Aug 16, 2018

Converting mall retail space requires considerations

As present retail trends continue to change and the large American shopping mall finds itself attempting to survive, owners and tenants in retail developments are determining what to do next.

Retail centers, originally heralded by the expansion of suburbs, brought a central hub for shopping, satellite offices for professional services and small retail centers to communities. For decades this model fueled the increasing boom of suburban development. Even in larger metro centers the model remains fairly consistent — a big-box retail store affixed to a shopping area with satellite functions and businesses hoping to cash in on the expected foot traffic. Today, the large shopping malls are seeing an increase in vacancy rates while big-box anchors are disappearing, producing the need to readapt to avoid closure or investor default.

Preventing loss when an anchor retail tenant leaves

From a policy perspective, everyone, for the most part, likes the concept of keeping portions of the shopping mall environment active. From a legal perspective, repurposing or changing the types of tenants raises important questions for owners of the major retail developments. The most pressing concern is satisfying existing investors and lenders when a tenant is under distress, defaults or disappears due to filing bankruptcy or market termination. In these situations, many loan agreements require an amendment, modification or workout.

Though the loss of an anchor tenant is difficult, repurposing the space does not have to be an insurmountable feat. While the original loan may have been written based on the anticipated income from the major tenancies, and the original underwriters likely viewed the loan as a shopping center with major anchor department store tenants, it is not unlikely a lender will modify the loan if the owner is able to ensure the tenant will pay a comparable rental rate to that of the departed big-box.

Major retailers have enjoyed favorable rates over the last cycle as many landlords sensed market distress. Therefore, it is not impossible that a new tenant may pay the same or perhaps negotiate a more favorable rate. 

Considerations when the shopping mall drastically changes

Having a sense of optimism is important in this rapidly developing market. Some conceptual innovations may be necessary, such as: structural modifications to the design and space use, including altering common areas to suit new tenants; adjusting the usable and rentable square feet of the property; and revising the load factor used in calculating the rent. This may also change some of the economics of the property from a lender’s perspective which should be discussed as the loan requires. 

Technically, the major retail developments are zoned and approved for traffic-heavy uses, making them very viable conversions for medical, office and educational centers. Usually, there is no need for a traffic volume study or the addition of surface parking when converting a big-box anchor space into, let’s say, a technical college. A creative thinker would say, ‘Why not? A food court is already there with plenty of strolling space for a campus (albeit often indoor) and the proximity to residential developments is also available.’ To a true optimist, a mall is practically a college town.

There are legal considerations for existing tenants as the smaller tenants located near anchor-tenant entrances tend to pay a premium for access to areas with a high traffic volume. Owners should offer space relocation and other incentives if requested, which should be fairly simple to implement as long as there are no territorial exclusivity agreements with other market competitors in the same space. For example, a jeweler outside of a high-end department store would not want to move across the promenade from a competitive jeweler.

Retail centers are beginning to consider the reuse of big-box shells for distribution centers and other retail-related, non-storefront business options. There are legal aspects to consider such as different property uses have different attendant nuisances. Warehouses and distribution centers are not quiet environments — they usually have a constant din of safety alerts for moving equipment and other sounds that would drown out a mall’s piped-in music. Developmental leases containing covenants regarding hours of operation, noise and acceptable levels may disturb existing tenants. Changes such as these may require the installation of sound-deadening improvements, but everything is possible. Zoning relief may be necessary, too, as an increasing large truck traffic onto adjacent arteries may be outside of the existing use authorization for the development. Ultimately, shopping malls have excellent proximity to concentrated residential areas so this potential shift may be popular, if allowable.

Unusual issues arise if the anchor tenant does not renew their lease. Many leases have provisions that require the tenant to return the space into a similar condition as the one originally leased to them, which often requires removal of many interior items, constructed areas, displays and escalators. 

As many big-box retailers seek bankruptcy protection to avoid the painful lingering in their decline and often choose to sell, usually online, productive assets, big questions arise about how the departed tenant pays for restoration of the space. Chances are, bankruptcy trustees (those responsible for the assets of the debtor company) will have little willingness to pay for restoration of the space and the removal of tenant improvements and, ever more likely, the bankruptcy estate will have little or no funds to pay for the renovations. Owners should consider working with the trustee and the court to address this issue. Generally, a bankruptcy puts a stay on any actions against the debtor or its property without the court’s permission. This means that even a forfeited security deposit may require court approval. Funds may be available in certain circumstances like security deposits, property tax or common area maintenance prepayment or tenant improvement funds. If there is no bankruptcy, then the lease’s provisions on forfeiture of these amounts would govern. Bankruptcy, however, complicates this process.

Prior mixed-use retail and service tenancies may leave hidden treasures that can cause massive problems. A good example is the large retailer in a mall environment that also offers auto service or retail gasoline. These uses often require underground storage tanks for gasoline or waste oil. The old tanks can lead to environmental and disclosure issues for subsequent leases or subsequent purchases and may leave an expensive abatement obligation on the table for changes in use. 

As the cycle continues to be optimistic, retail real estate will likely embrace the changes ahead. Just as residential builders have pivoted from condominiums to rental apartments, perhaps retail developments will shift from department stores to college, hospital or movie theater hybrid-use areas.

This Chuhak & Tecson, P.C. communication is intended only to provide information regarding developments in the law and information of general interest. It is not intended to constitute advice regarding legal problems and should not be relied upon as such.

Client alert authored by: James R. Stevens, Principal