations to closely reflect sales volumes, ranging in increases of 3% to 10%. The guaranteed escalations take into account economic changes, thereby buffering the tenants from unrealistic increases, while protecting the landlord.
Current supply and demand has resulted in extremely high rents. In New York City, especially, these rates have been exacerbated by a particularly limited amount of available space. But the fact is, supply and demand establishes rent values, even if unrealistic in terms of the line of value formula comprising 10% to 12% of gross sales.
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So here we are once again, approaching economic turbulence, only this time precipitated by massive layoffs in the dotcom new media categories, which in turn has already begun affecting office markets, housing markets and, to a lesser extent, retail. One chain, Bradlees, has closed and others such as Gap and Lechters Housewares are reducing the number of stores across the country.
Historically, however, layoffs have led to more competition in pricing retail space.
Economic cycles are inevitable, but the best way for landlords to protect themselves and their tenants is to adhere to a guideline based upon the volume of goods or services sold per square foot in the store.
It is almost an unfortunate byproduct of the good times that retail rents are determined by location, volume of traffic and availability of space, rather than practical dynamics.
Every industry has available data that can help the store owner determine potential sales volume in a given location. But sales volumes fluctuate with changing economic conditions.
Current market research indicates that consumers are making more conservative purchases, which was not the case just three years ago when computers were flying off shelves, cars were being traded annually, and a host of such expensive electronics as DVD players and entertainment systems were becoming household staples.
Looking
to line of value
For
the next cycle, depending on such other influences as interest rates
and tax cuts, it appears we will be slowing down, although a true
recession is not indicated. So reiterating the concept that keeps
businesses afloat, a retailer must assess the potential “line
of value” before leasing a space. And the landlord, in order
to assure a long-term profitability, must also use this guideline
as the foundation for determining the asking rate.
The reality of the next few months may not be optimal, but it doesn’t have to be desperate either. For 25 years, Garrick-Aug has been focusing exclusively on retail leasing, and we have survived three recessions (five in my professional life) and watched many retailers continue to flourish for decades.
But it is knowing how to assess the “line of value” that is the key to maintaining a business through all economic cycles.
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