Landlords of well-located shopping centers are in a strong position to correct below-market rents and ramp up their tenant mixes, some say. “There’s never a better time to replace your weaker merchants than when demand is high and supply is low,” said Retail Specialists executive vice president Bill Read.

Demand for space is especially strong within the open-air-center portfolios of national REITs like Brixmor, which owns and operates about 360 properties. Brixmor’s second-quarter earnings report revealed that the company broke records in three categories: total leased occupancy, at 95.4%; anchor-leased occupancy, at 97.5%; and small-shop occupancy, at 90.8%. “When you look at the industry as a whole, occupancy numbers are the highest they’ve ever been,” said Brixmor senior vice president and head of leasing David Gerstenhaber. “Every time we have a box or space available, there is incrementally more competition on it than we’ve seen before.”

Robust demand has helped Brixmor update multiple tenant spaces in recent months.

• At Barn Plaza in Doylestown, Pennsylvania, the landlord replaced a combination Marshalls-HomeGoods with Barnes & Noble and Bucks County’s first Whole Foods Market. Barnes & Noble opened last month, and construction on Whole Foods is underway.
• At Coastal Landing in Brooksville, Florida, Sprouts Farmers Market opened in August in a former Bed Bath & Beyond.
• Wayfair Outlet opened this month in a former Bed Bath & Beyond at Westridge Court in Naperville, Illinois. In April, another Wayfair Outlet, pictured at top, backfilled a Bed Bath & Beyond in Wendover Place in Greensboro, North Carolina.

And lack of new construction isn’t the only driver of tenant demand. Open-air centers are appealing to mall retailers thanks to their high visibility, low common area maintenance fees and accessibility, Gerstenhaber noted. “The second piece of it is a lot of retailers are performing well right now and are in expansion mode,” he said. Growth is strongest among those in entertainment, pet supplies, quick-service restaurants, health-and-wellness, beauty and fitness. “We are now seeing a handful of players in categories where historically we might have seen only one or two,” Gerstenhaber said.

How to Spot Trouble Among Your Tenants

Attention to tenant performance allows landlords to identify those that might need to be replaced. NewMark Merrill Cos. president and CEO Sandy Sigal said his company has always prioritized tenant monitoring but there is a bit more focus now on finding replacement-tenant opportunities due to today’s landlord-friendly economics. “We certainly talk about it a lot more for sure,” he said. “The difference is really just that it’s more offensive than defensive.”

Spotting problems early gives landlords a chance to step in and help some tenants understand and overcome their business issues, said Equity Retail Brokers principal David Goodman. “This is one of the main reasons that so many landlords want tenants to report sales,” he said. “When they see a downward trend, that’s a trigger for them to talk to the tenant to find out what’s going on.”

With more transparency into financials, Read added, landlords can flag situations in which retailers’ total expenses are unsustainably high. “I handle a couple of large shopping centers, and there have been merchants where, when you looked at their occupancy costs, you realized that they shouldn’t be in that center,” he said. “It’s a heads-up that you should start marketing that space.” Landlords also can ferret out trouble by asking their collections personnel to run trend reports on late payments by retailers, Read added.

NewMark Merrill watches tenants’ social media reviews for signs of slipping performance, Sigal said. “If the retailer’s customer service is going in the wrong direction or if customers are reacting negatively to what’s happening in the store, that’s a good sign that the tenant might have a pricing or labor-supply issue,” Sigal explained.

Traffic data from mobile devices can illuminate gaps in the tenant mix, as well, Gerstenhaber said. “We’re using geofencing traffic data to see not only how well they perform versus their peers and their other locations around the country but also trends across both the retailer and the center.”

Meanwhile, staying in touch with retailers, brokers and leasing agents can help landlords uncover opportunities to bring in better operators. “The relationships that we have at the local, regional and national levels are a critical way for us to understand how our tenants and retailers are performing,” Gerstenhaber said.

Giving Tenants an Out

Shopping center owners certainly can decline to renew weaker tenants when the time comes to renegotiate their leases. But if a retailer is still making rent and fulfilling its obligations, owners generally are reluctant to take advantage of renewals in this way, Goodman said.

On the other hand, a strong replacement opportunity, such as an expanding national credit tenant with a keen interest in a specific submarket, can spur a landlord to start a conversation with a struggling operator. “Let’s say I learn about that new opportunity and bring it to the landlord,” Goodman said. “The landlord might then go to the existing tenant and offer to let them out of their lease.” This is especially likely, Read added, if that tenant is paying below-market rents.

Retailer restructurings and liquidations can lead to replacement opportunities, as well. The landlord might win back the lease in a Chapter 11 bankruptcy auction or regain control of the space after the court grants a lease rejection requested as part of the tenant’s restructuring process.

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In Greater Philadelphia’s suburban markets, Goodman said, landlords have been mostly upbeat about replacement prospects for spaces formerly occupied by chains that have restructured or liquidated, including Big Lots, 99 Cents Only, Bed Bath & Beyond, Party City, LL Flooring and Rite Aid. “It might be tougher to replace a Big Lots or a Rite Aid at a B or a C center,” Goodman said, “but in a quality shopping center in this market, a distressed tenant is an opportunity.”

That includes the opportunity to bring up below-market rental rates, Gerstenhaber added. “A tenant like Big Lots, for example, tends to have very low in-place rents, significantly lower than what our average rent is,” the executive said, “so we do have a lot of opportunity there.”

The Cost of Downtime

In deciding whether to replace struggling tenants, landlords need to factor in how long it will take for a new merchant to open in the space and start paying rent. “At a minimum, the landlord is probably looking at seven months of downtime,” Read said.

Dollar Tree announced in May that it had picked up 170 99 Cents Only leases in two bankruptcy court-approved transactions. Then, in its earnings report for its second quarter, which ended Aug. 3, Dollar Tree lowered its sales outlook owing in part to longer-than-expected times to convert those 99 Cents Only stores to Dollar Trees, CFO Jeff Davis said, according to a Seeking Alpha transcript of the earnings call.

Increasingly, retailers aim to protect themselves from such costs. “Now, many tenants will only tie rent commencement to when they have their permits in hand,” Goodman noted. For the landlord, that can translate into financial risk. “If rent commencement is tied to permits and either the township or the tenant is dragging their feet,” Goodman said, “the landlord could be looking at an open-ended period of time before being paid.”

But landlords can protect themselves in their leases. “They can require that replacement tenant to apply for permits within X number of days after executing the lease and to pursue those permits diligently,” Goodman said. “And if the tenant doesn’t have the permits after a certain amount of time, then the landlord can pursue those permits on the tenant’s behalf.”

Lower-Than-Usual Tenant Improvement Allowances

Landlords with the most leverage are now able to shell out less than the historical norm for replacement-tenant buildout, Read said. “They are tighter with construction-allowance and tenant-allowance dollars these days than I’ve ever seen,” he said. “The cost of money has gone up for them, and because of the tight supply constraints, they feel that they don’t have to put in as much as before.”

But as Read sees it, virtually all national tenants require some tenant improvement dollars. He recently re-leased an Atlanta space previously occupied by WeightWatchers for 21 years. A newer national weight loss operator wanted to add eight meeting rooms, a break room and an office area. “They’ll be spending almost $100 a foot, and the landlord did elect to put in TI,” Read said.

While some landlords are against paying TI on philosophical grounds, it is generally not an issue for well-capitalized owners, Goodman said. “They know they’re going to amortize it in a higher rental rate,” he explained. “In fact, some of the national REITs much prefer to do an as-is deal or one with minimal landlord’s work and write a check to the tenant.”

This frees them from having to tackle the construction project themselves and also bolsters their performance in the eyes of REIT investors. “If they’re buying the rents up with TI,” Goodman said, “they can report higher rents.”

By contrast, smaller landlords often “do not have the financial wherewithal to meet the cost structure that many national tenants require,” Read said. Replacing a Big Lots with a TJX concept, for example, “is likely to cost you well over $80 a foot.”

The Big Picture

A beloved, family-owned pizza joint that opened in the 1990s might not pay the highest rent or boast the strongest credit, but it could make a center special to the community. When contemplating the future of a given space, in other words, landlords should consider the role the tenant plays in the asset as a whole. “It’s important to look at whether that tenant does its share in terms of drawing traffic that benefits other tenants in the shopping center,” Sigal noted.

Gerstenhaber advised: “Think about the long-term plan for that center and how that tenant is going to transform it if you put it in. It’s about more than dollars and cents.”