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Shopping Centers Today -> June 2003
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DEFLATION HITS RETAILERS, MALLS
BY DONNA MITCHELL
Federal officials may have started voicing concerns about the possibility of deflation, but retailers have been grappling with the problem for the past three years.
Apparel prices fell 1.4 percent in March from the month before, according to the U.S. Bureau of Labor Statistics. Women’s outerwear and girls’ wear were hit even harder, dropping 5.2 percent over the same period. Last year the apparel sector overall declined 1.78 percent; it has fallen 7.67 percent over the past five years.
This certainly affects retail revenues, but it can hurt landlords too, given that most leases contain a percentage-rent clause by which a portion of the rent is set by sales.
“This is something that landlords are keenly aware of,” said John Kriz, managing director of real estate finance at Moody’s Investors Service. “This is an important issue for them.”
Indeed, percentage rents account for 2.4 percent of total rental income for mall REITs and 1.5 percent for strip center companies, according to Morgan Stanley. For Simon Property Group, for example, that amounts to $48 million in 2002, Morgan Stanley said.
Unless retailers can increase sales volume by, say, opening more stores, deflation will steadily decrease their profitability and overall financial health, says Kriz. Eventually, it could affect their ability to pay rent or open new stores.
Retail price deflation can be traced back to 1992, when the consumer price index (the cost of goods, minus food and energy) started to weaken across the entire economy, said Michael P. Niemira, a Bank of Tokyo-Mitsubishi retail analyst. With minor fluctuations, the CPI has declined steadily since then. Inflation across the U.S. economy was 3 percent in 1992; today it is 0.6 percent.
Deflationary pressures intensified for retailers about two years ago, observers say. For much of 2001 sales revenues slipped, prompting retailers to scale back excess inventory to levels they carried in 2000, says Dorothy Lakner, a retail analyst at CIBC Oppenheimer.
That cutback triggered excess supply at mills and factories in Asia, which then dropped their prices.
A strong U.S. dollar meant retailers could get even more for less from those Asian factories, which lowered retail prices even further, said Niemira.
For three years now, the cost of producing soft goods at factories has declined at a 6 to 8 percent rate per year, says Steven J. Feniger, CEO of Hong Kong-based Linmark, an intermediary between retailers and manufacturers.
Industry participants say the situation may intensify, especially after 2005. That is when the United States will begin cutting some import quotas and the duties on various categories of merchandise, explains Mark Minsky, senior vice president of ladies’ sportswear and men’s and children’s apparel at The Doneger Group, a New York City-based retail consulting firm. China, which recently joined the World Trade Organization, will be able to enjoy quota-free access to the U.S. market after 2005. To compete, vendors in Cambodia, the Philippines and other Southeast Asian countries are lowering prices.
Meanwhile, retailers themselves might be inadvertently contributing to deflation by buying their inventory eight times a year instead of four. They put in smaller, more-frequent orders, replacing end-of-season write-downs with an overall everyday low-price model.
Some of this is a response to another important event of the early 1990s: the rise of discount retailers. Wal-Mart, with its expertise in distribution, has been a stiff price competitor, prompting the industry as a whole to streamline inventory management and cut prices.
“There really was a structural change in the way that retailers did business,” Niemira said. “Through a combination of competition and the supply-side issues, retailers had better control over the costs of supplies.”
Falling prices resulted in one benefit for a significant number of retailers, however. “Retailers had been able to eke out gains in their profit margins, because they were getting better pricing from the manufacturers,” said Lakner.
Analysts are unsure when deflation will ease. Much depends on the performance of the dollar and the overall economy. If the dollar weakens overseas, especially in Asia, the cost of goods will increase. Additionally, economists forecast that U.S. GDP growth will reach 3.5 to 4 percent in the second half of 2003, which would be a big improvement over the 1.5 percent average over the past two quarters.
“As the economy starts to grow, you use more resources and it firms prices,” Niemira, said. “If there is activity, then there is less of a need to discount.”
Until then, retailers will have to boost sales and battle revenue erosion as best they can by opening more stores, introducing new categories of merchandise or raising the quality of what they already carry.
Putting even more pressure on retailers is the rising cost of worker’s compensation, which has skyrocketed in some states. In California alone the cost of coverage rose 41 percent in 2002 from the previous year. Issaquah, Wash.-based Costco Wholesale, which operates about 400 membership warehouse stores in 36 states and around the world, took a $26 million pretax charge on second-quarter 2003 operating results to cover increased worker’s comp costs.
“While the costs of workers’ compensation claims are on the rise everywhere, the trends in California have been most alarming,” the company wrote in the report, released in March.
California accounts for a third of Costco’s workforce of 26,000.
“Our worker’s comp in that state is equal to or greater than the other 35 states where we do business combined,” Jim Sinegal, Costco president and CEO told SCT.
That sort of thing jacks up the cost of doing business, while the sluggish economy prevents a retailer from raising prices on the consumer, Niemira says.
“Profit margins will narrow, given these factors,” he said. “And that is not a positive picture for the retailers this year. It paints a pessimistic outlook on the profit side, unless you get this miracle burst of demand from the consumer.”
To immunize themselves against deflation, landlords could tinker with the percentage rent margin, but there’s no sign of their doing so yet, observers say.
“I don’t see in our portfolio a material change in the ratio between percentage rent and base rent,” said Daniel Hurwitz, executive vice president of leasing and development at Developers Diversified Realty, Beachwood, Ohio. “Our percentage rent comprises less than 2 percent of our rental income.”
That leaves precious little recourse for them or any of their colleagues.
“There is not much [landlords] can do about it,” said Kriz. “This is just one more turn of the screw.”
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