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Smarter Perspectives: Real Estate

Podcast: The Evolving Department Store Dilemma

Guest Dan O’Brien Host: Steve Katz

This podcast features a discussion with Dan O’Brien of Hilco Real Estate about the continuing dilemma facing department store tenants amid sustained foot traffic declines and a definitive and concerning shift in consumer shopping trends away from the mall environment.

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Steve Katz:

Hi, everybody, and thanks for taking time out of your busy schedule to listen in our Hilco Global Smarter Perspective podcast. As return listeners know by now, I'm your host, Steve Katz, and if this is your first time with us, well, then welcome. We are really glad that you could tune in today.

Steve Katz:

Today, we will be talking about the dilemma that's facing department store tenants right now with foot traffic remaining low and consumer shopping trends continuing to shift. And as a result, the outlook for many of the regional malls is questionable to say the least. And I know that's kind of a bleak way to start out, but thankfully, we'll also be exploring potential opportunities that exist for both those tenants and their mall landlords when strategic and timely action is taken to address these types of difficult matters.

Steve Katz:

And with us for that conversation is return podcast guest, Dan O'Brien, who's Senior VP at Hilco Real Estate. Dan, welcome back to the podcast.

Dan O'Brien:

Great, thanks. Good to be here again, sharing with you today what I believe are some timely thoughts on the real estate market.

Steve Katz:

Well, it's great to have you back on and here we go. Dan, we all need to get on the same page here on this. Developers started building these malls several decades ago, and it really was sort of a, using a phrase from a movie, "if you build it, people will come" dream come true for an incredibly long time, right? I mean, mall owners were happy. Operators were happy. Tenants were happy. People were flocking to the malls. What was the model for that level of success? And when did we really start to see signs of that model's weakness first begin to appear?

Dan O'Brien:

Yeah. By the time James Earl Jones uttered those words in 1989 when Field of Dreams debuted in the theaters, the phrase was already a mantra amongst commercial real estate developers across the US. Having spent many years at General Growth Properties, one of the largest mall developers prior to my time at Hilco, for years, I saw firsthand that oftentimes, these developers would find prime real estate, maybe going to the intersection of two main roads or creating an off-ramp of a highway. And they would build, among other things, multimillion square foot regional and super regional malls with three to five large format department stores with anywhere from 50 to 100 small shop retailers and restaurants.

Dan O'Brien:

They also constructed power centers, oftentimes around the regional malls with one or two retail anchors, as well as a collection of midsize boxes and a smattering of small shop tenants. They also erected neighborhood centers with a grocery store and multiple daily needs operators.

Dan O'Brien:

But when developers had a project that could attract the right anchor, they knew that would serve as a draw for consumers. And then the higher paying, small format retailers and restaurants would soon follow suit and justify the investment and people did come. But now, in the aftermath of the.com era and with the proliferation of omnichannel retailing, not to mention a worldwide pandemic, a major shift has occurred. People are shopping differently. Groups like Amazon have created limitless department stores online, not to mention the talk of the metaverse that's now being thought of. And that's created a sea change for many of the large format traditional department stores.

Dan O'Brien:

Store revenue, in fact, has dropped nearly 40% for a lot of those users over the past 12 years. And while some have weathered the storm, others have not leading to an alarming rate of closure. Meanwhile, retailers that still exist are working feverishly to reinvent themselves or determine a path forward for their existing businesses.

Steve Katz:

Okay, so here's my question. Department stores have always had ups and downs, comings and goings through recessionary and other periods, right? What is so different about this market, this point in time?

Dan O'Brien:

Yeah, Steve, you're right. Woolworths seemingly ceded to Sears. Marshall Field's here in downtown Chicago gave away to Macy's, while some like Montgomery Wards and Mervyn's are operators that cease to exist altogether. Some brands like J.W. Robinson's and May and then eventually federated, along with Sears and Kmart tried to merge with one another to fortify their businesses, yet throughout all these comings and goings, there was always someone to backfill the locations vacated by these changes and maintain the traditional mall for these properties, typically, at these regional and super regional centers. Some redevelopment of these boxes occurred primarily over the last two decades, but the marketplace has more radically shifted in recent past. Again, with the proliferation of omnichannel and .com, it's just thinned the herd amongst those large format department store operators.

Dan O'Brien:

Earlier this year after bankruptcy filing in 2018 and years of fighting what seemed inevitable, even Sears and Kmart completed their liquidation of all stores. Lord & Taylor filed in late 2020 after being acquired only one year previously. Now, the company only exists as an online operator. Similarly, former department stores such as Carson Pirie Scott, Bergner's, and the Bon-Ton have all disappeared from brick and mortar marketplace. And operators such as Saks Fifth Avenue, Bloomingdale's, and Macy's are working to close many of their non-performing stores.

Dan O'Brien:

Even in May of 2020, one of the most interesting cases on our radar following a similar filing by Neiman Marcus, JCPenney filed bankruptcy and has split into two distinct entities, one, an operating company, or opco, which runs the day-to-day retail operations and is interestingly enough, owned by two of the major mall landlords in the US: Simon Property Group and Brookfield. And the second part of their company is a separate property company, propco, which manages the own real estate under which the opco operates and even more interestingly is managed by none other than Hilco Real Estate on behalf of that ownership.

Dan O'Brien:

With all of that, the unique dynamic here at play is that when developers first assembled a tenant mix for those regional malls and relied on those department stores to draw consumers and small shop tenants, those anchors were granted ownership of the parcels of real estate. This included not only the store but the parking lot, as well as improvements. Easement agreements, either operating easement agreement or reciprocal easement agreement, were then signed between the anchors and landlords to regulate the ownership and development of these properties. Requiring approvals from the group, if and when one wanted to build on their track. Often, these OEAs or REAs made for an interesting working relationship with approvals from all involved parties required for any sort of building. And often those approvals, as you could imagine, were kind of held as ransom. So if anyone wanted to change anything, whether there was a vacancy or whether someone wanted to add an out parcel, the collective had to approve it. And therefore, there was usually some quid pro quo. As a result, change to those individual parcels or the overall property was often hard to come by.

Dan O'Brien:

And in the current environment with all these vacancies with more and more openings at these centers where you used to have maybe one of four or five anchors leave, you see two, three, four, or even an entire fleet of anchors leaving a property. But these OEA, REA partnerships are creating a distinctly new hurdle for the remaining anchors as retailers, as well as for the landlords as managers of these malls. Many of these properties and the anchor tenants face challenges to remain prominent and or reinvent themselves, and the parties to the OEAs and REAs must work together to adapt.

Dan O'Brien:

Furthermore, loss of anchor tenants can also affect small shop leases that regularly have co-tenancy agreements requiring that the properties have certain department stores or at least some larger format tenants to "anchor the property." But with all of this change, there's also opportunity intermixed with these challenges as more tenants seek out innovative ways to maximize the value of their companies as both operators and landowners. Similarly, landlords are leveraging new and creative approaches to redevelop or retenant these large spaces and/or tracks of land as higher and better uses are required. As a result, we are seeing the remaining anchor tenants and their landlords collectively pulling out all the stops to determine what is possible and what will work best moving forward.

Steve Katz:

That's great, Dan. Really kind of encapsulates a lot of what's going on and I'm also kind of intrigued by that piece you talked about where Hilco is handling management for that propco, so maybe we'll get you back on to talk about that at some point as well.

Dan O'Brien:

Sure.

Steve Katz:

So let's move on, but just following your thoughts there, what are the department store tenants doing now to respond to these challenges in the current market, and are the landlords actually supporting that? Are they stepping forward to help coordinate efforts? Are they resistant? Is there any sort of collaboration going on there? What's the landscape for that?

Dan O'Brien:

Yeah, the answers to your questions can differ greatly based on the circumstances at play in each particular case. The ultimate success of these efforts is largely dependent on the nature of the process that's undertaken to inform a course of action. Again, the good news is that there's opportunity in all of this chaos. You have certain tenants that are trying to repurpose their existing retail footprint. They're obviously trying to maximize their return as an operator, but you also see many of them as landowners trying to figure out, really, the highest and best use for their parcel on a kind of a micro level, as well as a macro level within that marketplace at that property.

Dan O'Brien:

The good news is that because our Hilco Real Estate team has performed work on behalf of many of these operators and has been involved in almost every major restructuring and repositioning and bankruptcy within the department store world over the past decade, what we find ourselves doing right now is bringing that knowledge, experience, and clarity to clients in order to guide them through the steps to help ensure positive outcomes. So from our perspective, there are really three critical areas that should be considered as best practices for undertaking these endeavors.

Steve Katz:

Okay, great. Can you walk us through all three of those?

Dan O'Brien:

Absolutely. The first, as you can imagine, is the analysis and valuation phase. Operations must be carefully analyzed to determine short- and long-term value. Diligence should be used to establish the value of owned and leased assets within each of the stores' given markets. But with that questions must be asked. Is retail the highest and best use of a site moving forward, or should the business look to sell or redevelop that site, maybe remaining in a smaller footprint or leaving altogether. With that, what tenants may have interest in the site? What alternate uses may be better for the site?

Dan O'Brien:

Again, going back to those OEAs, REAs in a partnership with the landlord, tenants have to ask themselves is the landlord interested in incorporating the parcel into a larger redevelopment of the property, or is there a hybrid option possible, where the tenant remains in some capacity, but there may be excess real estate that can then be sold or leased? And finally, if closure of a store and the sale of a property is chosen, what is the best plan to liquidate inventory, market the asset, negotiate the best price, and close on the sale of a non-performing store.

Dan O'Brien:

Second, really, you have to get into that strategic design phase. Once the diligence and analysis is complete, reviewing all options to establish optimal value, then coming up with a plan of attack must be determined to achieve said value. One must consider carefully can the plan be successful, given the challenges of cost, logistics, the property dynamic with the landlord, OEA, REA, the overall trends within the marketplace, as well as, again, going back to that OEA, REA. Can each plan be undertaken? The ability to both think strategically and creatively while drawing upon experience and comprehensive understanding of a marketplace is to great advantage. Quite often, we find that the most obvious approach or the scope of initial effort typically is not the optimal path to maximizing the stakeholder's returns.

Dan O'Brien:

And then third is the execution of all this. So once you've done your research, once you've come up with your plan, ultimately, the effectiveness of the work conducted really boils down to the precision and efficiency, which the steps determined are undertaken. Whether you're doing that as an operator or a quasi-developer or on your own or in conjunction with the landlord. But it's important to recognize that efforts and skill sets may vary greatly here, making it essential for this part of the process to be overseen and often, carried out by highly experienced and well-coordinated team of professionals.

Steve Katz:

All right, well, that's a very systematic and thorough way to come at these efforts, which I'm sure is, of course, a function of how long you and the team have been doing this over the years. And I think what you've explained makes a lot of sense, particularly with the stake so high, and it is encouraging, I think, to hear that landlords are willing and actively participating when the situations warrant. Obviously, they're looking out for their own interests as well, but it's good to hear that they're actively involved.

Steve Katz:

I'm looking at my watch and believe it or not, we are getting close to our time limit here. So to close us out, any additional guidance you'd like to provide to the listeners today?

Dan O'Brien:

Yeah, absolutely. For operators and lenders with department stores and retail businesses in this anchor variety in their portfolios, we advise as proactive and comprehensive an approach as possible to addressing these types of challenges that we've discussed here today. Early analysis and diligence typically provides for greater optionality and superior outcomes, particularly when you have so many different groups involved, potentially, in a redevelopment or repositioning process. And then obviously, the efforts conducted really must be done by those seasoned professionals with the necessary experience, creativity, and resources to help drive maximum asset value.

Dan O'Brien:

The process to determine highest and best use can be a challenge. Department stores and landlords have many options to consider in this marketplace and market to market, property by property. A box can be sold by a department store back to a landlord and redeveloped into a lifestyle center, retail component, restaurant, entertainment, or possibly mixed use with office, indoor residential. Same space can be backfilled by a non-traditional tenant, such as a school or a fulfillment center, or a department store can choose to remain in place, possibly on one of its existing levels, while finding a new use for others. Given that associated investments for all options are quite significant, there needs to be a high degree of confidence that the financial returns will be there for both landlord and tenant.

Steve Katz:

All right. Well, I guess the bottom line on all this is kind of where we started. If it's reimagined and it's rebuilt, the people who had better come, right, Dan?

Dan O'Brien:

Yep. James Earl Jones said it right.

Steve Katz:

He did. He did. All right. Well, thanks for those insights and for joining us today, and how can people best get in touch with you?

Dan O'Brien:

Yeah, absolutely. Great to be here today. Best way to get in touch with me via email is my Hilco address at dobrien@hilcoglobal.com. That's dobrien@hilcoglobal.com. That's hilcoglobal.com, and my direct phone number is 773-680-0818.

Steve Katz:

All right, thanks again. And listeners, if you're an operator or a lender with department store and retail anchor businesses in your portfolio, I would encourage you to reach out to Dan to discuss the current situation or situations that you're working on or working through right now or those that are brewing and might be coming somewhere down the pike.

Steve Katz:

As always, we hope that this Smarter Perspective podcast provided you with at least one key takeaway that you can put to good use in your business or share with a colleague or client to help make them that much more successful moving forward and be sure to remember, you can check out more podcasts and articles featuring timely insights by Hilco experts at hilcoglobal.com/smarter-perspectives.

Steve Katz:

Until next time, for Hilco Global, I'm Steve Katz.

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