When rumors surfaced in July that the mid-price department store chain Mervyns was on the brink of entering bankruptcy proceedings, the news hit landlords hard. Although Mervyns's traffic-generating power has been on the decline for years, private equity firms Cerberus Capital Management, Sun Capital Partners and Lubert-Adler and Klaff Partners bought it from Target Corp. for $1.2 billion in July 2004. The firm does still serve as a viable anchor in many downscale markets. As of May, the chain operated 175 stores in seven states, primarily on the West Coast, and was planning to open another five.

But now, if the rumors prove true and Mervyns ends up closing its doors, property owners might be left scrambling for yet another replacement tenant as it joins the growing ranks of desperate retailers. This is especially unwelcome since another frequently used anchor, home furnishings seller Linens 'n Things, has already filed for Chapter 11 and might be forced to liquidate. The chain announced 120 store closings since April, when it entered bankruptcy proceedings, and plans to close 57 additional stores.

In the meantime, Boscov's, a mid-tier department store chain based in the Northeast, has been struggling to pay for its merchandise orders because of falling sales and may be contemplating bankruptcy, according to published reports.

“It creates a major problem, more so than normal, because there are so few tenants out there who are still signing deals,” says Gary A. Glick, partner with the Los Angeles-based real estate law firm Cox, Castle & Nicholson LLP. “Plus, Mervyns being a fairly substantial tenant in terms of size, there are a lot of co-tenancy provisions that might be violated. Other tenants may now have the ability to pay less than full rent and it will have a bit of a domino effect.”

Three months after the RECon Convention, which was marked by an optimism that the retail real estate industry might skate through the troubled economic times unscathed, the industry can no longer pretend everything is fine.

Landlords should brace themselves for a rough ride, says Suzanne Mulvee, senior real estate economist with Property & Portfolio Research (PPR), a Boston-based real estate research and portfolio strategy firm. Already in the second quarter of 2008, vacancies at regional malls averaged 6.3 percent, 40 basis points above the same period last year, according to Reis Inc., a New York City-based provider of commercial real estate information. Vacancies at shopping centers averaged 8.2 percent, 50 basis points above last year and the highest level in 13 years. In the meantime, developers will deliver another 136 million square feet of new retail space to the market this year. The historical average, according to Mulvee, is 104 million square feet of new space annually. As a result, “we don't expect vacancies to top out until the beginning of 2009,” she says.

Two stories last month from Charlotte, N.C., showcase just how precarious market conditions have become. In late July, Chicago-based General Growth Properties, Inc. and local partner Childress Klein Properties stopped site work on the 1.3-million-square-foot Bridges at Mint Hill open-air center. The developers reportedly told town officials that they needed more time to complete planning work, but the venture did not provide an updated schedule on when construction will resume and there is speculation the owners are having trouble luring tenants.

On the same day, Columbus, Ohio-based Glimcher Realty Trust announced its intention to walk away from the 1.1-million-square-foot Eastland Mall because the rents the company is getting don't cover approximately $42 million in mortgage payments or Eastland's operating costs.

To be sure, most of the big firms in the retail real estate sector are weathering the current downturn well. In July General Growth Properties was able to close the first stage of a $1.75 billion mortgage loan facility and Santa Monica, Calif.-based Macerich Company closed more than $1 billion in loan commitments. That can be read as a sign that banks believe the firms are still strong. The only large firm facing significant debt problems remains Australian listed property trust Centro Properties Group.

Going forward, however, market conditions could continue to deteriorate. PPR estimates that year-to-date, retailers have announced 4,172 stores will close, representing a 35 percent increase over the same period in 2007. By year-end, store closings in the U.S. could push past the 8,000 mark, says Matthew Bordwin, managing director and co-group head of real estate services with KPMG Corporate Finance LLC investment bank. Matthew is based in the Melville, NY office of KPMG. In July ICSC warned that closings could climb to a 14-year high without providing an exact estimate. As a result, Mulvee expects the overall vacancy rate for the retail sector to rise 100 basis points over the next 12 months — to 12.9 percent.

For owners of large centers, which have several anchors, the higher vacancy rate might not be life-threatening. But for those who operate smaller properties, the environment is proving to be catastrophic.

Consider the case of one Starbucks-anchored strip center in Nevada.

When Starbucks Corp. announced it was closing 600 of its U.S. stores on July 1, the center was already missing one of its three tenants, a T-Mobile store that vacated the property without warning. But the owner hoped the high traffic brought in by Starbucks would help him find a replacement. Unfortunately, that Starbucks ended up on the list of the 600 stores slated for closing. And after it left, the remaining tenant, a struggling Quizno's franchisee, announced he was leaving as well, since without the Starbucks he couldn't make ends meet.

As a result of all of this, suddenly the center's vacancy rate is 100 percent. The owner, who requested anonymity, and Starbucks are now in the process of negotiating an equitable lease termination settlement. Meanwhile, he also faces the daunting task of trying to keep his lender at bay while attempting to find another tenant that can generate the same kind of foot traffic that Starbucks did.

“We will get nothing going until we figure out how to replace the Starbucks and it is going to be a challenge,” he says.

Even some REITs have began to suffer. On June 30, the New York Stock Exchange delisted Great Neck, N.Y.-based Feldman Mall Properties because the firm failed to meet minimum NYSE standards. In addition, a Credit Suisse analyst recently downgraded the stock of industry stalwart Kimco Realty Corp. The analyst, Michael Gorman, lowered the firm's price target to $32 per share, from $45, because of concerns the firm will have to cut back on its development pipeline.

A long way down

The most obvious challenge for the retail sector right now is the dire state of the economy. In May, housing prices fell 10 percent compared to the same period a year ago, according to Deloitte. Unemployment claims rose 20 percent. Over the July 4 weekend, gas prices in the U.S. rose to $4.10 per gallon, an all-time high and food costs continued their upward climb.

“Our data show that consumers suddenly feel worse about everything, starting with jobs and ending with investment,” says Ayuna Kidder, economist and consultant with TNS Retail Forward, a Columbus, Ohio-based consulting firm.

With consumers struggling to pay for necessities, retailers that sell nonessential items, including clothes and jewelry, are getting hit the worst, says Bordwin. From January to May of this year, for example, the percentage of consumers who shopped at jewelry stores fell by more than two-thirds, to 4 percent from 15.4 percent, according to America's Research Group, a Charleston, S.C.-based retail research firm. As a result, apparel took the number one spot in terms of store closings this year, accounting for 34.7 percent of all closings in the first half of 2008, according to ICSC.

As the year progresses, expect more bankruptcies in the apparel sector, as some of the weaker operators will not be able to survive the steep downturn in consumer spending, says Craig Johnson, president of Customer Growth Partners, LLC, a New Canaan, Conn.-based retail consulting firm. Already, such giants as Gap, Inc., Ann Taylor Stores Corp. and Charming Shoppes, Inc. announced plans to shutter hundreds of stores. Some of the remaining operators in the furniture sector might not survive either, as the housing downturn continues unchecked.

The recession has also started to affect office supplies sellers, which previously seemed immune from the downturn. On July 8, Office Depot, Inc. issued a warning that its second quarter results will be weaker than anticipated. Meanwhile, in the first quarter of 2008, Staples's same-store sales declined 6 percent, due to slow shopper traffic and decreased average order size.

Freeze point

At the same time as retailers are getting clobbered by the falling housing values and high gas and food prices, the debt markets continue to tighten. Because of the enormous amount of new housing stock that has been built in the past few years, it will take months, if not years, for housing prices to stabilize, according to Sam Chandan, chief economist with Reis.

And that will mean tighter lending requirements for commercial properties. In the commercial mortgage-backed securities market, for example, which accounted for 70 percent of real estate financing in 2007, year-to-date issuance has stalled at $12.1 billion, according to Commercial Mortgage Alert. During the same period last year the figure was $158.9 billion. That, coupled with worries about the economy, has wreaked havoc in the investment sales sector. From January to May, sales of retail properties totaled $5.6 billion, according to Real Capital Analytics, down 75 percent from 2007.

Out of credit

The effects of the credit crunch, however, are not limited to real estate owners. When the moderately priced apparel seller Steve & Barry's filed for Chapter 11 on July 9, it was as a result of debt troubles. In March it defaulted on a $197 million loan from General Electric. The problem became exacerbated by the fact that the retailer overexpanded in recent years, attracted by discount rents proffered by landlords with distressed properties. Steve & Barry's operates 276 stores in 30 states. “They were strong on the surface, yet their cash flow was dependent on one-time payments from landlords to attract them,” says Mulvee.

In May, a Portland, Ore.-based chain Nau, which sells outdoor apparel, had to close its doors because it failed to secure financing to pay down $34 million in debt. Last year, the retailer was talking of opening 150 stores. Instead, Nau ended up being acquired by Horny Toad, a Santa Barbara, Calif.-based apparel seller. As of May, the chain operated five stores.

Similar problems might be facing many of the retail chains that have been bought out by private equity firms in the past couple of years, according to Bordwin. Linens 'n Things for example crumbled under the weight of too much debt. Apollo Realty Advisors and NRDC bought the chain in 2005 for $1.3 billion, putting $633.4 million of equity into the deal. At the time of the bankruptcy filing, Linens 'n Things had $1.42 billion in debt.

Blue Christmas

Right now, the retail outlook may seem less bleak because $91.8 billion in stimulus checks drove up sales in the second quarter, according to Kidder. For June, ICSC reported same-store sales growth of 4.2 percent for U.S. chain stores, above the year-to-date average of 2.4 percent. Things will get significantly worse, however, once consumers run out of the rebate money.

Historically, retailers have held off on filing for bankruptcy until after the holiday shopping season because they hoped to pull in extra cash with holiday purchases, says Bordwin. In 2007, for example, only 1,522 stores closed their doors from July to December, compared to 3,081 stores closed between January and June. This year, however, some retailers may end up not having enough cash to buy merchandise for the holiday season, notes Carl Steidtmann, chief economist with Deloitte. “I think the number of store closings will be higher” in the second half of 2008, he says.

But even if retailers push off store closings until the beginning of next year, that will only mean the total number of closings in 2009 will be even higher than in 2008. “Unless we get some kind of a turnaround in the fall, next year could just be a disaster,” says George Whalin, president of Carlsbad, Calif.-based consulting firm Retail Management Consultants.

The new reality

As landlords start to realize just how bad things have gotten, they are becoming more open to the idea of reduced rents and concessions. In the second quarter, effective rents at shopping centers fell 0.1 percent, says research from Reis (data on effective rents for regional malls was not available). Encino, Calif.-based Marcus & Millichap Real Estate Investment Services estimates that concessions will limit effective rent growth in the retail sector to 0.9 percent this year.

“What we are seeing from a leasing standpoint is that we are focusing on renewals and retentions and assisting the tenants to weather the storm,” says Elizabeth Kelley, general manager of the Mall at Whitney Field, a 657,547-square-foot regional mall in Leominster, Mass., managed by Chicago-based real estate firm Jones Lang LaSalle Inc.

Other landlords are pursuing a similar course of action. Newport Beach, Calif.-based Marinita Development Co. Inc., for example, has sent letters to tenants that annual rent increases will be waived this year. And if things continue to deteriorate, the company will consider reducing rents for selected retailers. “We are not at that point yet,” says J. Scott Fawcett, a principal with Marinita Development. “But we are working with our tenants.”

As things stand, Marinita — and many other firms that find themselves hemorrhaging tenants — could find themselves reaching that point soon.