The real estate sector has an opportunity to strategize for a more resilient future.
Ariel Property Advisors
Even before the Covid-19 pandemic, there was widespread skepticism about the future of brick and mortar retail. It didn’t help that many retailers, from international chains to local shops, were investing in experiences to drive foot traffic and revenue. Now, consumers are looking to minimize their time indoors around other people.
Empty storefronts are bad for neighborhoods and, of course, don’t bring in revenue for owners, as well as can hurt property values. While some landlords have provided forbearance or revised lease terms to help their tenants survive, this isn’t a long-term strategy. Instead, the pandemic could be an opportunity to drive new strategies that enable landlords and tenants both to succeed, including rethinking how landlords can be more active in empowering businesses for their retailers by seeing themselves more as partners. Landlords could become, for instance, minority stakeholders in return for reduced rents, rather than seeing the spaces as simply passive income.
Retail’s Pre-Covid Cracks
While the pandemic brought unprecedented challenges to the real estate world, it has also exacerbated cracks that were already present. Retail is the starkest example of this. Before Covid, New York City retail was already marked by vacancies and availability. Reportedly, availability was up to 20% in Manhattan, while the city’s Department of Small Business Services reported in May 2019 that 8.9% of storefronts across the city were empty, major upticks from figures traditionally.
“In Brooklyn, you could walk down major retail corridors, such as Smith and Court Streets, Metropolitan Avenue, Fifth Avenue, Vanderbilt Avenue or Fulton Street and see the ‘For Rent’ signs for yourself,” says Sean Kelly, Senior Director of Investment Sales for Ariel Property Advisors. “Retail in New York was already trying to figure out what the next five years was going to look like, and then Covid happened.”
High retail rent pricing, particularly along major corridors, didn’t mean that leases weren’t getting signed, necessarily, as the vacancy rates belied the rising stock of retail square footage across the city, but the rising rents have made it difficult for local small businesses to survive once the ink is dry on the leases. Still, many spaces have suffered multi-year vacancies as some owners are holding on for national chains that could meet the high dollars per square foot.
“Investors underwrote top-of-the-market rents and pitched the investment opportunity to their capital partners. In turn, banks underwrote the assets using high watermark rents and provided financing accordingly,” says Kelly. “These investors were having trouble leasing space pre-Covid and had to explain to the capital partners that they were not going to hit the projected rents. Now, Covid puts them in an even worse position.”
On the other hand, many long-term owners with low leverage, especially ones collecting residential rent on the upper floors, could afford to be more selective about their tenancy and were capitalized well enough to wait for the right tenant.
But is this good for neighborhoods? Many local politicians don’t believe so and, on the heels of the Rent Stabilization and Tenant Protection Act, commercial rent reform is currently being proposed to create a dedicated rent guidelines board that determines annual rental increase rates for retail and office occupiers at less than 10,000 square feet and industrial occupiers at less than 25,000 square feet.
It remains to be seen how Covid-19 will affect this proposed bill. To avoid more legislation though, more owners may need to cooperate with tenants to promote greater occupancy.
More Active Landlords
Covid-19 accelerated issues already present in the retail real estate market, and in some ways, this may turn out to be beneficial overall for the retail ecosystem. The situation has forced lenders, owners and occupiers to find solutions quickly, whereas without this, retail vacancies and inflated rents may have dragged on for years without any serious culture changes.
In the months of the lockdown, some landlords did ultimately offer forbearance or worked with tenants during the worst of the crisis. Even with the loss of a couple months of rent, it is likely better to have an occupied storefront for the sake of property value and future revenue, as well as, of course, the benefits to the business relationship and the neighborhood.
“Some landlords, in return for forbearance, asked for lease extensions to protect themselves and ensure good faith between the parties,” says Kelly. “Long-term, some could look to create an arrangement called a percentage lease, in which the landlord reduces rent in exchange for a stake in the tenant’s business. The owner’s financial interest in seeing the tenant succeed could increase the chances of success for both parties.”
To make this work, the landlord would have to be much more of an active participant in the retail space. They would need to perform more due diligence on the viability of the tenant’s business plan before signing the lease. They would also need to take an active interest in the tenant’s books as an investor.
While this may not work for some owners looking for passive income, it does present a potential solution for how landlords can keep rents manageable for small businesses and still see greater upside. There are risks, yes, but there are also risks to signing retail tenants without understanding the ins and outs of their business models, which is often what happens now.
The upside is that the increased scrutiny could help to ensure that weaker or outdated retail models don’t take expensive real estate spaces where they are less likely to succeed. In this way, owners becoming more like partners can help to create a more resilient industry proactively positioned for success in a challenging landscape.
“During Covid-19, we saw a great deal of collaboration between owners and tenants,” says Kelly, “and they could continue to do this through percentage rent leases.”