Preemptive Surgery

As major retailers file for bankruptcy and vacate stores, a domino effect is taking hold across the country. Shopping centers are reeling from the loss of income, and some are so hard-hit the owners are handing the keys back to their lenders and walking away.

Restructuring consultants are guiding both property owners and retailers as they try to avoid the slide into bankruptcy. Landlords and tenants who wind up filing for Chapter 11 protection from creditors are hiring advisers to locate debtor-in-possession financing to cover operating costs during and after the bankruptcy process. But credit is so hard to get that the lack of financing has derailed many retailers' restructuring efforts and forced them into liquidation.

While retail chains have dissolved in court, property owners' financial crises have primarily been addressed out of court by their lenders, Shapiro says.

The damaged economy and global credit crisis have created a perfect environment for bankruptcy. ICSC estimates that 6,100 chain stores closed in 2008. Some estimates indicate the number could be twice that in 2009.

In 2008, 27 major retailers filed for Chapter 11, a 400 percent increase from 2007, according to BankruptcyData.com. In the first half of January alone, major retail filings for Chapter 11 protection in federal bankruptcy court reached a seven-year high. So far, at least 10 retailers have filed for Chapter 11 bankruptcy or moved to outright liquidation in 2009. Swiss-based UBS Securities identifies 39 at-risk retailers on its January tenant watch list, including retail icons Macy's, Neiman Marcus, Nordstrom and Borders bookstores.

Given the spate of bankruptcies and closures, retail vacancies are expected to reach about 17 percent by midyear, up from 11.8 percent at the same time in 2008, says Suzanne Mulvee, real estate strategist for Boston-based Property & Portfolio Research.

Small shopping centers hit hard

When a retailer catches pneumonia, the landlord shivers, since the health of a shopping center is tied to its tenants. “Smaller [shopping center] owner-operators have had significant problems and have handed the keys over to the lender,” says Stuart Eisenberg, partner and managing director of the real estate group at BDO Seidman. The Chicago-based financial adviser's clients own hundreds of shopping centers, and include such retailers as Barnes & Noble and Jones Apparel Group.

Some larger shopping center owners also have decided that a site doesn't warrant further investment and have returned the property to the lender, Eisenberg says. “Even some [REITs] have elected to let go of a property as opposed to continuing to lose money on it.”

For example, the Shops at Atlas Park in Queens, N.Y., a sparkling $200 million, 400,000-square-foot center, opened just two years ago. But in February, it was taken over by its lenders, the French banks Société Générale and Calyon, after the owner Atco Properties & Management defaulted.

An echoing cry for help

Hilco Real Estate advises companies on which stores to close, and combs through its database of thousands of names to market the leases of the abandoned stores and wring value from the underperforming locations. Northbrook, Ill.-based Hilco helped Linens 'n Things close 371 stores, and Circuit City, more than 700 stores.

In addition to helping firms restructure, Hilco can arrange for liquidations before or during bankruptcy. Consultants can search for a new lender or steer a company away from costly mistakes, such as inadvertently violating loan covenants and triggering punitive actions by a lender.

“In the last month alone, we've had seven new accounts,” says Greg Apter, president and principal of Hilco Real Estate. “All seven are pre-bankruptcy, because everybody's so worried about going into bankruptcy.”

The fate of landlords and retailers is interwoven. Retailers buffeted by waning consumer demand face a real threat of inadequate financing during and after a bankruptcy. Hilco recently launched a program to help companies avoid bankruptcy and liquidation. Too many firms can't recover from Chapter 11, Apter says. “They are unable to emerge or able to emerge for only a short period of time.”

Under pressure from lenders, suppliers and other creditors, retailers are also taking bitter pills to avoid or cushion a bankruptcy. The measures vary from pleading for reductions in rent to lopping off weak segments of their operations. Landlords, in turn, are granting painful concessions such as lower rent, which reduces their income streams but may make the difference between losing and keeping an ailing tenant.

An overriding factor in recent bankruptcy cases is that too many retailers are being crushed by debt. “Because there was so much liquidity in prior years, we're finding that many of these companies leveraged their balance sheets to the hilt. There's no cushion,” notes Bill Lenhart, director of business restructuring services at BDO Seidman.

The wave of private equity buyouts that swept through the industry a few years ago hasn't helped matters. In many cases, private equity firms larded up retailers they acquired with debt in order to pay themselves fees. That debt is now proving to be crippling.

In addition, too many retailers paid high prices for inventories that later did not sell as consumer demand has slowed. Furthermore, when credit was easier to obtain, many retailers expanded unwisely, borrowing against store leases and brands.

As a remedy, retailers can auction the leases of underperforming stores or borrow against leases of healthier locations. But many retail chains are over-leveraged and have no leases or name brands left to borrow against when they need emergency capital. Furthermore, as property values fall and rental rates decline, many leases are considered overvalued and find no takers at lease auctions. That's exactly what happened to Circuit City, which was forced to cancel a planned lease auction because of a lack of bidders.

“If you're a retailer and you signed leases two to three years ago for new locations, today those rents are so above market that they have zero value,” says David Solomon, president of retail services for NAI Global.

Shifting Bankruptcy Laws

Unlike previous slowdowns, when a company could emerge from bankruptcy court as a healthier and leaner version of its old self, the example of more than two dozen high-profile retailers over the past year shows that, more often than not, the path to a bankruptcy filing is a swift and jarring road to liquidation.

When Richmond, Va.-based Circuit City Stores filed a petition in U.S. Bankruptcy Court under Chapter 11 of the Bankruptcy Code last November, executives first shut 155 stores. They kept the doors open at 567 superstores, but those efforts weren't enough. On Jan. 5, the company asked the court's permission to put the chain up for sale. When two potential investors expressed interest and negotiations started, landlords across the country hoped that the tenant chain might survive under a new owner. But when no deal occurred by the Jan. 16 court deadline, Circuit City took steps to liquidate its assets.

Changes to the federal bankruptcy law in 2005 made it tougher to emerge from Chapter 11, says Keith Shapiro, former chairman of the American Bankruptcy Institute and now an attorney with the Chicago office of Greenberg Traurig. The legislation reduced the time retailers have to decide which leases to keep or reject. Retailers now have 210 days, including an extension.

“They have a very powerful right to walk away from leases with minimal damages,” Shapiro says. Another development is the new clout of junior lien holders such as hedge funds. Some of the liens stem from mezzanine loans, he adds.

A property owner or retailer facing bankruptcy needs debtor-in-possession (DIP) financing to pay operating expenses while restructuring. But with credit scarce, many borrowers are at the mercy of their existing lenders, who may be in no mood to issue a new loan to a defaulting client, Shapiro says.

On the first day of a bankruptcy case, the judge typically issues first-day orders, including interim approval of DIP financing. A liquidator may help close unprofitable locations and sell real estate inventory.

If dumping leases and chopping costs aren't enough, a company can hunt for a buyer. But realistically, a cash-strapped retailer may make just a brief stop in Chapter 11 before calling it quits. “If there's no buyer for a retailer, a lot of lenders are now forcing liquidation,” says Solomon. No longer can a retailer make a pit stop in bankruptcy, drop underperforming stores and turn things around. He contends, “That playbook has fallen by the wayside.”

Steps for Survival

If a shopping center has lost a key tenant and other tenants are threatening to leave, a landlord needs to take steps to forestall a disastrous exodus and potential insolvency. Here are five steps owners can take to stay solvent and avoid bankruptcy, based on advice from financial consulting firms.

1. Take Stock — examine your retailer base and determine what steps you can take to assure the center's long-term viability. Try to understand your tenants' needs. Some may be facing bankruptcy.

2. Renegotiate Lease Terms — you may need to bite the bullet and renegotiate a tenant's lease before the current term expires. As consumer spending has waned, many retailers' incomes have declined. Reducing the rent may keep the space occupied, and less income is better than none.

3. Offer Short-Term Relief — consider a brief rent-free period. This may strengthen the retailer's financial position in the long run.

4. Fill Vacancies Quickly — when a major tenant exits, find a replacement fast. If a remaining retailer's long-term prognosis is poor, line up a new candidate and negotiate for early possession of the space. Anticipate that a retailer in Chapter 11 may reject its lease, and prepare to rent the profitable space.

5. Talk to the Lender — negotiate with the shopping center lender for more favorable financing, just as tenants negotiate with the landlord. — Denise Kalette