The Retail Industry in Perspective – A Little of the New and A Little of the Old
 
May 17, 2004
 
James Mayer - Chicago
Tara A. Scanlon- Washington

The past year in the retail industry saw continued low interest rates and availability of equity funds that resulted in fierce competition for buyers of real estate and lower rates of return. These and other converging and conflicting economic patterns have resulted in considerable obstacles for retail sales and development for some, and a great opportunity for others. The retail landscape was particularly challenging when international events affected business decisions, such as the invasion of Iraq and the continued violence against the American presence in that country. It was also the year that saw a continuation of the expansion of the largest owners of North American shopping centers, through merger or other arrangements, and the growth of the size of the assets of such owners by portfolio acquisitions.

One area that looks like it will continue to be active is the like-kind exchange or 1031 exchange market. 1031 exchanges allow property sellers to defer paying capital gains taxes on a sale of real property of equal value. Those who utilize 1031 exchanges have been aided by “private letter” rulings by the Internal Revenue Service. One such ruling allowed a taxpayer to ask the IRS for a written opinion about his or her tax liability in connection with a 1031 transaction. Prior to this ruling, there was little or no guidance at all. Another ruling confirmed the taxpayer’s ability to carry out so-called “reverse exchanges,” which allows those doing 1031 exchanges to acquire a replacement property before selling the property to be exchanged. 1031 exchanges have continued to be in strong demand as a result of exceptionally low interest rates and a stock market that has not yet been strong enough to beat the returns of most long term investments.

Competition in the retail industry and the high cost of construction has resulted in a number of mall developers turning to life style centers. Not only have life style centers grown in popularity, but their sales reflect the reason why mall developers will continue to turn to these developments. The average life style center generates $400 per square foot in sales versus $330 per square foot for regional malls. While there are currently about 100 life style centers in the United States, in 2002 there were only approximately 30. The attractiveness of life style centers also results from the reduced construction time for these developments. Where a mall might take several years to construct from beginning to end, a life style center can be completed in as little as a year. This shortened time frame is attractive to all parties – the developer, lender, retailer and consumer.

The influx of carts and kiosks, now seen throughout the common areas of most shopping centers, is another retail development that continues to see great growth. Whether a consumer wants to try out a massaging chair or purchase sports memorabilia, the presence of these convenience retailers will continue to expand because their operating costs are small, and the mall owners enjoy an increase in gross rental income.

Two more serious recent developments facing retailers has been their ability to confront the threat of terrorism, and the reactive or proactive response to the Sarbanes-Oxley Act. The Department of Homeland Security considers shopping centers to be potential targets for terrorists. Property owners are scrambling to create anti-terrorist plans, hoping that by having a plan, terrorist acts may be avoided. And, while retail real estate companies are continuing to attempt to understand their compliance obligations under Sarbanes-Oxley, everyone seems to understand that compliance will be both costly and time consuming. In response to the directive of this Act – to attack deceptive corporate practices and to unmask fraud relating to certain accounting methods – retail companies are responding by strengthening audit and corporate governance committees to study and ensure compliance, tasking trustees with recommending governance guidelines, and reviewing Board of Directors’ and individual trustees’ performance, including the appointment of independent trustees.

Another developing trend has been the ability of the discount retailers to dominate the sales market for children’s toys. The ability of such retailers as Wal-Mart and Target to become more firmly entrenched with consumers as the point of sale for toy purchases has proven disastrous for certain other retailers. FAO Inc. filed for bankruptcy protection for the second time in a year, closing its Zany Brainy stores, and it is seeking a buyer for its Right Start and FAO Schwartz stores. Toys ‘R Us posted third quarter losses, and it is shutting its Kids ‘R Us and Imaginarum stores. KB Toys is following suit with its own filing for Chapter 11 bankruptcy protection.

At the same time, “dollar stores” are now seen by many landlords and consumers as very desirable tenants. The leading chains of dollar stores have seen stronger sales and explosive growth in recent years, which has resulted in stockpiles of cash, low levels of debt and increasing stock prices. The segment is now seen as one of the best performing and fastest growing sectors in retailing. While such tenants were once seen as less desirable, dollar stores are now actively being sought-out to lease space in higher-grade properties. Not only are they opening more stores than any other class of retail trade, but they are opening them in locations that reflect a wide diversity in consumer income.

Just how quickly the retail industry responds to the trends and challenges it faces may determine whether the coming year is a profitable one – or not.

For more information, e-mail Tara A. Scanlon at tara.scanlon@hklaw.com or James T. Mayer at james.mayer@hklaw.com, or call toll free, 1-888-688-8500.