Online Returns Crush In-Store Retail Sales, "Materially" Lowering Rent for Property Owners

 

As if the rise of e-commerce on its own was not enough to singlehandedly cripple brick-and-mortar retail, retail property owners are getting hit with collateral damage. Online returns being made in-store, which are then subtracted from a store's sales, are turning out to cost property owners "material" amounts of money. Many retail property owners are paid rent that is correlated to the amount of sales consummated on their property, but the convenience of being able to buy online and return in store has put significant pressure on these figures and - in turn - property owners' earnings. Bloomberg reported this morning:

Mall owners, already squeezed by e-commerce and spending billions on property makeovers to draw shoppers, have a new headache: retailers deducting returns for items bought online from their sales figures.

David Simon, chief executive officer of Simon Property Group Inc., says a “significant number” of tenants are underreporting sales and that the company, the largest U.S. mall owner, is negotiating with them to find a solution.

For America’s beleaguered retail landlords, sales per square foot is a crucial metric, used by investors to gauge their financial health. In addition to the dollars lost themselves, a low number can damage a mall’s reputation on Wall Street.

The issue Simon is flagging arises from rents that are based on how much a retailer sells in its physical store. It’s common for a tenant to pay a base amount and then give the landlord a cut of sales that exceed a set threshold. Occasionally a retailer has no base rent and is obligated to pay only a percentage of sales rung up at the property.

“We are getting dinged by internet returns,” Simon said on a conference call with analysts Friday. “Every retailer is different, and there is not a standard response yet. It needs to be addressed in future leases.” He declined to quantify the problem but said it was “material,” telling the analysts that “we have audit rights, and in our normal procedure we saw some anomalies about sales.”

This news couldn't be coming at a worse time for retail property owners. The time and resources spent to audit these returns, as suggested in the Bloomberg piece, will also come at a cost, though maybe not as material as the returns themselves. Regardless, it is retailers and their landlords both trying to get the better of one another, and both trying to cauterize their respective wounds quicker than the other. The article continued, talking about landlords possibly shifting to smaller, local tenants, instead:

The tension adds to a growing list of troubles for retail property owners as the rise of internet shopping erodes brick-and-mortar revenues. Landlords are dropping big sums to reconfigure their shopping centers with attractions customers can’t enjoy online, such as restaurants and gyms.

Remaking the mall can mean adding small, local merchants and relatively unknown retailers to the mix as large chains cut back on space, exacerbating the issue of online returns, according to Burt Flickinger, managing director of Strategic Resource Group LLC, a retail-advisory firm. Big, well-known companies, especially publicly traded ones, are likelier to hew to established guidelines when they report sales figures, he said.

“As the big chain tenants close, they’re replaced more often with newer, more entrepreneurial independent owner-operators, who can be more casual in terms of responsibly reporting,” Flickinger said.

But this solution seems temporary in nature and unlikely to be big enough to replace the steady stream of cash that comes from larger corporate tenants. And the "returning in-store" model makes sense - when people are returning items, they want their credit or their money immediately, so they don’t mind making the trip up to the store. Bloomberg continued,

Managing returns is a critical issue for both landlords and retailers, and e-commerce has only made it more complicated. Anybody who has bought a pair of shoes or a sweater online can attest that shoppers are far more likely to take back apparel they bought on the internet than picked out in person at a store. The rate of returns for online purchases is estimated to be as much as four times the rate for physical-store sales, according to David Sobie, CEO of Happy Returns Inc., which operates in malls and other shopping venues, taking online returns from consumers for retailers that don’t have a lot of physical stores.

The obvious solution is going to be lease modifcations moving forward. Rents will likely be more of a fixed figure and tied less to the amount of sales that take place in the store. Or, there needs to be some type of way to determine how many returns are being done from online shopping and calculate a “non-GAAP“ sales number that deducts these returns from a store's sales. 

It was just 2 weeks ago that we noted that the death of retail stores was continuing. We documented that over 77 million square feet of retail real estate has closed this year and that 2018 will easily pass 2017's record of 105 million square feet closed. The silver lining to the industry was supposed to be that property values would hold up. This argument was made by real estate investment trusts as well as activist investors and analysts who tried to put a positive spin on the death of brick and mortar retail. But instead the bid under former retail property is at risk of falling off as supply is starting to get far ahead of demand:

Real estate can put a floor under the value of a retailer and make it easier for the company to borrow. Maybe a particular store concept doesn’t work out as consumers’ tastes change, but in that case, investors can always sell the land and buildings to someone with a better plan. Long-term leases can be similarly valuable. But what if the problem isn’t that a particular store is out of fashion, but that consumers are just shopping less at brick-and-mortar retailers in general? As more storefronts empty, the valuation floor will look wobblier.

This pace of closings puts 2018 on pace to pass 2017's record of 105 million square feet of retail space closed:

At last count, U.S. store closures announced this year reached a staggering 77 million square feet, according to data on national and regional chains compiled by CoStar Group Inc. That means retailers are well on their way to surpassing the record 105 million square feet announced for closure in all of 2017.

It doesn't look like the pace of these closings is going to slow anytime soon, either:

And with shifts to internet shopping and retailer debt woes continuing, there’s no indication the shakeout will end anytime soon“A huge amount of retail real estate in the U.S. is going to meet its demise,” says James Corl, managing director and head of real estate at private equity firm Siguler Guff & Co. Property owners will “try to re-let it as a gun range or a church—or it’s going to go back to being a cornfield.”

So as retail property owners face yet another headwind, at least there is one mild positive to the story: in-store returns are at least putting foot traffic to their properties.