The Toll of COVID-19 on Retail and Office Spaces

Before the pandemic took over, the Commercial Real Estate (CRE) industry was booming, with experts predicting greater capital availability and healthy liquidity scenarios for the players in the space. Moreover, records from history had always portrayed the CRE industry as a space where the players faced a lagged impact of any major economic threat. However, the coronavirus pandemic, with its unimaginable magnitude of economic disruption, has impacted the CRE industry in an unquantifiable way. With a halt in most of the economic activities, imposition of world-wide shutdowns, dearth of labour and lack of liquidity, there has been an increase in uncertainty towards leasing and investment projects and in the number of bankruptcies. Also, the new safety mechanisms adopted by estate owners has led to an increase in operational costs in a situation with very low revenue collection and significant retail space vacancies. Companies have been forced to allow employees to work-from-home and may now choose to continue the policy for indefinite periods. This can only lead to lesser demand for new office spaces in the ‘new normal’ era of economic functioning.

How badly hit is the Commercial Real Estate (CRE) industry?

Source: Deloitte Insights, FTSE Nareit U.S. Real Estate Index

Source: Moody’s Analytics REIS

The pandemic has had an immediate impact on the CRE industry with major implications on the aspect of liquidity. Many shop owners and businesses experienced hikes in regular operating costs and a downfall in rent collections. The shopping center REITs (Real Estate Investment Trust) received only 46% of the total estimated rent in the initial weeks of April and many borrowers in the space applied for debt relief, owing to liquidity crunches since the beginning of the pandemic. Submarkets like Manhattan witnessed a decline of 25% (year-on-year) in leasing volumes in 2020 and investment proposals took a major hit. According to a survey by Pension Real Estate Association dated March 24, about 74% of the respondents shelved their CRE investment plans and 63% of respondents worried about uncertainties in property appraisals. The transaction volume of the Commercial Real Estate industry of the US declined by 27% YoY in March and realtors reported a decline of over 30% in buyer traffic in April. Further, the Fannie Mae Home Purchase Sentiment Index (HPSI) declined 11.7 percent in March to 80.8, its lowest level since December 2016, indicating a potential decline in new home sales. The crisis period has impacted the residential, office, and industrial spaces alike and analysts estimate the CRE industry to witness a worsening situation in the upcoming quarters before any forthcoming recovery period. 

What’s in store for retail?

While it was a flat first quarter for the retail, in terms of rent growths and vacancies, currently mall vacancies stand at 9.7%. The growth of online marketplaces amidst global lockdown situations has fueled the existing dire situation of retail and has added thrust to vacancies and retarded growth in rent figures. Moody’s Analytics REIS estimated that in the months of March and April, the proportion of e-commerce relative to total retail sales spiked rose from 11.4% at the end of 2019 to 16.4% as of the latest figures. Warehouse/distribution vacancies, on the other hand, were up above 10.1%, trending higher relative to last year. 

Source: US Department of Commerce, Moody’s Analytics REIS

Source: Moody’s Analytics Structured Finance Portal

The online shift has led to store closures and increased bankruptcy filings by retailers, both big and small, and one can only expect vacancies to break historic highs. 

Neiman Marcus, J. Crew, Brooks Brothers, Nordstrom, and JC Penney – have a concentrated retail presence in malls, and currently face distress. Most of these retailers have filed for bankruptcy under Chapter 11 of the bankruptcy code to safeguard their interest - shed debt and exit costly lease agreements. Macy’s have a retail presence in over 200 counties, but the top 20 counties account for about one-third of all the space they occupy. The largest concentration risk, however, lies in Los Angeles county, where they have a presence in over 20 retail properties. LA county accounts for about 50 percent of COVID-19 cases in the California state, resulting in economic distress for the retailer in terms of high operating costs and negligible consumer demand due to the imposed lockdowns. 

Adding to the long list of those impacted by COVID-19, Lord & Taylor, the mega retailer with a 194-year legacy, filed for bankruptcy due to shortage of cash. The retailer has a large loyal customer base, a prime real estate portfolio, and strong brand relationships. Having registered sales of $253.5 million in the year 2019, the company’s cash resources have now reduced to a mere $100,000 in 2020. The immediate future for the company appears cloudy and the firm seeks buyers for itself and its parent company Le Tote.

“The global pandemic, combined with a very difficult economy, has exacerbated what has already been a difficult time for mall-based apparel retailers,” said David Silverman, an analyst for Fitch Ratings. “For a lot of these companies, the pandemic was the final straw."

Has the demand for warehousing actually increased?

Moody’s Analytics REIS expects vacancies in the retail space to rise to 13.3% in 2021. The current situation has helped e-commerce in a major way and is bringing about a shift in demand from storefront spaces (malls and stand alone stores) to industrial spaces (warehouses and distribution). Prologis estimates that e-commerce players require about three times the space for warehousing and distribution to create revenues equivalent to those of brick and mortar stores. For instance, to create revenue of $1 billion , a regular retailer requires about 350,000 to 400,000 sq. ft. of warehouse space while an e-commerce retailer requires about 1.2 million sq. ft. Hence, the trend towards e-commerce is resulting in additional demand for warehousing infrastructure, owing to opportunity costs of lost sales and the urge to maintain a large inventory to satisfy customers with a myriad of preferences.  

This is allowing for the vacant infrastructure of bankrupt retailers to be repurposed to suit the requirements of e-commerce players and generate demand for not only the existing industrial infrastructure but also the additional square feet in the time to come. 

What is the situation-in-hand for mall-based retailers?

Source: Karsten Moran for The New York Times

The bankrupt retailers occupy a sizable amount of space in malls and commercial establishments; department stores account for 30% of the total mall square footage in the country. About 25% of the country’s total malls face the impending threat of such closure. Macy’s announced plans to close 125 stores in the “lower-tier malls” of the country within the next three years while Nordstrom plans to close 16 of its 116 full-line department stores.

The stressed situation of the mega retailers has caused a domino effect on small mall retailers and on the mall operators in the country.  Simon Property Group, the biggest mall operator in the country, has been trying to terminate its acquisition of Taubman Centers, owner and operator of two dozen high-end shopping centers, for $3.6 billion. The situation is dire for mall owners as the small mall retailers often have a co-tenancy clause in their lease agreements wherein they may choose to pay reduced rent or opt for an exit and break the lease in case anchor retailers exit the mall.

84% of America’s 1,174 malls were reported healthy in June 2020, with vacancy rates of 10% or less, by CoStar Group, a data provider of the real estate industry. With the recent store closure announcements into effect, it could account for more than 83 million square feet of retail space. “The reality is there are going to be dark boxes for some time,” said Vince Tibone, a retail analyst at Green Street.

What options lie ahead for malls and store spaces in the ‘New Normal’?

The anchor closures in the commercial establishments, such as malls, might leave owners with the only option of redeveloping their properties.Analysts claim that non-competitive malls could get converted to affordable housing, co-working spaces, and entertainment venues. Mall owners could take the initiative of expanding from retail to community centers and establish hotels as the new showrooms for retail to make their establishments more desirable to the adaptive costumes of the new normal era. Redevelopments are taking the form of expanding food courts to food halls with a variety of quick service food joints, incorporation of various services like salons, gyms, Pilates studios, dry cleaners, childcare facilities, attractions like mirror mazes, electric go-karts, and even medical facilities such as ambulatory care. 

A report by Colliers suggests that incorporating co-working spaces in malls might eventually lead to more consumer traffic towards mall-based restaurants and shops. "It’s no longer a backfill to vacant boxes, but rather a lifestyle shift, offering flexibility and providing a nontraditional office environment," said Anjee Solanki, Colliers National Director of Retail Services.

“Is the mall dead? No,” says Susan Swanezy, partner at Hodes Weill & Associates. “Is the old mall dead? Yes.”