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McNellis: Leaving Retail

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Los Angeles, International Council of Shopping Center, Wall Street Journal, McNellis Partners

By John McNellis

Bay Area, San Francisco, McNellis Partners, John McNellis, Silicon Valley, Palo Alto
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I received an invitation to attend a cocktail party in Los Angeles at next week’s International Council of Shopping Center (ICSC) meeting. In declining, I explained that we would not be attending the ICSC, our first absence in decades. Somewhat forlornly, our host replied he was hearing that a lot.

Why the shopping center industry’s premier west coast event may go lightly attended is worth considering. One answer is simple: Pizzazz is in short supply at an event where the chalk talks will be about playing defense and even the biggest liars you ever met will admit to challenges facing their portfolios.

The writing may not be on the wall, but it’s sitting every afternoon on our front porch. A cardboard box waits outside almost daily. These boxes contain everything from hair products to prescriptions to pillows. While hard-put to tell a tweet from a text, the household’s reigning monarch can nevertheless shoot the e-commerce rapids blindfolded, ordering any item in a trice.

When the first few raindrops splash you after a long drought, you don’t necessarily think monsoon. When one package a month arrives at your door, and it’s a pair of shoes that are being returned the next day, you’re unlikely to worry about the future of traditional retail. But when that occasional delivery becomes a reliable year-round stream, it’s time to scope the bricks and mortar. If half a dozen friends confirm that they too receive a daily box, you might—if you’re a retail developer—begin to consider your business in a new light, possibly wondering what the ratio is between doorstep deliveries and skipped trips to your mall.

We have been in the retail development business for thirty-five years, developing a couple projects a year. Through more luck than strategy we focused on smaller, supermarket-anchored, service-oriented neighborhood centers in towns with high barriers to entry. That is, we just happened to pick the most internet-resistant strain of retail long before the net began its march to the sea. And because our best properties are in smug towns that encourage new development about as much as high school smoking, we have a bulwark against retail’s far greater problem, its staggering over-building from coast to coast. But even with this tight portfolio, we are faced with weekly tenant bankruptcies, defaults and requests for rent or space reductions. In short, our retail is no fun.

Yet despite the Wall Street Journal’s almost daily pronouncements, traditional retail is not dead. But it is so badly overweight—so bloated with unwanted shopping centers—that it has Type 2 diabetes. America was choking from a vast oversupply of empty storefronts long before the internet and changing buying patterns rendered tens of millions of additional square footage redundant. But unlike most dieters, retail will ultimately—painfully—shed its excess weight.

How?

Retailers will do it the same way the savviest brick tenants are thriving today: by selling at the same price one can get anywhere on the net (never being undersold), by having great customer service and by absorbing on-line ordering as an in-store service—you try on one shirt in the store, buy it and then order five more on the spot from the retailer’s web site. Having successfully executed this playbook, Best Buy’s stock is up 44 percent over the past year. This means of course that the next generation of brickers will be shrinking their store sizes, creating even more vacancies for landlords. And many tenants will be unable to compete in this new razor-margined, twin-river world and will fall by the curbside, further jamming landlords.

As discussed previously, (Death of Retail), the best centers—whether lowly strips or glamorous malls—have nothing to fear from the net or overbuilding or even the economy itself. If one has the best tenants on the best corner at the best intersection in a growing town, one need only keep her property in first-class condition to weather all economic storms. Most owners are less fortunate, however, and are faced with the overriding challenge of reverse musical chairs: Each time the Muzak stops, there is one more empty chair.

The big-picture fix from the landlord’s standpoint is, like so much in life, easy to prescribe, hard to swallow: repurposing or flat-out razing thousands of economically-obsolescent shopping centers. But rather than talk about generic fixes, it may be more useful to describe our company’s approach to retail’s climate change.

Because we believe too much of it exists everywhere, we are reducing our exposure to retail, to the point of selling a number of quality assets. This summer we sold our interest in our flagship community center, we have two more first-rate properties listed for sale, and will add a third late this fall. And we are about to convert one of our larger free-standing boxes into a non-retail use.

While we have never been buyers of finished retail properties, we have decided to forego retail development projects unless the property is in a superior location and largely pre-leased to tenants we consider to be net-proof.

Four of the last six deals we have done have been residential, one has been automotive service and just one—a project on which the jury is deadlocked—was retail. In a word, we are diversifying.

For the keepers in our portfolio, we are directing our leasing efforts to service tenants—spas, nail salons, opticians, insurance brokers and the like. And, finally, we are paying down the debt on our properties, it being our goal to own our best assets free and clear.

All of this said, I have little doubt that, as the horrible expression goes, the baby will be thrown out with the bath and that canny investors will soon be picking off solid retail properties—centers that have always fit well within retail’s fighting weight—for fifty cents on the dollar, leaving the rest of us wondering why we couldn’t have been just a bit bolder.

John E. McNellis is a Principal at McNellis Partners in Palo Alto, Calif.

Articles published in our Contributor section do not necessarily represent the views of The Registry or Mighty Dot Media, Inc. They represent a selection of topics chosen for the value of their editorial perspective. We welcome feedback and alternative positions on topics, and we will consider publishing those, as well.

mcnellis-book-coverTo read more from McNellis, please consider his book Making It in Real Estate: Starting Out as a Developer.