Mall Owners Accuse Retailers Of Under-Reporting Sales To Keep Rents Lower

The American shopping mall - that centerpiece of the 1980's big-box retail model - has fallen on hard times in recent years as the growing dominance of e-commerce has finally started to take a toll on brick-and-mortar retailers - a subject that we've frequently discussed.

Shifting consumption patterns (i.e. the dawn of e-commerce), years of underinvestment by mall owners, and a seemingly unceasing stream of retailer bankruptcies are the factors that have been responsible for most of the damage to Mall REITS, particularly products tied to lower quality malls.

Emptying storefronts and malls have only exacerbated a glut of American retail space. The country now has roughly 24 square feet of retail space per capita, more than twice that of Australia and 5 times that of the UK.

And as if all that weren't enough, mall-management companies are swiftly discovering that e-commerce is impacting their businesses in ways that they did not anticipate. For example, the increase of customers returning items to the nearest big box retailer location (instead of returning an item purchased online through the mail) has allowed for a quirk in how retailers report sales that is making it even more difficult for these mall owners to placate their Wall Street overlords.

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As Simon Property Group Inc. CEO David Simon explained to Bloomberg, this trend has led a "significant number" of tenants to underreport their sales figures as many of these stores have begun deducting the returned items from their total sales.

Often, this total sales figure is used by mall owners to calculate rent increases - so stores have every incentive to maintain the status quo. Unsurprisingly, mall owners are agitating for change and accusing stores of effectively underreporting their sales. This hurts malls twice: Once when they collect the rent, and again when Wall Street views the mall as less financially healthy than it truly is.

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."

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.

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"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.

The problem will only get worse as online sales grow. Items purchased online are four times as likely to be returned than an item purchased in-store. And online sales are projected to grow to 24% of all retail sales by 2027, according to RBC Capital Markets data obtained by Bloomberg.

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Devising a standardized solution to this problem is proving difficult, because returns affect retailers in different ways depending largely on how the customer behaves (do they take the money and leave? Do they trade it in for a different item? Or a similar item of a different size?).

It’s hard to parse how the various parties to an internet sale and subsequent return are affected, said Daniel Hurwitz, CEO of retail real-estate consultant Raider Hill Advisors and the lead director of GGP Inc., the second-largest U.S. mall owner. For example, if a consumer trades in an item for one of a different size or color, the inventory at that location is reduced even though no money has changed hands at the cash register, Hurwitz said.

"The mall business has become obsessed with sales per square foot as an absolute measure of success," Hurwitz said. "The reporting of sales has become less pure because there are so many moving parts with online returns. As an industry, it would be prudent to come up with a way to deal with this."

Fortunately for mall owners, returns aren't always a bad thing, as the owner of a business that charges customers to handle in-store returns pointed out to Bloomberg, if consumers are coming to the mall to return an item, that foot traffic should improve sales at a mall's ancillary businesses.

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.

Bad for both store and landlord, right? Not necessarily. When it comes time to seek a refund, people prefer to get it in person instead of printing up a label, making a trip to the post office and waiting weeks for the cash to show up in their bank accounts, Sobie said. That typically works in the landlord’s favor, since anything that triggers a trip to the mall can drive additional purchases.

"Returns from internet purchases as a source of foot traffic are valuable," Sobie said. "Of course you’re going to browse, and maybe get something to eat."

Of course, a shift in perspective is hardly what desperate mall owners are looking for...after all, the Wall Street analysts responsible for rating those mall REITS will probably tune out the minute they hear a CEO say "you're looking at it all wrong."