Getting and Keeping Retail Tenants on a Weak Economy

When Phoenix-based Alliance Residential conceived 935M, a retail and apartment project in Atlanta, it envisioned a hip, urban restaurant in a 3,500-square-foot space on its ground floor. Four years later, that space still sits empty. “We haven’t been able to make any headway on a closing deal,” says Kellea Curns, vice president of operations in the Southeast for Alliance. “It’s not that we haven’t had interest. Closing a deal has become a problem because the market is so competitive.”

The company has broadened its definition of “hip” and “urban” in order to expand the universe of possible tenants for the space, but as of press time it still had not gotten any restaurateurs to sign on the dotted line for its 3,500 square feet. Alliance isn’t alone. While the apartment rental market has made tremendous strides in the past year, lease-up activity in the retail sector is still in the early stages of recovery. Consider that the national average vacancy rate for downtown retail space stood at 8.2 percent in 2010, down slightly from the high of 8.9 percent in 2009, according to Princeton, N.J.based NAI Global. Multifamily vacancy rates nationally are roughly half that, a dichotomy that’s made life difficult for apartment owners who double as retail landlords.

Even in the thriving Washington, D.C., market there are issues. What remains of Dallas-based JPI is still trying to entice restaurants to move into its 909 New Jersey Avenue development in the up-and-coming neighborhood around the Washington Nationals’ baseball stadium. Even in the best of times, renting apartment retail components can be challenging. There usually isn’t room for a large anchor tenant such as a Target or Best Buy, and parking is often more difficult. That leaves owners broadening their reach to find tenants and then offering incentives to lock them in. In fact, owners are modifying their agreements with tenants who moved in during the heydays of 2005 and 2006 to keep them in place.

Cutting a Deal

In fact, when it comes to paperwork and logistics, the retail leasing system makes renting an apartment look downright easy. Instead of generally providing a one-year lease with monthly rent (that may or may not include a month of free rent), the retail lease has more variables. As an example, a standard five- to 10-year lease may require the tenant to pay base rent plus a percentage of sales. If the tenant is new (and especially if it’s a restaurant), it will often require the building owner to put in a significant amount of money for tenant improvement (usually called TI) and rehab.

With a lot of variables in retail deals, though, there’s also a lot of room to negotiate. Unfortunately, to fill a space lately, the owner is the one offering the concessions. “In challenging areas, you’re talking about six months to possibly up to a year’s free rent or materially discounted rents,” says James N. Duncan, senior vice president and partner with McLean, Va.–based developer Jefferson Apartment Group (JAG), which is looking to lease the ground floor in its 14W project in the heart of Washington, D.C. “But for the right operator, you’ve got to be willing to give a great deal.”

In its Second Street project in Austin, Texas, Chicago-based AMLI Residential is, in some instances, rewriting deals to keep its original tenants in place. Some smaller boutique retailers moved in thinking they’d be making $50,000 or $60,000 a month. Instead, they’re at $20,000 to $30,000 a month, due to economic conditions.

“Some of our original tenants are unable to afford the rents they originally leased for,” says Taylor Bowen, executive vice president at AMLI. “Given these were first-generation tenants, and they required some TIs, leasing commissions, and up-front costs, it puts us in a difficult position, as it forces us to decide whether to restructure a lease to keep a viable tenant in the district or terminate their lease and look for another retail tenant.”

Without a better candidate waiting to fill the space, if AMLI decides to restructure a lease with a tenant, Bowen must first review past sales history, as well as the tenant’s future marketing plan, and ask for detailed financials to avoid committing to a tenant that may not be able to survive, even with a rent reduction. If a tenant once had good sales numbers, is temporarily having problems due to the larger economic conditions, and has the long-term potential to come back, Bowen will try to work with them.

When Bowen does decide to restructure, the lease typically reflects lower base rents to where the retailer can survive, but with a higher-percentage rent provision. So if the gross sales improve, then the landlord keeps that extra amount of rent. “All of our leases incorporate triple net rents, which involves passing through a portion of common area charges, taxes, and insurance to the tenant,” Bowen says. “We’re trying to come up with ways to tie their rent to their occupancy costs, so if the economy and the retail sales environment improve, then the rent we receive will improve with them.”

However, AMLI still protects itself, even in the restructuring scenario, in case things change. “We ask for a minimum base rent and sometimes we put relocation and early-termination clauses in our lease amendments so we don’t encumber the space,” Bowen says. “If we decide to work with a troubled retailer to keep them in the space but think a better tenant might want the space, we can’t be hamstrung and unable to re-lease it. Using some or all of these various restructure options gives the tenant the ability to improve their business and remain in the space longer than they otherwise would, but also allows us, as the landlord, the ability to continuously bring additional tenants to the space that will enhance the district, our customers’ shopping experience, and retail in the city as a whole.”

Spread the Net Wide

When Alliance needed to change direction to find occupants for its space at Piedmont, it changed brokers. It’s not unusual for retail owners to get brokers. For instance, JPI hired a broker to find a tenant for its D.C. project and secured an upscale, local liquor store seeking a new location. That’s often the advantage of relying on brokers: They know what’s going on in the market and what retailers may be looking for new homes.

“[The liquor store owner] knew the area,” says Duncan, who used to work for JPI. “They wanted that second store, and this was a great space for them.”

Not all brokers are the same, though. Alliance started with a larger broker that Curns says didn’t have the “connections or expertise” in 935M’s Western Atlanta submarket. That didn’t work, so the company recently switched to a local operator that she says is “well ­connected” and knows the submarket.

“We’re really relying on the broker to utilize their networking and connections in this submarket to bring us some of the restaurants trying to break into the market that have a strong backing or are part of a healthy franchise that could just step right in,” Curns says.

Duncan doesn’t necessarily always wait for a broker, however. He has also gone to owners of stores and restaurants he may like, to sell them on moving into his spaces. “We have often gone to operators and said, ‘I’ve got this location. You should look at it for this concept that you’ve got,’?” he says.

Alliance is also getting more creative with its advertising by reaching out through Craigslist and other Internet avenues to find customers. Craigslist and LoopNet have been especially effective in the one place retail is thriving—the live/work sector. In two locations in Atlanta, the company has live/work spaces, ranging from 1,080 square feet to 2,415 square feet, which people like tax consultants, attorneys, and owners of hair salons find attractive. They rent the second floor and have retail space on the bottom floor with a storefront.

“We’ve sold [live/work] a lot faster than true retail space,” Curns says. “They’re paying one rent instead of one for home and one for work.”