This week the retail real estate business faces a new reality: The proposed $17 billion (including debt) Federated/May merger, following the $11.6 billion deal to combine Kmart and Sears, 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 Lungren says his deal will reinvent the department stores around which malls evolved. (See following story.)

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 Sak's fighting for identities in a market where discounters and luxury chains are king.

Once, department stores were kings. Developers gave some rent-free space to lure shoppers into malls through their marketing efforts. Now, department stores are much less productive relative to inline stores. And, they still pay less rent.

"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. "It would differentiate the property and generate activity all day long. It's much easier to lease that. ... We're seeing some centers now built without department stores at all."

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 -- for them, nothing can save the department store. "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."

For now, the big REITs are lining up behind Lundgren and cheering him on. But you can be sure that each of them is redoubling efforts to plan for a world in which the role of department stores is vastly diminished -- or even nonexistent. Hence the increasing popularity of hybrid malls, combining big boxes, lifestyle centers and, sometimes even, malls and the incorporation of the large discounters into traditional mall settings.

Clearly, the vision of the regional mall as a vanilla shell with four department store anchors is becoming obsolete. Instead, the balance is shifting towards alternative anchors and design 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 pigeon-holed 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 that have done so much damage to department stores are showing up at the mall -- so developers can take back the cross-shoppers who have no trouble segueing from the Elizabeth Arden day spa to the discount store. Another part of the mix is non-traditional offbeat tenants such as Lucky Strike Lanes, a hip new 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."

Unplanned Obsolescence

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 in an interview at last month's ICSC conference on open-air centers. "Perhaps we should call them 'alls,' not 'malls,'" suggested Michael McCarty, president of the community centers division at Simon Property Group at the same meeting.

Some signs of these new times: Within the past month, 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, noting that even if some anchors are lost, centers will most likely be able to re-lease space to another store at a higher price or break up the buildings and generate more rent from inline stores.

"We feel that this merger is very good for the industry and especially for the consumer. We look forward to working closely with the combined new company in the coming months and years," said Simon Property Group in statement issued Monday.

"The only response we've had so far has been positive," said Federated CEO Terry Lundgren at a press conference in New York Monday. "They've supported consolidation in the past. They've been to able to change some dead anchor space into gross leasable area that works better for them."

That happy face may fade as the consummation of the Federated/May marriage (probably toward the end of the year) approaches and actual store closings are announced. Federated won't speculate on how many stores might close. But analysts put the figure at somewhere between 50 and 200. Overall 101 regional malls will have multiple anchors owned by the combined company, according to Key Bank Capital Markets. (See chart.)

Strong centers should have no problem filling the space. Older malls in secondary or tertiary markets may have a harder time, says Bernard Haddigan, director of the Marcus & Millichap Real Estate Investment Brokerage Co.'s national retail group.

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 since stopped depending too heavily on their department store tenants. On a per-square-foot basis, department stores nationally posted sales of $140 per square foot in 2004, according to the Urban Land Institute. Wal-Mart, on the other hand, posts $450 per square foot at its 200,000-square-foot super centers. The industry average for malls was $356 in 2004, according to ICSC.

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, department stores pay $3 per square foot or less.

A dark anchor may be a nuisance, but it also provides developers 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 non-traditional anchors at its 67 enclosed malls.

CBL still has eight Federated stores and 28 May stores in its portfolio, including the Monroeville Mall near Pittsburgh, where a (Federated) Lazarus and a (May) Kaufmann's cohabitate. "Federated and May department stores will continue to be a strong anchor and retail destination at our mall store properties," says Deborah Gibb, a spokeswoman for CBL. "We haven't been advised about the future of these anchors and it would inappropriate to speculate."

The Replacements

Meantime, the new anchors are learning to like life in the mall. About 25 percent of Dick's 240 stores in 33 states are now based in malls, says Jeffrey Hennion, senior vice president of strategic planning. "The mall locations have done generally well for us," says Hennion. "There is significant customer traffic in malls."

For regional malls to retain their dominance and prosper in a post-department store world will take more than a Dick's here and a Lucky Strike there. Increasingly, 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 Hechts to buy China or coffee pots. "Over the years, the mall shed 13 retail categories to big boxes. Mallgoers were pretty much down to gimmickry and fashion," said Stan Eichelbaum, president of research firm Marketing Developments Inc.

"The people putting up malls now are much more sophisticated as landlords than landlords 20 years back," says Gwen McKenzie, vice president of retail investment for Sperry Van Ness. "They are able to hire top-quality people to generate traffic. ... The leasing team does need to merchandise the center. Retailers know that too. That's why they are very big about only going next to certain people. Some retailers only want to be in the Nordstrom wing or the J.C. Penney wing."

To that end, mall companies have also tried to carve out identities for themselves and tried to brand their centers to build customer loyalty on that level. At the upper end, Bloomingdales, Nieman Marcus and Nordstrom have been successful. But mid-tier stores -- except for J.C. Penney--have struggled to create an identity. Lundgren unsurprisingly has described the merger as "reinventing" the department store and talked about the continued role department stores can play.

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

-- David Bodamer