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Monday, November 15, 2010

Attention REIT Buyers: Hidden Impact of Slimmed Down (a.k.a. voluntary downsizing) Stores

This " voluntary downsizing" , whether by
the mall ownership or the retailer,
has mostly negative implications.

Analysis by Kenneth Leonard
Kenneth Leonard Bio
Gerson Lehman Group

An article titled "BIG STORES SLIM DOWN IN A BID TO FATTEN PROFITS" in the 11/10 issue of the NYT, caught my eye and prompted me to comment for the benefit of any GLG reader who closely follows the Mall REIT industry. The impact of this growing activity is poorly understood and the NYT article did not contribute to this lack of information.

The first thing any analyst should take away from this article is that the writer is simply not familiar with the industry she is covering. She writes about this activity as if it were a phenomenon when in actuality it is simply a recurring activity. It is not well understood because most people do not notice it when it happens. In fact, neither the stores nor the malls in which it occurs, have any interest in calling attention to this occurrence.

This " voluntary downsizing" , whether by the mall ownership or the retailer, has mostly negative implications.

For the retailer it means that they have badly misjudged the market or sales potential and must pay for their mistake until the end of their lease term. Their rent and CAM charges continue for the entire space so if they reduce their size by 50%, they have effectively doubled their occupancy costs. It also means that they will be making substantial and costly adjustments to their basic prototype and buying patterns. The only good thing that comes from this enforced downsizing is that they will have less inventory and less employee help on the floor.

When the mall ownership is forced to lease only the front portion of vacant mall stores because of poor demand for deep spaces, it has an even greater impact on the bottom line of "the downsizer". The most obvious cost is that the tenant who only pays for a portion of the space available between the four walls of their proposed space, is doing so for the entire length of their lease.

Take for example a typical 20'x100', 2000 sf, vacant storeroom in any mall anywhere. If the only tenant available is only willing to lease the "front" 20'x50', 1000 sf space, (which happens more times than owners of underperforming mall REITs care to admit), the mall owner has not only lost the income from 1000sf of space that he built or bought for approximately $200.00 psf, but he must now take the pro rata share of CAM and RE Taxes out of his own pocket to pay for what that tenant did not lease. This situation is fixed for the entire term of the lease because there is no way to lease the "back" portion of that space for the entire term of the lease.

In the typical under performing regional mall this type of downsizing occurs quite frequently. Whenever any prospective investor is attempting to evaluate the true market value of any "C" level mall, they must be careful to add this hidden vacancy rate to the actual vacancy rates or they will find that they are buying much more vacant space than they bargained for. Additionally, this type of vacant space has virtually no chance of ever being leased.

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