Investment Analysis

Retail Remodel

Are partnerships the key to brick-and-mortar success?

In today’s slowly improving economy, retail success depends upon regularly updating the customer experience and a constant focus on managing occupancy costs. One way to accomplish both of these goals is to combine store remodeling campaigns with commercial lease restructuring efforts. With a partnership approach between tenant and landlord, these seemingly unrelated and potentially conflicting efforts can have a beneficial outcome for both parties by creatively aligning incentives.

For the majority of landlords who work with credit tenants, it is in their best interests to adopt this new way of doing business. A partnership attitude between landlord and tenant creates a win-win for both parties and can comprise various strategies, depending on the existing situation as well as local market conditions.

Working together, tenants and landlords can restructure existing leases to increase cash flow for tenants while also enabling property owners to refinance at today’s record-low interest rates. Landlords and tenants can split the costs of remodeling brick-and-mortar locations to create more consumer-friendly store layouts and improve revenue for the tenant. At the same time, these improvements add value to the underlying asset for the owner. The property’s value can be further enhanced with a term extension that can result in a lower capitalization rate and a higher valuation.

Transparency is key in building a successful partnership. Tenants must approach landlords with full disclosure of the store’s specific financial situation as well as that of the corporation. Landlords must clearly understand whether the store and the company as a whole are struggling or thriving, and tenants must understand where the property falls within the landlord’s portfolio. In addition to accurately communicating the store’s financial health and broader corporate situation, tenants must be well educated on market conditions, co-tenants, vacancies, and current comparable rents.

From a landlord’s perspective, approaching tenants with an understanding of what adds value for the tenant sets the tone for a mutually beneficial relationship. Framing negotiations in ways that demonstrate how both parties can benefit is an effective strategy for landlords to use in building successful long-term relationships with their tenants. For example, in the case of a remodel, a landlord could be incentivized to contribute to the remodel cost in the form of cash or a rent abatement for a period of time. In exchange, the landlord could receive some portion of increased revenue generated by the refreshed property or an additional firm term by the early exercise of an option period.

Remodeling Options

Certain types of exterior and interior remodeling options not only increase traffic and revenue for stable retail sites, but also can keep distressed brick-and-mortar stores afloat. Successful property modifications include creating new logos, refreshing exteriors, and updating signage and other outside imagery.

Renovating exteriors is an especially attractive remodeling option for landlords. For example, a new facade to part of a building’s exterior entices previous customers to return and revisit the store on a regular basis. Refreshing the inside of the store completes the new shopping experience and helps maintain the higher revenue stream. This applies to both stores and restaurants. Additionally, anytime a nearby competitor constructs a new building or renovates an existing one, the tenant must be motivated to follow suit or risk losing some local traffic.

As building owner, the landlord directly benefits from a renovation of its physical asset. If the landlord is trying to sell the building, remodeling can increase the value of the building. If the owner needs to refinance debt, property renovation will improve the lender’s loan-to-value ratio, increasing underwriting support. When a space turns over from one tenant to the next, an improved exterior condition lowers the landlord’s tenant improvements costs.

Renegotiating Leases

In addition to remodeling properties, renegotiating tenant leases can also increase the value of a landlord’s assets. Negotiating lower rent for a longer fixed term can greatly help landlords in both selling and refinancing a property.

For example, if there are only four years left on a lease, the tenant can exercise early and extend the lease to 10 years in exchange for a rent reduction. Having a 10-year rather than a four-year lease will make selling or refinancing significantly more attractive to a buyer or a lender. Providing this type of financial certainty for a significant length of time helps to preserve the buyer’s cash flow and equity as well as support a lender’s debt service requirements.

Another important factor to consider in lease restructuring is the impact of the 2008 financial crisis on current rental rates. The financial crisis left many tenants in leases that are far above market rates, which presents a great opportunity to renegotiate lease rates closer to today’s market.

In renegotiating a lease or proposing a remodeling package to a landlord, tenants without experience in this area may want to work with a qualified lease restructuring advisory firm. Professionals that specialize in lease restructuring can clearly and effectively present the current conditions and future possibilities, which help both landlord and tenant achieve the highest level of success.

Bridget Grams and Mark Richardson are principals at Huntley, Mullaney, Spargo & Sullivan. Contact them at bgrams@hmsinc.net and mrichardson@hmsinc.net.

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