Self-interest could spell death for retailers and landlords locked in rent disputes

retail store worker

Source: Unsplash/Korie Cull

Retailers and landlords are locked in a negotiation that will decide their future.

With a lot at stake, both parties are fighting to protect their own interests. Landlords are fighting to protect their leases, cash flow and valuations, while discretionary retailers are fighting to reduce their fixed costs and for ultimate survival.

The prisoner’s dilemma is a concept in decision-making and negotiation where two parties acting in their own self-interests do not produce the optimal outcome and become worse off as a result of their inability to find a mutually acceptable position.

Here, both parties to the negotiation focus and choose to protect themselves at the expense of the other party. As a result, both parties find themselves in a worse state than if they had co-operated with each other in the negotiation process.

Both parties must give ground to find the minimum mutually acceptable position in the long term interest of the relationship.

Fundamentally, retailers enter leases with landlords to access customers and generate sales. If customer traffic collapses and conversion and average order value cannot compensate, sales will decline and the store could become unviable.

With Apple and Google population mobility data showing big declines on pre-COVID levels and shopping centre traffic significantly down on last year (as tracked by Kepler Analytics), discretionary retailers are suffering and trying to respond to the crisis by cutting costs, protecting cash, and accessing funding to endure the crisis.

We have also seen an accelerated rise in e-commerce sales, which have grown by more than 50% growth over the last quarter versus last year, which raises questions about whether we will ever see pre-COVID traffic levels in regional shopping centres.

Discretionary retailers fear their store networks will become unviable when government policies like JobKeeper and early superannuation access end and traffic and sales do not rebuild to pre-COVID levels.

They also believe the old lease model of fixed gross rent, paid in advance, and with annual increases above CPI for a five-year term, are broken.

These leases were developed for growth, not recessions, and never imagined a pandemic that would result in lockdowns and store closures. Into the future, more retailers will seek more flexible and variable terms, where the risks are shared, and extraordinary events like lockdowns are considered.

Those landlords that seek to strictly police the obligations of pre-COVID leases — leases that never imagined a pandemic would result in massive reductions in traffic, store closures and sales losses for discretionary retail — will see their relationships irreparably damaged, resulting in reputational damage, record negative leasing spreads and record vacancy rates.

At the same time, retailers must acknowledge that all the key value drivers for landlords, including rental income, management income (car parking, media), development fees and profits and construction fees have been devastated by the effects of the crisis.

Burdened with high levels of debt, many large landlords have raised capital, closed down their development pipelines and cut expenses. Some landlords have seen their market capitalisation halve versus last year and dividends to shareholders have been cut in a destruction of value.

As a result, landlords will fight to protect the terms for existing leases, and for renewals, they will fight to protect passing rents taking the store to market to explore interest. Further, landlords will accelerate their efforts to generate demand for space, incubating new retailers and concepts, to provide options and to create price tension.

Landlords are unlikely to accept variable rent deals (based on percentage of turnover) paid in arrears, as it will damage valuations. Instead, discretionary retailers affected by the crisis, and landlords need to negotiate in good faith to create a new commercial agreement. A new lower fixed rent deal with capped occupancy is where mutual value will be found.

There are no easy solutions to landlord and retailer negotiations, and they are likely to end badly for both parties if they pursue their own self-interest. Protracted negotiation, mediation, one party acting unilaterally in their self-interest, and retailer administrations post stimulus are likely outcomes of self-interest.

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