During the COVID-19 pandemic, many retailers have gone bankrupt, leading to higher vacancies in malls around the U.S. And many retailers are uncertain about their future needs -- how much square footage will they need if more sales shift to e-commerce? Which locations will be the best and worst performers in a post-pandemic world?
As a result, there's been a big trend toward short-term leases in malls and shopping centers over the past year or so, according to a new CNBC report. While the typical retail lease has historically run 10 to 20 years in initial term length, we're seeing more leases with timeframes in the three- to five-year range -- and sometimes even less.
Tanger Factory Outlet Centers (NYSE: SKT) now classifies 7% of its tenants as temporary, which includes things like pop-up stores. Leading mall operator Simon Property Group (NYSE: SPG) has reported receiving a high level of tenant interest in shorter-than-usual leases. And many retailers are reporting that their average lease length is declining.
Should investors worry?
Mall and other retail real estate investment trusts (REITs) are taking somewhat of a gamble here. While it's standard practice to use some short-term leases to fill empty space (like with those Halloween stores that pop up every year), doing so on a large scale has the potential to backfire. After all, retail is a cyclical business -- especially the types of retail you generally see in malls. The point of a long-term lease is to insulate the commercial landlord from the ups and downs of the business.
As a hypothetical example, let's say a clothing retailer signs long-term leases at 20 malls in 2021. Fast-forward three years, and the U.S. is in a bad recession. Retail sales are down 25%. If this clothing retailer has signed 10-year leases, they'll continue to make their rent payments as agreed (assuming the business isn't bankrupt) and the mall operators' income won't be affected. On the other hand, if they're on three-year leases that happen to expire in a tough economic time, they could choose to close their worst-performing stores or take advantage of the poor economy to negotiate a lower rental rate. This is the concern.
Of course, the COVID-19 pandemic isn't a "normal" situation by any means. There have been holes left in malls after the bankruptcies of Ascena Retail Group (OTCMKTS: ASNAQ) (LOFT's parent company), Lucky Brand, Brooks Brothers, and others. So, using short-term leases to fill those spaces while the pandemic is still ongoing can be an excellent temporary solution to boost rental income.
And if the economy is booming in a few years, all these short-term leases could end up working to the mall operators' advantage by allowing them to raise rent or demand a longer commitment. Simon Property Group CEO David Simon said on the company's recent earnings call that while tenant interest in short-term leases is high, it's also likely in Simon's best interest to wait a few years to negotiate a longer-term rental rate.
However, if this becomes a permanent solution and the new normal in the post-pandemic world, it could be a bit more worrisome.