In March, the retail real estate business faced a new reality: The proposed $17 billion (including debt) Federated/May merger, following the $11.6 billion deal to combine Kmart and Sears, which closed late that month, makes it clear that 40 years of conventional wisdom is under revision. This, of course, isn't the first inkling — the changes in retailing that have made department stores so vulnerable have been obvious for at least a decade. But it is still a stunning moment.

The new reality is that the traditional regional mall, the dominant product of the retail real estate industry, needs rethinking — just as Federated CEO Terry Lundgren says his deal will reinvent the department stores around which malls evolved.

The key reason: The department store sector has lost its pull. Coming months will likely bring more mergers for smaller chains, such as Dillard's and Saks, fighting for identities in a market where discounters and luxury chains are king. Meanwhile, Neiman Marcus is entertaining various alternatives with French luxury retailer LVMH mentioned as a possible suitor.

Once, department stores were kings. Now, department stores are much less productive relative to inline stores. The number of chains has also dwindled. In 1989 there were 59 chains that accounted for 6.6 percent of non-auto retail sales. At the end of 2004 there were just 18 and they accounted for 4.8 percent of sales. On a per-square-foot basis, department stores nationally posted sales of $140 per square foot in 2004, according to the Urban Land Institute. The industry average for malls was $356 in 2004, according to ICSC.

“I would bet that if you asked a mall owner today whether they'd want to do a department store or bring something in like American Girl, they would want to do the latter,” says Anthony Buono, managing director for national retail services with CB Richard Ellis Inc.

Putting Lipstick on a Pig

While Lundgren and his team try to reinvent the department store, mall developers are not likely to sit back and wait to see if their efforts will reverse a 30-year slide. Some retail experts are already dismissing the effort as too little, too late. “The merger craze of mega-sized retailers is a short-term defensive strategy rather than a long-term strategy,” says Milton Pedraza, CEO of The Luxury Institute. “There may be some economies of scale achieved, but this is putting lipstick on a pig. It doesn't deal with the most important component: the customer.”

Clearly, the vision of the regional mall as a vanilla shell with four department store anchors is becoming obsolete. Instead, the balance is shifting toward alternative anchors and designs that turn the enclosed mall inside-out. According to Friedman, Billings, Ramsey REIT analyst Paul Morgan, just three of the 37 major mall projects opening in 2004 and 2005 are traditional, enclosed regional malls. The rest are lifestyle, hybrid or mixed-use projects. And retailers can no longer be pigeonholed by the type of project they inhabit. Department store chains, notably Sears, are pushing off-the-mall concepts for both lifestyle centers and standalone sites. At the same time, the Wal-Marts and Targets are showing up at the mall. Another part of the mix is offbeat tenants such as Lucky Strike Lanes, a hip bowling alley concept.

“No longer can you look at a tenant and say, ‘That's someone that goes into a mall,’” says Gwen MacKenzie, vice president of retail investment for Sperry Van Ness. “All retailers and landlords are playing. There's a lot of blurring going on.”

That's becoming a common refrain — and it extends beyond developers of regional malls. “Every type of traditional center is obsolete,” said Terry Brown, CEO of Edens & Avant says.

Some signs of these new times: Within the past few months, The Mall of America unveiled plans to double in size — with more than half that space slated for entertainment, not retail. The most ambitious project in the works is Mills Corp.'s 5-million-square-foot Meadowlands Xanadu, which will have only about 1 million square feet devoted to traditional retail.

While they are pouring investment dollars into these new hybrids, mall developers are saying nothing publicly about the health of their core products: those 30-year-old enclosed malls. And, they are publicly upbeat about the Federated/May deal.

“The only response we've had so far has been positive,” says Federated CEO Terry Lundgren. “They've supported consolidation in the past. They've been able to change some dead anchor space into gross leasable area that works better for them.”

Perhaps one reason developers aren't sweating about this phase of the department store consolidation is that they have already absorbed so many shocks — from Montgomery Ward to Kmart — and have long stopped depending too heavily on their department store tenants. Moreover, because the mall industry originally flowed out of the department store sector, most of the older chains enjoy sweetheart deals, paying little to no rent or owning their space outright. According to Richard Latella, senior managing director with Cushman & Wakefield Inc.'s retail division, many department stores pay $3 per square foot or less.

The Replacements

A dark anchor may be a nuisance, but it also provides developers with an opportunity to chop the space into smaller spaces and/or fill them with big-box stores, such as Dick's Sporting Goods and Bed Bath & Beyond, that generate higher sales and pay higher rents. Generally, big boxes pay more than $20 per square foot while inline tenants play more than $30 per square foot.

Some developers have already made big strides toward a post-department store future. Chattanooga, Tenn.-based CBL & Associates Inc., for example, has been moving away from department store anchors for several years. Its new anchors are Linens ‘n’ Things, Barnes & Noble, Dick's Sporting Goods and Steve & Barry's. CBL has 22 nontraditional anchors at its 67 enclosed malls.

For regional malls to retain their dominance, it will be up to developers to create the merchandising excitement for which the merchant princes of the department store era were famous. As department stores retreated from specialized competitors and discounters, and reduced their stock to cosmetics and apparel, malls lost shoppers that used to go to Hecht's to buy china or coffee pots.

“The people putting up malls now are much more sophisticated as landlords than landlords 20 years back,” says McKenzie. “They are able to hire top-quality people to generate traffic. … The leasing team does need to merchandise the center.”

Maybe going forward, developers will create malls that are the end-all, be-all that department stores used to be. You could have breakfast, buy furniture, have your hair done, get some lunch and pick up sewing supplies and a new hat.