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The Current and Future State of Class B Regional Malls

Glenn-Brill

There’s no question that regional malls, especially those outside major metropolitan areas, are feeling the brunt of market disruption. The brick-and-mortar retail environment has long been fighting the battle against e-commerce encroachment, shifting consumer habits and changing demographics. In the last five years, based on CoStar data:

Retail rents in general have grown only 1 percent on average annually since 2011 while multifamily and office rents have seen 5 percent increases during that same time period.

Class B and C regional malls have experienced a negative annual average growth of -3 percent; rents are down by approximately 19 percent.

Also decreasing is the square footage being leased, from approximately 17,000 square feet on average to 11,000 square feet between 2010 and 2015.

Currently, one-fifth of all U.S. malls have vacancy rates above 10 percent as department stores retrench.

On the flip side, CoStar reports regional mall asset sales volume has risen significantly over the past three years, demonstrating that these properties can still-be attractive investments, particularly among private equity investors and REITs. They are buying Class B malls at relatively high capitalization rates at times approaching 8 percent or 9 percent (compared to a sub-6 percent cap for Class A malls), and are therefore enjoying immediate cash-on-cash returns and a strong yield.

However, with the prospect for a continuing downturn in occupancy and rent in these properties, the environment also requires innovative capital preservation, repositioning and exit strategies to support investment returns.

State of the Class B Mall Today

Many regional malls are no longer the destinations they once were; rather, many consumers want the anytime convenience of online and mobile shopping and showrooming as they seek out the best values and the lowest possible prices. On the retail side, Standard & Poor’s reports that merchants are experiencing declining margins as they seek a balance between bricks-and-mortar stores and their e-commerce platforms.

Second, due to the socioeconomic conditions in many markets nationwide, middle class consumers are ever more price-conscious and more attracted to outlet malls and discount mass market standalone superstores. This is especially true across many of the country’s smaller cities and less populated regions. Lower-priced retailers are eating away at department stores’ customer bases, creating a domino effect on Class B tenanting issues — higher vacancies, smaller leases, declining tenant quality and concomitant revenue declines.

A third factor is changing consumer habits and demand for greater convenience with stores open earlier and closing later to meet the needs of working people; and malls that go beyond traditional fashion retailers, offering supermarkets, gyms, services, and entertainment and dining options.

Turning a Profit from Class B Investments

Owners of Class B malls — and the investors who are buying them — must weigh several factors in order to derive value from these assets.

Many long-term owners are actually in a good position to sell, depending on how much money was borrowed against the asset; there is room in the market to exit the asset at a relatively favorable price and preserve a satisfactory overall investment return largely based on years of operating income.

Buyers of these assets are wise to go into the deal with eyes open and an opportunistic exit strategy at the ready, based on a rapidly shifting marketplace.

Given the low cost of capital today — with many buying assets at a relatively high cap rate — buyers have a very attractive shorter-term yield on these investments, especially if they can manage the asset in a changing local market.

However, buyers must understand that the yield may decline along with the economics of the mall. That said, if they “buy-it-right” at a low enough price and work toward repositioning the asset, they’ll reap residual value and may more than recoup their investment.

Many buyers of Class B and C malls invest expressly for the purpose of repositioning the asset, often partnering on joint ventures with others with experience in mixed-use development.

Repositioning, Repurposing for Renewed Life

With an understanding of prevailing socioeconomic conditions in any given market, investors holding Class B assets can turn a failing mall into a more valuable asset through repositioning or repurposing.

Developers and REITs are repurposing tired regional malls into thriving outlet centers based on consumer demand. Others are thinking outside the retail box, selling portions of the property to mega churches, cloud computing and other digital-age companies that need large spaces, or repurposing the space to accommodate healthcare facilities and medical offices. In some cases, department stores are being converted into retail offerings with dining and entertainment to drive traffic to the mall.

Given the underlying value of the land, one approach is to completely demolish the asset and construct a revenue-generating mixed-use development. Other malls are becoming retail villages, lifestyle centers or town centers, as suburban dwellers seek more accessible and walkable main street environments where they can work/shop/play. These properties may incorporate a gym, supermarket, restaurants and entertainment along with shopping, residential and office components.

Class B and C malls represent opportunities for the right investor. Understanding what the local market will support and being open to redevelopment to meet consumer needs can help turn around an obsolete asset and turn a profit in the long run. SCB

— Glenn Brill is a managing director in the real estate and infrastructure solutions practice at FTI Consulting Inc. Contact him at [email protected]

This article initially ran in the April 2017 issue of Shopping Center Business magazine.

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