Across the country, thousands of battered retailers emerging from the worst sales year on record are pleading with their landlords to throw them a lifeline in the form of rent relief.

Retail sales plunged 6.2% in 2009 from the previous year, the U.S. Commerce Department reports. That represents the greatest decline since the government began recording annual sales in 1992, and the figure eclipses the 0.5% drop in 2008.

From mom-and-pop sandwich shops to national furniture and apparel chains, retail tenants are facing financial crises that for some will be insurmountable. “It's going to be a tough year,” says Bernie Haddigan, head of the national retail group for real estate services firm Marcus & Millichap, based in Encino, Calif. “I think 2010 is going to test whether the strong will survive and the weak will perish.”

While sales sputtered amid a cascade of job losses, retailers got little help from banks, whose restrictive policies made it all but impossible for most firms to obtain loans in order to pay bills through the downturn. With no capital to keep them afloat, and as stores fell into distress and closed or downsized, the national vacancy rate at community and neighborhood shopping centers jumped to 10.8% in 2009 from 8.9% a year earlier, according to New York-based research firm Reis.

With few other options, distressed tenants turned to their landlords to negotiate lower rent or delayed payments. “They came to us in a deluge,” says Larry Casey, chief operating officer of Donahue Schriber, a privately held real estate investment trust (REIT) based in Costa Mesa, Calif. The REIT owns or operates 90 neighborhood and community shopping centers in California and other Western states.

“We're dealing with folks that are viable merchants who have run into some tough times,” Casey explains. “We're applying our resources to the tenant that we've been doing business with for a number of years. We've seen them be successful. They, like everybody else, are suffering right now.”

Retail sector slammed

Essentially, the tenants are asking the landlord to help them carry out their business plan by temporarily easing the financial burden, he says. “We're willing to help them until things turn around, and in some instances they'll pay us back and in some they won't.”

Requests for rent concessions soared in late 2008 and during the first four months of 2009, says Casey. Currently, about 5% of the company's tenants, 100 out of 2,000, receive some form of rent relief. The number of requests for help is higher than the amount granted, however. An estimated 10% to 15% of the REIT's tenants seek relief, the executive says.

In November, New York-based research firm Real Capital Analytics estimated that the amount of distressed commercial real estate properties in the U.S. had reached a record $180 billion. Of all commercial real estate sectors, retail was the hardest hit with $37.5 billion in troubled assets.

The problems were evident throughout 2009, as some 5,000 stores closed their doors nationwide. That number has yet to stabilize and is expected to climb this year. Apparel, furniture and jewelry stores are among those reporting lagging sales. Neighborhood centers anchored by grocery stores have fared better than those anchored by retailers dependent on discretionary spending.

Aid can boomerang

Rent relief has a domino effect. It means less income for the landlord at a time when many shopping center owners face financial crises as vacancies rise and revenue from rent drops.

Most landlords have an incentive to negotiate because when a retail space goes dark, it can become an eyesore, driving away customers and potentially triggering co-tenancy clauses in the leases of remaining stores. The co-tenancy provisions could give retailers an opportunity to vacate their space without financial penalty.

Landlords also are motivated to work with financially troubled tenants because the effort to find new tenants is costly and time-consuming. When a lease finally is executed, it can take up to eight months longer to obtain needed permits and renovate a building for the new occupant.

Tenant loss at a shopping center can extract a heavy financial toll and make rent relief for remaining businesses more cumbersome. “A lot of shopping center owners are in some form of receivership or a lockbox situation where the bank is taking the rent and has major decision powers, so a lot of decisions have to be deferred to the lender,” says Bill Bauman, executive vice president at Studley, a New York-based brokerage that offers tenant representation.

Some lenders cooperate in rent relief situations and some don't, says Bauman. When landlords do provide relief, it can take several forms, particularly lower rent in exchange for a percentage of sales. Typically, tenants request at least a 20% reduction in rent, and many ask for 50%. When full lease payments are deferred, the agreement is frequently for a six-to-12 month period of lower rent, after which the tenant resumes paying the contract amount.

Big name firms are among those asking landlords for relief. “Pier I Imports went and got quite a bit of rent concession,” says Bauman, an observation confirmed by other brokers. Pet supply stores have also sought rent relief, along with some office supply and sporting goods stores, he adds. Few retailers have remained unscathed by the economy.

Relief is not automatic

Landlords are selective in granting concessions. “The landlord needs to do their homework with respect to requests for rent relief,” says Casey. He believes rent relief should not be granted to tenants just as a matter of course.

His company created a checklist that starts with the tenant's first point of contact, generally the property manager, and includes decision-makers who evaluate the request to determine whether the tenant's claim of financial need is valid.

If a tenant is part of a larger company operating retail units in other locations, the REIT tries to determine whether healthier units could assist the tenant, explains Casey. “If one [unit] is profitable and yours is not, then certainly you would look to the other operation to support your facility and you would be less inclined to give rent relief.”

Because the REIT uses a sophisticated financial system in which tenants provide detailed monthly sales reports, it's hard to fool the landlord with an unmerited request for aid. “We can see their sales,” Casey points out. Genuine distress is obvious. “With most of the rent relief that has been granted, we knew as soon as the tenant knew that this person was going to have difficulty paying the contract rent because sales had declined.”

Some tenants are in such deep trouble that even a drastic rent reduction won't help. In that case, the tenant often reaches the conclusion long before the landlord does, that there's no point in battling on. Some entrepreneurs max out their credit cards and exhaust their personal savings trying to keep the business alive before finally throwing in the towel.

If negotiating fails

When negotiating doesn't work and a tenant abandons his lease, the penalties can be stiff. Faced with its own mounting bills, a landlord often decides to enforce the lease and require the departing tenant to pay the remaining balance. That, in turn, imposes greater hardship on the tenant, since leases commonly run three to five years for smaller spaces and up to 25 years for an anchor space.

At Donahue Schriber, where lease terms average three to seven years, if a tenant breaks the lease, the file is sent to the legal department and litigation could result, says Casey. The REIT currently has 25 active cases of litigation, a relatively small number given its 2,000 tenants. However, litigation is a last resort, adds Casey.

Because so many of its centers include supermarket tenants, Donahue Schriber has managed to weather the recession with fewer of the legal and financial traumas that other shopping center owners have suffered.

Last summer, the developer opened six Western shopping centers that had been in the pipeline for years. However, because of evaporating tenant demand, the REIT has no plan to accelerate projects currently undergoing entitlement. The strategy is to wait until a tenant signs a lease for an existing space before starting any construction, and no new building is under way on the ground.

Signs of life

With a wave of retail mortgage loans maturing over the next few years and borrowers largely unable to refinance, the level of retail distress could rise significantly. Securitized loans supported by retail properties that have been transferred to special servicing climbed to $23.9 billion in the fourth quarter, up from $22.01 billion in the previous quarter, says Victor Calanog, chief economist for Reis. That figure is “absolutely” likely to rise, he says. The research firm also projects negative effective rent growth for neighborhood and community centers, and a vacancy rate of 12.5% in 2011.

Still, some companies report encouraging news for landlords and tenants. Donahue Schriber is seeing upticks in occupancy. “I think [the market] is actually turning, and the distress isn't what it was at the end of '08 and the beginning of '09,” says Casey. In fact, some tenants are taking advantage of soft rents to negotiate their way from Class-C to Class-A shopping centers for the same cost, he reports. The move can bring the retailer a more vibrant merchandising mix and higher daily traffic.

Haddigan of Marcus & Millichap says retailers will continue to seek rent relief. “If you're Gap and you've got 1,000 locations out there and you're dealing with 50 different landlords, you can't overplay your hand on any one of those deals.”

The key to negotiation is leverage, says Haddigan, but with the downturn affecting both landlords and tenants, it's not always clear who has more clout. “It really becomes a game of poker.”

Denise Kalette is senior associate editor.

When should a retail landlord offer a struggling tenant a subsidy?

When a retail tenant says he can no longer afford the rent, there may be sound reasons for the landlord to offer a concession in the form of a capital subsidy. Indeed, many landlords offer financially distressed tenants the chance to defer lease payments in exchange for higher rent later on when the business recovers.

“We would give you some relief now and as times improve, we would seek to have deferred return in the form of higher than contract rent,” says Larry Casey, chief operating officer of Donahue Schriber, a privately held real estate investment trust (REIT) based in Costa Mesa, Calif. The REIT owns or operates 90 neighborhood and community shopping centers in California and other Western states.

However, when the tenant's circumstances turn more dire, Donahue Schriber may consider an outright subsidy. For instance, if the owner of a small business cannot envision his or her firm recovering from economic blows in time to fulfill his lease obligations and hang on during a downturn, it may make more sense to help the tenant financially so he can later become viable again.

Before making the decision, executives consult with the REIT's leasing experts, Casey says. “Is there a tenant waiting to replace someone who wants rent relief?” The decision-makers also examine market conditions to determine rent and vacancy trends, among other information.

If a decision is made to grant rent relief, whether in the form of a subsidy or lower lease payments, top executives are required to sign off on the plan, including the executive vice president.

“Each case is evaluated separately,” says Casey. “In many cases the rent relief is for a short period of time. It's not given out in years, it's given out in months. It may also be tied to a term that is coming due.”

When an outright subsidy is granted, it is generally with the provision that if the retailer's sales improve, it will provide a percentage of the sales to the landlord until the company can return to paying the contract rent amount. “So the subsidy isn't open-ended, it's based on what they do with respect to sales,” says Casey.

Taking that approach changes the landlord-tenant relationship and makes it more of a partnership, says Casey. “From our perspective we have become their partner because we are essentially providing them the working capital to stay open while the economy suffers through this recession.”
— Denise Kalette