Malls, Stores And Distress: What Does An Empty Store Mean?

Five Unit Strip Mall

Forget empty houses… what about empty commercial space?

Justin Fox in Time:

I live in a very prosperous neighborhood of New York City, the Upper West Side, where the main thoroughfare, Broadway, is full of vacant storefronts. Except for a few recent restaurant closings, this isn’t a product of the recession—it was just as true a couple of years ago. I mainly blame the banks, which at the height of their expansionist frenzy were adding branches on every corner, driving out more useful neighborhood businesses and overpaying on rent, thus driving up the expectations of every commercial property owner in the neighborhood. That led to lots of shop and restaurant leases not being renewed, and lots of ground floor commercial space going unused because for all their expansionism the banks were never going to need all the commercial space on Broadway.

Now the banks are retrenching. I imagine rents will eventually sink far enough to reflect this new economic reality, and the storefronts of Broadway will fill up again. But it’s taking absurdly long, and millions (hundreds of millions? billions?) of dollars in economic value is going lost in the process. The Upper West Side commercial real estate market would seem to be spectacularly inefficient.

[...]

Marcus’s explanation:

“[M]any of these buildings are worth more as losses, write offs and deductions that as going concerns. The potential rents are so low that few can actually be bothered renting them. The commission for real estate agents are negligible. Commercial leases are by default prohibitively long and often require property owners to meet expensive obligations.”

That, and the cost of complying with regulation can make small businesses and small real estate transactions uneconomic. Marcus came up with a clever partial solution in Newcastle—starting an nonprofit called Renew Newcastle that persuades property owners to let it take over their vacant commercial space on a rolling 30-day basis and then cleans it up and rents it out for use as shops, galleries, studios and a tea house. I don’t know how you make that work in a neighborhood like mine that isn’t in obvious need of rejuvenating but does have a temporarily dysfunctional commercial real estate market (that is, I can’t imagine landlords along Broadway agreeing to participate in Renew Upper West Side). But the common theme—that commercial real estate is prone to market failure—is pretty striking.

Felix Salmon:

Justin is absolutely right about the corrosive effect of bank rents on New York rental rates: all landlords want the kind of rents that only banks can afford, but of course not all landlords can have a bank as a renter. But the bigger picture is that commercial real estate in general often stays empty for extremely long periods of time — something which harms neighborhoods and lets huge amounts of economic value go to waste.

Why is this? I think the answer lies in the fact that commercial leases tend to be very long-term things — so long term, in fact, that the discounted cashflow from any given lease is likely, in a normal (non-bubbly) property market, to be more or less the same as the value of the commercial property itself. Looked at this way, a developer spends a certain amount of money on putting up (or simply buying) a building, and then sells that building, in lease form, for a profit.

If prevailing leases are low, or tenants hard to find, the developer will quite rationally choose to keep the property empty. Leasing at a low rate will lock in a loss, while keeping the property empty has significant option value: at some point in the future, rents might well rise, and the developer can at that point lock in a profit instead. This is why successful property developers generally need very deep pockets: anybody who needs immediate cashflow, in the form of rent today, is in an invidious bargaining position and is likely to lose out over the long term.

Matthew Yglesias:

If you look at suburban strip malls, the same long lease dynamic applies, but widespread strip mall vacancies are normally a sign of specific economic distress. The current recession has less to a lot of them, but in normal economic times you tend not to see this. Instead, even depressed areas reach a low-rent equilibrium. Possibly this is because strip mall property is less speculative in nature than urban property. But I think the specifically urban nature of the problem probably has something to do with the level of regulatory uncertainty surrounding new retail endeavors in most American cities combined with the reluctance of many neighborhoods to play host to the sort of “uncool” national retail chains that could better manage the risks involved.

Megan McArdle:

One guess is that malls are likely to be owned by professionals who are better managers of their retail yield than individual landlords.  First, they are professional retail managers, not just owners of property, and second of all, malls place a very high value on having foot traffic.  Stores in malls benefit greatly from spillover traffic, which is why anchor stores like Macys are big focuses of the industry.  Urban stores do too, but there’s no one landlord in charge of them.  A building on Broadway and 86th Street is not going to lower the rent on its vacant space because the fish store on one block up will see an 8% rise in sales.

The other guess–or perhaps it’s more of a corollary–is that because malls are not so dependant on casual foot traffic, there is less worry about lock-in.  That is, a restaurant in the Paramus Park Mall is not getting any significant number of its customers from the area immediately surrounding the mall.  Any other mall with decent foot traffic of the right demographic is a very good substitute for one they’re already in, so they can leave if the landlord gets too frisky.  Plus, the space they rent very likely is a space specifically designated for a restaurant, allowing them to demand some capital improvements from the landlord that an urban tenant can’t.  In the city, a pizza place that hates its landlord has to worry about finding and building out a new space, and then charming customers away from the 22 other restaurants within a ten block radius.

Karl Smith:

The difference is that a mall has a single owner who internalizes all of the externalites associated with vacant storefronts (and trash and crime, etc). An ugly mall is a less popular mall and thus commands lower rents overall. Typically its worth for the mall owner to take a hit on one store if he can make it up in higher rents for the others. This, of course breaks down when demand for the whole mall declines.

The externality problem means that, in general, communities will be more pleasant, though much more expensive, if one landlord owns the whole shebang. I think this one reason many people find University campuses to be so nice.

More Salmon:

If one landlord owned all the shops on Broadway, she could happily rent a few of them out to banks at high rents, while renting others out to high-prestige, low-profit artisanal shops at much lower rents, all in the interest of maximizing total rental revenue. (I’m reminded that at the Time Warner Center, the landlord actually paid a set of bold-face names like Thomas Keller and Jean-Georges Vongerichten to open up restaurants there: they would never have opened up in the middle of a shopping mall otherwise.) Those cross-subsidies can’t work when there’s a multiplicity of landlords.

So yes, one solution to the problem of empty storefronts would be for a single landlord to take over a large shopping area. But I don’t think many people want that: you invariably end up with something which feels like an outdoor mall.

Yglesias:

And of course a mall owner can better internalize positive externalities as well. In general, the whole strip mall is operated as a unit. By the same token, this is why you see whole malls go totally dead which rarely happens on urban retail corridors even in depressed areas. It becomes more of an all-or-nothing thing.

UPDATE: Sommer Mathis at DCist

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