Circuit City’s decision last week to cancel a planned auction of 154 leases due to lack of bidders could be another troublesome milestone for the rapidly deteriorating retail real estate industry. The market for excess space, once seen as a potential bright spot amid troubles in the sector, may already be becoming oversaturated.

The Richmond, Va.-based retailer, which filed for Chapter 11 bankruptcy protection on Nov. 10, instead signaled it may break the leases on 155 stores in all, representing 22 percent of the 715 domestic locations the chain operated as of Nov. 30. (One lease was not part of the planned auction). The portfolio of Circuit City stores slated for closure includes both stand-alone and in-line locations ranging in size from 15,280 square feet to 67,680 square feet, in 28 states with a large concentration of properties in Arizona, California and Georgia.

The auction had been slated for Dec. 18, but the company canceled the auction on the night before, after bankruptcy administrators informed it that there was not enough interest in the leases. Circuit City did not return calls for comment.

But the issue is much bigger than Circuit City’s leases. Many retailers are suffering sales declines, closing stores and slowing the pace of expansion. That’s creating a lot of excess space along with a shortage of potential replacements. While some segments of the retail industry are still growing—most notably discounters and grocers—there isn’t enough overall demand to absorb the space that’s coming to the market right now; especially in the mid-size big boxes Circuit City inhabits, notes Andy Graiser, co-president of DJM Realty, a Melville, N.Y.-based real estate disposition and restructuring firm that is handling Circuit City’s portfolio. As a result, failed auctions of excess retail space could become a common occurrence next year, according to Graiser.

“I think you just have to assume in most cases that if leases become available, it’s going to be a very, very, very dormant market,” says Graiser. “Which means landlords will have a lot of surplus for a while. It’s going to take a while to fill that space.”

This year, U.S. retailers have already announced 8,117 store closings, according to J.P. Morgan. In 2009, there could be twice as many store closings, according to Excess Space Retail Services, Inc, a Huntington Beach, Calif.-based real estate disposition and restructuring firm. (See “Store Closings Could Double in 2009.”

One of the issues that will affect the success of excess space auctions will be the rents the retailer vacating the space is paying. In Circuit City’s case, the chain was paying market rates, which in the current environment seem inflated, says Graiser. By year-end, retail rents nationally will have declined 3.6 percent from the same period in 2007, cites Property & Portfolio Research (PPR), a Boston-based real estate research and portfolio strategy firm. The fall will likely continue into 2009, when rents could drop an additional 5.6 percent, according to PPR. And, the firm predicts vacancies will rise to 17.3 percent. Its projections are culled from data for retail properties of all formats greater than 30,000 square feet in size across 54 markets in the United States.

The upshot of all this is that as retailers vacate space, much of it will revert back to landlords. In the past, many “fought like heck to get back their spaces,” says Matthew Bordwin, managing director and national co-head of the real estate services team in the Melville, N.Y. office of KPMG Corporate Finance LLC, a middle-market investment bank. “But in this market, a bad retail location is like a hot potato. Everybody says ‘You take it’ and nobody wants it.” In essence, the market has turned the typical situation on its head. When retailers shut stores in a booming market, they battled with landlords for control over the vacant space. Landlords could potentially re-lease the space at a higher rent. Meanwhile, for the retailer subleasing or selling vacant real estate could generate some ancillary income. Today, however, neither party seems to wants to deal with excess space.

As a result, landlords would be well-advised to hold onto existing tenants for as long as possible, says Al Williams, principal with Excess Space Retail Services. To help struggling tenants survive and prevent a rise in vacancies at their centers, landlords have already become much more open to granting rent concessions and modifying lease terms, note both Williams and Graiser.

Although getting rid of excess space has become increasingly difficult, some transactions are still closing. On Dec. 11, for example, department store operator Kohl’s Corp. and discount apparel seller Forever 21 joined forces to purchase 46 leases from department store chain Mervyns through a bankruptcy auction for approximately $6.3 million. Most of the leases averaged 80,000 square feet and had 20-year terms. However, unlike Circuit City’s leases, Mervyns’ featured rents that, in many cases, were one-fourth or one-fifth of the rates in their respective markets, says Graiser, whose firm advised Mervyns and Kohl’s in the transaction.

Mervyns still has more than 100 leases it needs to either sell or break. Additional bankruptcy auctions might help the chain find takers for some of those spaces, Bordwin says. But, he adds, the majority of them could go back to Mervyns’ landlords.

--Elaine Misonzhnik