The headlines have been full of companies making announcements about store closings. A July report from ICSC projected that nearly 144,000 stores (about 36,000 per quarter) will close in 2008, up 7 percent from 2007, and the largest increase in at least 14 years. Retailers like Wilsons Leather, Geoffrey Beene outlets, Charming Shoppes stores, Pacific Sunwear, Ann Taylor and Talbot's are all among those slated for increased store closures. Linens 'n Things is in the process of shutting 120 stores and disposing of its leases and Starbucks is in the midst of closing 600 locations in the U.S. The list goes on.
The economy is behind much of the cutback activity, says Andy Graiser, co-president of New York-based DJM Realty, a consulting and disposition firm. “The market has cratered like I've never seen it,” he notes. “In 16 years I've never seen anything like it. And I don't see it ending anytime soon.” DJM's business is up 50 percent over last year, he says, and the firm can barely keep up with the number of dispositions the company has on its plate. “It means the economy is not in good shape. People just aren't shopping,” Graiser says.
And that's just where the story begins.
After a company has announced plans for store closings, the lawyers come out of the woodwork. Representatives for tenants and landlords knock heads to figure out issues such as how quickly the tenant will turn its space over, how much rent the tenant will pay out of its remaining obligation and who will decide — the tenant, the landlord or some third party — what the replacement tenant will be. When bankruptcies are involved the issue gets even trickier. Landlords have to join a long queue of creditors in an attempt to get paid back. Meanwhile, bankruptcy laws give retailers a certain amount of leeway for occupying space before it has to be turned over.
In most cases for a lease settlement in a store closure, retailers will sit down with the landlord and try to come to an agreement on a figure — usually a lump-sum payment that the retailer can afford. It all depends on the financial health of the retailer, says Graiser. An otherwise healthy retailer that may just be streamlining, like a Starbucks, should theoretically pay out several years worth of rent owed, he says. An unhealthy retailer, however, may only be able to pay a few months.
It also depends on how hard a landlord is willing to fight. In recent years, landlords have not been too strident when it comes to lease terminations. When business was booming, they were eager to get space back from struggling tenants because they knew they could turn it over easily. They could gut the store, sign a new lease and have a replacement lined up within six months, according to Ivan Friedman, president of New York-based RCS Real Estate Advisors.
Now, however, pickings are slim. It may take 18 months or more in the current leasing environment to fill some vacancies. Therefore, landlords have become much more aggressive about getting all they can out of a retailer that is closing its location. “If a space is going to stay empty for 12 to 18 months, the landlord may say, ‘I want two years’ rent instead of one,” Friedman says.
Many times the landlord can work with a troubled retailer, and allow it to pay reduced rent in order to avoid a vacancy, Graiser says, but it requires a mutual trust between both parties (see related story on p. 36). “You need to have full disclosure, and allow the landlord to look at the cash flow,” he says. “If you're forthcoming, the landlord will see the situation, and be willing to work something out.” And trust is a necessary ingredient if a retailer is backing out halfway through a long-term lease. Rarely does it work out that the retailer is ready to close as the lease is coming to an end.
Some major landlords are already feeling the pinch of lost occupancy, and are working to come out ahead. Indianapolis-based Simon Property Group sees store closings as opportunities to re-tenant the space, according to a company spokesperson. Simon lost 151,000 square feet of occupancy to bankruptcy in the first half of the year. “Let me just say, these are clearly challenging times, but we're positioned, well positioned to succeed,” said CEO David Simon on the company's second-quarter earnings call.
Working with retailers
Certain retailers have better reputations than others when it comes to reneging on lease agreements. Landlords have been unhappy with how Starbucks has handled its recent bout of store closings. It sent out mass notices of termination agreements to landlords, demanding a signature even before owners had had a chance to sit down with the coffee chain to negotiate. “Starbucks has been sending letters saying ‘We're doing this.’ But they don't have a unilateral right to terminate,” says Tara Scanlon, a partner with Holland + Knight, a Washington, D.C.-based law firm specializing in commercial real estate. “If they haven't made an agreement with the landlord to go dark, they need to work out an agreement. If the landlord doesn't mind that it's vacant, he can sign the agreement without a problem, but some might have a problem with it.” A Starbucks spokesperson said that the retailer will work with all its landlords to negotiate termination agreements.
A lot of the lease settlement depends, in the end, on a retailer's financial situation, and the leverage it has in terms of its real estate. But retailers must tread carefully in working out multiple leases. Major retailers with healthy balance sheets trying to get out of multiple leases on good real estate generally won't run into trouble on settlements, Graiser says. “But large retailers need to be consistent with all parties,” he adds. “Landlords will talk to each other and will find out if there are inconsistencies and are being paid less than someone else to settle.”
The retailer, who has an obligation to the lease legally, does not have to find a new tenant for the landlord, but may either find itself faced with very high costs to terminate, or oftentimes, denied a termination agreement. As a result, many retailers find it less of a hassle to just pay rent on a dark space rather than go through protracted lease termination talks, Friedman says. He points to firms like Circuit City, McDonald's and Wal-Mart as firms that are currently sitting on empty real estate because the companies decided it would cost less to do that than to go through termination talks.
If a retailer enters bankruptcy, however, it becomes an entirely different matter.
It used to be that retailers filing for bankruptcy had 60 days to assume or reject a lease after filing for bankruptcy, but they could also file for repeated 60-day extensions. In the end, landlords were often left waiting for six months or longer as tenants filed repeated motions.
In 2003, however, Congress reformed bankruptcy laws. Under current rules, tenants actually get a longer initial period — 120 days — to assume or reject a lease. But now they are limited to one 90-day extension. Leases can only be extended beyond that if the landlord agrees. In essence, landlords are left with a 210-day period during which they cannot look for a replacement tenant or collect rent from the current one. After that, landlords can gain control of the space. “They're in a holding pattern,” Scanlon says. But at least now the holding pattern has a definitive end.
While it may be easier today to get control of space occupied by a bankrupt tenant, it remains difficult to collect back rent. Landlords can make claims for unpaid rent. In the process, they get added to a queue of creditors, most of whom will only ever get paid a fraction of what they are owed. It's not unusual for creditors in a bankruptcy proceeding to collect 15 percent or less of what they are ultimately owed. And in these situations, which firms get paid is entirely up to a bankruptcy court judge, who divides up assets and allocates them, Scanlon says. “It's unfortunate, because it works to the disadvantage of the ‘nice guy,’ the landlord who lets things go,” she says.
The nature of bankruptcy today, too, has changed. What was once thought of as a break in operations to streamline and reorganize before reopening for business is now becoming a process solely for organizing a company's liquidation. “The traditional retailer isn't looking at bankruptcy as a genuine reorganization anymore,” says Ed Dolan, partner in Washington, D.C.-based firm Hogan + Hartson, which specializes in bankruptcy cases. Dolan points to opportunistic funds and liquidators that buy a bankrupt retailer's leases in order to re-lease them or sell them. The problem for landlords, then, is that they don't have much input on who the replacement tenant becomes. As a result, less retailers than ever are emerging from bankruptcy. Graiser estimates that 95 percent of the time now retailers are not emerging from bankruptcy.
A landlord can be better served if it works with a retailer to assign its lease to another tenant. If that happens, the new tenant becomes liable for any damages owed. “As part of the sale of the lease in bankruptcy, the landlord should be made whole, and shouldn't be out any money,” says Dolan.
“If the lease is assigned to someone else, it has to have landlord approval, and the tenant does have to cure all defaults, and provide adequate assurance of future performance,” he adds.
The economy has also changed the patterns of litigation, Scanlon says. Landlords, through increased vigilance, are attempting to prevent litigation before the situation can arise. Litigation is not any different now than in a normal climate, if the landlord brings up damages, but it's now framed differently due to the economic situation,” she says. “Any landlord who agrees to a lease termination without knowing who is going to pay rent is in trouble.”
The credit crunch has dried up the liquidity of many retailers, and with no credit facilities or private buyers to stand behind for support, some see no avenue besides bankruptcy. “Private equity has changed quite a bit,” Graiser said. “They don't have the kind of financing for acquisitions anymore because of the credit crunch; a lot of it has dried up, so they're not jumping into retail.” Retailers like Shoe Pavilion, he noted, saw their financing dry up, and with no liquidity, Chapter 11 was the only solution.