Telltale signs can signal opportunities for tax reductions in declining retail properties.
For a number of years the mantra in the retail industry has been that retail property values and shopping center values, in particular, will continue to decline because consumers make purchases online rather than in brick-and-mortar stores. While this may be true, simply reciting the words to property tax authorities rarely succeeds in arguing for a reduced assessment.
The best strategy to obtain significant tax reductions for declining retail properties is an analysis of indicators that measure the mall's or shopping center's health. These factors come in four categories: anchor tenants, in-line tenants, tenant occupancy costs and prevailing lease agreements. While these dynamics may not be readily apparent, their analysis is the key to obtaining property tax relief.
Mall anchor tenants have a significant say in how the property is configured, and in the mix of inline tenants. Consequently, when a national chain department store or other anchor tenant starts to experience a decline in sales per square foot, it can send tremors through the entire shopping center. Declining anchor tenant sales grow more serious when the anchor tenant's sales per square foot fall below the national chain-wide average. If the anchor consistently underperforms the chain-wide average, the store is often deemed a candidate for closure.
Inline tenants are the bread and butter of most shopping centers. No other group receives more scrutiny than tenants occupying 10,000 square feet or less. The first thing mall evaluators look for is the types of inline tenants, as well as the trends in those tenant types. Landlords and investors prefer permanent inline tenants over temporary tenants. It is also better to have retail inline tenants than non-retail users, such as offices, government agencies and the like. Of course, the level of inline vacancy is also important because higher vacancy levels may trigger co-tenancy clauses in leases, thereby permitting tenants to vacate before their leases expire.
Tenant Occupancy Costs
The trend in tenants' cost of occupancy (COO) may be the best predictor of inline tenants' future performance. By extrapolating COO trends, it is also possible to project a mall's performance several years into the future.
The COO measures the ratio between gross sales and real estate expenses, including rent, maintenance charges and other costs that a tenant bears. The COO ratio for Class B and higher malls is usually in the 13 percent to 17 percent range, depending on the strength of the tenants, and between 10 percent and 12 percent for lower-end Class C malls.
COO ratios that are higher than these ranges indicate tenants are spending more of their gross revenues to pay property occupancy costs. This reduces the available revenues to pay other operating expenses and, obviously, limits the tenant's profits. Year-overyear increases in COO ratios means tenants are experiencing increasing financial pressure. Eventually, COO ratios become so high tenants will either ask for rent relief or other lease concessions, or just walk away.
Prevailing Lease Agreements
Most inline tenants enter into triplenet lease arrangements with the property owner when a shopping center first opens. Triple-net leases require tenants to pay for maintenance, insurance, real estate taxes and other property operating expenses, including the cost for operating common areas within the mall. As a mall declines, inline tenant sales per square foot dwindle, rental rates for new tenants decline and COO ratios increase. At some point, tenants will be unable to pay their rent and still make a profit. At this point, they are likely to ask the mall owner for some type of rent relief.
Rent relief for inline tenants takes different forms, but usually consists of converting triple-net leases to leases paying a percentage of sales, or sometimes to gross leases, both of which make the mall owner bear more operating costs. An increase in the number of percentage and gross leases shows that inline tenants are unable to generate enough sales to pay rent and other occupancy expenses.
As more and more leases become percentage or gross leases, the expense burden on the mall owner increases, and the likelihood grows that the mall will close. During this time, the mall owner may replace departing inline tenants with new tenants that demand gross lease arrangements, which further contribute to the mall's decline.
Seek Early Property Tax Relief
The four factors discussed above are interrelated. The progression of falling dominoes starts when the anchor tenant's sales begin to decline. This then leads to a fall in the number of permanent inline retailers, a rise in COO ratios, and the replacement of preferred triple-net leases with percentage or gross leases. All these factors put downward pressure on a retail property's value, which typically reduces the property's tax assessment.
Most of this sequence cannot be observed because it happens below the surface, but it may be the precursor to a mall's failure. Thus, the local property tax authority may not realize a mall is in decline until it falls off the cliff, as when an anchor tenant closes its doors or high-end retailers fail to renew their leases and move to other malls.
Astute retail property owners and operators will identify the underlying problems in a mall or shopping center early on, and bring those difficulties to the attention of the local tax assessor. Doing so may reduce taxes - and mall operating expenses - well before a property is in free-fall mode. If the tax relief is significant and obtained early in the process, it may even extend the life of the mall.