The art of sweetening the deal

Some of the recent statistics on retail leasing across the U.S. might sound a bit contradictory. Rents in many major markets nationally are still strong and in some cities, such as San Francisco, breaking records. At the same time, a record number of retail outlets shuttered in 2016, and a number of national legacy brands — bedrock American companies from Kmart to Sears — have closed a slew of stores and/or filed for bankruptcy protection.

With this kind of uncertainty in the retail world, landlords are increasingly turning to incentives to sweeten deals for cautious retailers, even on High Street strips. Lucrative incentive deals may include a period of lower rent at the start of the lease term, huge contributions to the tenant build-out and, sometimes, lower rent for the entire period in exchange for a percentage of total revenue.

Incentives are nothing new, but “the race to incentivize is more than we’ve seen in the last five years on Fifth Avenue in New York,” said Naveen Jaggi, president of retail brokerage at JLL. For luxury retail in other major metropolitan areas, he said, landlords are “incentivizing, but not on the same level as in New York.”

Until very recently, retail on High Streets had generally performed well since the darkest days of the recession, with rents hitting records in the last five years in many of top shopping corridors nationally — Chicago’s Michigan Avenue, New York’s Fifth Avenue and Rodeo Drive in Beverly Hills. But since the recovery, consumer preferences have shifted and occupancy costs have gotten higher. Retailers are making do with less space, including sometimes having only a showroom-type space, even for clothing or shoes.

Taking rents are now hovering around 15 percent below asking, one prominent retail broker who asked not to be named said. And in some areas, including Manhattan, asking rents are already falling.

Faith Hope Consolo, a retail broker with Douglas Elliman, said the tide has definitively turned in the tenant’s favor in lease negotiations. “It’s an epidemic. They are offering not only tenant improvement, which they never did, but better terms and lower rent in the first couple of years,” she said.

Douglas Elliman’s Faith Hope Consolo

Better terms can be a mix of incentives, some of which might help shield both tenant and landlord from overcommitment. These include lower introductory rent and flexible options on both sides, brokers said. With all the churn in the retail landscape, that makes sense for both parties.

Still, the uptick in incentives could mean that retailers who can’t quite afford spaces in the long run are coming in, leading to turnover, more defaults or landlords being forced to lower rents even further. But Consolo disputed that, saying, “the idea is not to finance the weak or undercapitalized groups but to set a platform for those companies to take locations now versus when the market improves.”

Landlords also say they are not incentivizing to get space rented to just anyone. They want the right retailers: fitness, furniture, international fashion brands and, above all, food. “Food is fashion,” Consolo said. “Anything green, organic” is sought after. And Americans are just as obsessed with working off those calories once they consume them. “Anything to do with fitness — Lululemon, Sweaty Betty…your SoulCycles, your Pelotons” are the appealing tenants du jour, according to Consolo.

Most often, the incentive takes the form of a contribution to a tenant’s build-out. In some cases, that could be seven figures or more, as at the Tom Ford store at 680 Madison Avenue, where landlord Thor Equities reportedly plunked down $12 million for the designer’s build-out last summer. But for a restaurant, landlords will sometimes even slice a portion of the rent off the top as well. Consolo said that for restaurants, she is able to negotiate 8 to 10 percent off of total rent in a mix of incentives at the moment, but she declined to name specific tenants.

As restaurants have become “an anchor tenant” for some landlords, their negotiating power has grown, said James Chung, managing principal for retail in the West at Cushman & Wakefield. “The food sector has driven 60 to 70 percent of transactions,” he said, while grocery stores have also seen a resurgence. “The grocery space is as active as I’ve ever seen it, and that is not always the case.”

Another harbinger of the turning tide for retail landlords is their willingness to offer lower rent in exchange for a percentage of revenue. Consolo says this provision — a “risk-sharing” mechanism that can benefit the landlord in boom times and the tenant when sales are down — is often on the table. “We are seeing percentages [in play] on Main Street now, in order to offer an upside to the lower rent,” Consolo said. The lease provision had once been reserved for large, high-end shopping centers.

JLL’s Naveen Jaggi

At the same time, rents in many markets remain at record highs. Chung said there were 4,000 closures nationally in 2016, as opposed to 3,600 in 2010 — the height of the recession for retail. But retail vacancy in the U.S. overall was down to 7.3 percent from 7.7 percent year over year at the end of 2016, he said. And while rents have faltered in some markets, they’re stable or rising in others.

Of course, the actual rents landlords are pocketing are likely not nearly as high as they’d like it to seem. Taking rents are carefully guarded, and many published reports don’t note that the taking rent and the asking rent might be divergent. There’s “artificial inflation and pricing” baked into what it seems tenants are paying, Jaggi said. “What we don’t know is the financial conditions of the owner and lender.” It’s often in landlords’ interest to seem leased up, and at good rates. They want to keep published rents high, brokers said, so their properties appeal to an investor or real estate investment trust that might want to buy them out. They also might want to be able to leverage the real estate to the fullest extent, and higher rents mean higher loan-to-value ratios in financing.

It’s also a game where, if one landlord is playing, others will join in. Incentives let them obscure their troubles. “Landlords are struggling to fill anything but the primest of prime retail locations,” said Tom Fink, managing director at analyst Trepp. “There’s caution for lenders on the terms they’re willing to give.”

Chung cautioned against generalizing based on anecdotal evidence. While incentives might be on the upswing, the negotiations are still happening on an “asset-by-asset basis,” he said.

But with retailers scrambling and landlords playing defense, incentives can make negotiating the new landscape easier on everyone. “In major markets, [landlords] are trading on how many square feet are leased. It’s really a matter of accounting,” Jaggi said. “It’s all about the tenant incentives.”

(To view a list of retail leases in Manhattan over the last six months, click here)