Legal covenants often cause excessive property taxation for mall owners that are looking to redevelop.
By Morris Ellison
The repurposing of malls and anchor stores is a popular topic in community development circles, but legal restrictions make redevelopment extremely difficult. Often locked into their original use by covenants, malls and anchor stores are often grossly overvalued for property tax purposes.
In pursuing a redevelopment, taxpayers should ensure the properties are fairly assessed and taxed.
It is difficult to overstate the plight of malls and department store anchors. Gone are the halcyon days when the mall was everyone’s shopping destination. There is even a website, www.deadmalls.com, devoted to failed malls. Credit ratings of most anchor store operators have fallen below investment grade. Commentators usually blame the retail apocalypse on e-commerce and shifting consumer spending habits.
COVID-19 exacerbated these trends and mall foot traffic has been slow to recover. Some chains, including Neiman Marcus and JCPenney, have filed bankruptcy. E-commerce volume surged in 2020 and 2021 before tapering in 2022. To date, e-commerce and brick-and-mortar sales have not yet reached an equilibrium.
One in five American malls have fully closed and remain “zombies” without a redevelopment plan, estimates Green Street Advisors, a commercial real estate analytics firm. A December 2022 article from The Wall Street Journal that detailed the “long death” of the White Plains Mall noted there is no shortage of dying malls. The article observed that converting enclosed shopping centers to other uses remains a “difficult feat.” Repurposing, while much-discussed, has not really happened.
The question is why. The answer relates, at least in part, to legal challenges inherent in changing the property’s use.
Any property valuation begins with a “highest and best use” analysis. A basic assumption about real estate directs that the price a buyer will pay reflects that buyer’s conclusions about the property’s most profitable use. Competitive forces within the local market shape a property’s highest and best use, but that use must reflect practical and legal restrictions.
Many people incorrectly assume that governmental requirements pose the only legal restrictions on use. Zoning ordinances may impose barriers, owners of neighboring properties may object to redevelopment proposals, or there may be other hinderances to changing the property’s use.
Zoning limitations pale in comparison to restrictions in recorded easements and unrecorded operating agreements between mall owners and anchor department stores. While zoning may permit non-retail uses, private agreements generally do not.
Malls would be economically unfeasible without department stores and inline stores that symbiotically drive traffic to each other. Generally, anchors own their pads and inline tenants lease space from the mall owner. A typical mall is subject to two levels of private restrictions designed in an earlier time period to promote the efficient functioning of the mall for retail stores.
Recorded operating restrictions or restrictive easement agreements (REAs) impact the entire mall and its anchors and are generally binding for 40 years or longer. Typically, substantive amendments to the REA require the consent of all parties, and their economic interests are not always aligned.
Unrecorded operating agreements govern the relationship between individual anchors and the mall owner. Terms typically address tenancy, hours of operation, required years of operation under a specified tradename and the size of each anchor and the mall. Operating agreements also generally restrict the size and construction of improvements on the anchor pad and regulate usage.
A simple example involves anchors using stores as a delivery point for e-commerce, a concept known as buy online, pick up in store (BOPIS). Many REAs and operating agreements severely limit implementation of this concept.
But what if the mall’s highest and best use is no longer retail? E-commerce and changed consumer practices undermine the REAs’ and operating agreements’ ability to ensure the property’s success, but those private agreements are understandably focused on preserving retail usage.
The common party to these agreements is the mall owner, making it the logical purchaser when an anchor looks to sell. The potential economic return on any proposed redevelopment must be sufficient to encourage an entrepreneur to take the redevelopment risk for the mall and/or anchors.
Legal risk escalates the economic risk. For example, owners of some anchor properties seek conversions to multifamily or industrial use as salvation from the “retail apocalypse.” Even if they overcome zoning objections, attempts to change REAs and unrecorded operating agreement restrictions may require unanimous consent among owners with competing economic interests.
The anchor pad may not even be worth its unimproved land value since its use is restricted to retail under the REAs and operating agreements.
Property tax implications
While mall owners and anchors struggle to remain viable in the changed retail environment, ad valorem property taxes pose an immediate challenge. Most states value property as what a willing buyer would pay to a willing seller, but the glory of malls and anchors before e-commerce generally encourage high property tax valuations.
Assessors performing an income-based assessment seldom recognize how anchor chains’ plunging credit ratings affect value. The sales-comparison approach is equally challenging, as anchor property transaction volume has plummeted since 2006.
Most sales involve a change to non-retail use and thereby require unanimous consent. Consent is easier to obtain when the new use increases foot traffic to the remaining inline tenants and anchors, but it is easy to envision anchors holding the process hostage in an attempt to force the purchase of their failing stores.
REAs and unrecorded operating covenants make calculation of an anchor’s value extremely difficult. They also call into question the comparability of previous transactions to repurpose anchors in the same mall, since those anchors may have agreed to one specific new use but may object to another.
REAs and operating agreements often hamstring mall and anchor redevelopment. Most were signed before e-commerce and did not envision retail losing its vitality. The parties to these covenants often have divergent economic interests and perspectives, and the natural party to lead redevelopment — the mall owner — must overcome these hurdles.
In the short term, however, owners should address highest and best use with assessors to reduce property tax burdens until their zombies can be brought back to life.
Morris Ellison is a partner in the Charleston, South Carolina, office of law firm Womble Bond Dickinson(US) LLP, the South Carolina member of American Property Tax Counsel, the national affiliation of property tax attorneys.