How Shopping Centers Can Mitigate Market Headwinds

Retail is at the forefront of rampant inflationary pressures as consumers face price increases for gas, groceries, housing, and other essentials. As a result, retailers have become hyper-aware of the shift in buying habits and their bottom line. Since COVID-19, retailers have had a tough time balancing the need to maximize retail margins, retain customer loyalty, and reconsider operationally strategies, from space needs to staff training, vendor management, and customer engagement. On the cost side, operating expenses are rising and making it difficult for retailers to remain profitable. A predominant challenge is the ability to attract and retain workers at previous wage rates. For example, retail annual wage growth has increased by 7.4 percent and 9.4 percent in food services. Costs are piling up and those who manage these costs effectively stand on competitive ground, allowing for great maneuverability.

“Inflation will eat into retail profit margins. Firms can pass along price increases to consumers, but only to an extent.”

Operational Responsibilities for Retailers

Now more than ever, maximizing margins on each transaction is critical as the market witnesses an increase in overall expenses.

Increase in Cost-of-Service Contracts or CAM Charges

Common area maintenance (CAM) charges are the costs of common area maintenance that landlords pass on to their tenants. These charges typically include all the costs of repairing, maintaining, and cleaning the common areas of the leased property. The exact expenses included in CAM charges depend on the specific lease that a tenant and landlord agree upon. Usually, landlords offer either a fixed fee for the monthly CAM charges or allocate a percentage of the total CAM charges to individual units based on the amount of space each rental takes up and how much the tenants utilize those common areas.

These can include:

• Parking Lot Maintenance
• Lawncare and Landscaping
• Snow Removal
• Sidewalks
• Hallways
• Bathrooms
• Elevators
• Utilities

For tenants, CAM charges can be intimidating, especially in the current environment, as retailers are exposed to various impacts from labor, operational, energy, transportation, services, and material costs. When there is no cap or fixed rate, and CAM charges are passed on to the tenant, there is an intricate balance that landlords need to decide upon – making sure expenses are paid and the tenant doesn’t vacate the space.

Short-Term Renewals

Across the nation, retail rents have increased, not due to inflation dynamics, but rather demand fundamentals. While some dense urban markets in costal cities are just beginning to emerge from the downturn caused by the pandemic, other markets are experiencing limited availability of desirable retail space, ultimately driving up rental rates in most U.S. markets. For those retailers that don’t have a lease secured, increased rents are impacting tenants’ bottom line. This begs the question, will rising costs impact tenants’ desire to stay, or will tenants require more services to hold their competitive advantage?

Shopping center landlords currently have negotiating leverage and are eager to secure high-quality tenants. As mentioned above, lease types will determine how much exposure to utilities, maintenance, and other variable costs occupiers will bear in real-time. Real estate costs account for ten percent of total operating expenses, so inflationary pressures could impact these expenses, increasing the overall allocated percentage.

The good news for tenants is that real estate costs are slow to react as most commercial leases are long, ranging from five to seven years. These leases typically include an escalation that enables occupiers to plan for future rental cost increases. The figure is usually a fixed number that is based on historical inflation averages. On the other hand, short-term leases do not have this option. They have a notoriously bad reputation in commercial real estate as short leases lead to higher turnover, which means extended periods of vacancy for the landlord and more frequent buildouts for new tenants. Having too many short-term leases can become a drain on profits; however, there are certain circumstances where landlords can benefit from short-term renewals.

Short-term renewals give landlords the flexibility to fill up gaps that will exist in a building’s rent roll. For example, a well-positioned and long-term lease tenant plans to expand into an even larger space after a few years. Instead of landlords allowing the space to sit vacancy, short-term tenants can fill the space and operate as a stopgap. By entering the short-term lease arena, it’s possible to avoid vacancies while keeping the space available for the future of the long-term tenant’s expansion plans.

Capital Expenditures

The good news is that most capital expenditures or retail improvements do not recur on an annual basis. For example, repaving a parking lot, replacing a roof, or adding outparcels. However, there has been a major shift in how consumers shop in the last two years. Improvements to make the overall property sustainable, convenient, and accessible are more crucial than ever. A significant consideration for retailers is the impact of e-commerce on shopping behavior. Over the last two years, there has been a rise in BOPUIS (buy online & pick-up in-store), impacting the layout of floorplans and overall parking lot structure.

A retail center that looks good and is well maintained will generally perform better than one that is poorly maintained. To keep a class “A” level, landscaping needs to be continually updated, facades need to be repainted or updated to current architectural aesthetics, parking lots need to be restriped and resurfaced, and amenities need to be updated or added. Tenants and landlords generally agree on this but do not agree on who should be paying for it. As mentioned above, CAM is covered under the lease, but extensive replacements and new additions are considered capital expenditures and not reimbursable.

Guidelines to follow:

• Make improvements on an annual basis
• Analyze whether the improvement will add value
• Review major leases before projects
• Keep overall CAM under lease caps