Deacons and how franchises are battling rents and landlords

According to Deacons , the debate about voracious shopping centre landlords and disgruntled tenants has gone on for years, and I suspect it started when the first property owner allowed the first tenant onto his property back in feudal days. Tenants have always complained about landlords and landlords have always felt they are doing the best thing for their tenants.

There is no doubt that the development of the shopping centre has been the primary driver of convenience for consumers, which has created record levels of retail sales. Shopping centres provide one-stop shopping in sprawling complexes in exactly the same way that more specialised retailers such as Bunning’s have provided more substantial big-box retailing to satisfy consumer demand. While small retail outlets may offer a unique consumer experience the reality is that we as consumers are voting with our feet and the result is more and more significant consumer traffic going into shopping centres. Many specialty retailers have developed an unhealthy dependence on shopping centres to provide traffic. Retailing is morphing into recreation and entertainment, and massive investment is being made to keep up with this trend. A 15-minute massage business or a day-spa was unheard of in a shopping centre of 10 years ago.

Shopping centre owners that fail to upgrade and expand their centres will find competing centres draw away customers and tenants. As Australia becomes over-shopped we will see smaller shopping centres falling in value.

The larger retail networks have been able to take control of their own destiny by developing specialist properties, sometimes offering tenancies to related, but not competing, businesses. The bigger players such as Bunning’s, Harvey Norman and Ikea have been able to make the economics work by spending money on advertising and promotion and having a footprint large enough to capture significant sales, and therefore reduce occupancy costs to comfortable levels.

At the same time some of these retailers have formed property trusts that are providing reasonable returns for investors. To avoid high shopping centre rentals, larger homemaker centres have been emerging to satisfy the needs of bulk-buy goods retailers such as Forty Winks , Beacon Lighting and Freedom Furniture , which are aggregating in these specialist centres to produce a compelling case for homemakers to visit the destinations.

Who brings the traffic?

Big stand-alone retailers including Myer, David Jones and the players mentioned above occupy substantial stand-alone locations and have developed highly sophisticated skill sets in marketing to their consumer base – they are prepared to commit a very significant proportion of gross revenue to advertising and promotion. While their occupancy costs might only be four to 10 percent of retail sales, these major players are committing up to eight percent of their turnover to advertising and promotional programs. This could be even more if you include the IT costs in tracking loyalty programs, database management programs and more sophisticated client retention arrangements. These costs are often not considered by smaller retail tenants in shopping centres, which simply believe the shopping centre is responsible for the traffic and therefore they commit little if anything to advertising and promotion. It is not unusual for retail franchise networks to have three percent of their turnover or less committed to advertising and marketing programs, and in many circumstances expenditure below one percent of sales, especially in food service franchises, is seen as the norm. This has created a dependence on the location to create traffic rather than the brand and marketing program, and as a result retailers without marketing skills will be ‘trapped’ in shopping centres.

Where are rents headed?

The reality is that rents are inevitably creeping towards 20 percent of total revenue in the major, high-traffic shopping centres. The JHD retail averages report for March 2002 showed the average speciality shop occupancy cost to be 16.5 percent, or $1,177/M2. Bigger retail networks are instead acquiring the properties under which they operate and becoming a landlord as well as tenant. In these circumstances, at least there is a strong understanding of margin and cost pressures and the impact of rent on retailer profitability. Accordingly, shopping centre retailers should not consider they are being discriminated against and understand that an environment where rents are 16 percent of occupancy is not unusual. The combination of occupancy costs and advertising currently ranges between 12 and 20 percent for many retailers, regardless of where they are located.

While shopping centre tenants may lament this situation, or refuse to acknowledge it should ever happen, wherever there are retailers willing to pay the rent, landlords will be prepared to sign them up. With virtually no vacancies in major shopping centres at present it can be argued that retail tenants are their own worst enemy if they are prepared to enter into leases that have unsustainable rental levels, escalation clauses, and outgoings that are not sustainable for the business.

Retail Darwinism – survival of the fittest

The reality is that economic forces are driving the whole occupancy issue. That is, retailers that are able to pay higher rents will be those that are attracting more than their fair share of customers and able to develop their brand, merchandising and marketing in a way that generates more sales in their retail location than other competitors within the shopping centre. These new breed, or reinvented, retailers are able to enjoy lower occupancy costs as a percentage of sales than their peers simply because they are better at running their business or have a better customer offering. Retailing has for many years seen the rise and then decline of retail networks in shopping centres with the stayers being able to continue to manage their total business, from top line sales revenue through to all operating costs. They understand that at some point if the economic model does not add up, then an exit from a lease is ultimately good business.

Many franchisors, however, feel they are being held to ransom by landlords that know the franchisor has obligations to the franchisee and it is the franchisee’s capital that is on the line. Franchisors need to better educate their franchisees that while it is possible to negotiate a new lease, the reality is that the terms of that new lease might make the business uneconomical or marginal to the extent where new capital reinvestment is not good economic management. This brings to the fore the need for franchisors to better inform their franchisees on the shopping centre retail environment prior to entering into leases and franchise agreements.

Be prepared to close or relocate

This fundamental truth will have a significant impact on how future franchisors behave with their franchisees. Economic realism will only come about when franchisors are able to have the alternative of either quitting a site and bringing the franchise to an end, or relocating a franchisee outside of a shopping centre into a retail strip or to another more reasonable rental location. The latter alternative needs a marketing program that is able to produce the same, or preferably better, levels of profitability, albeit it with lower retail sales.

This creates a real conundrum for franchisors, which in a perverse way have a similar interest to that of the landlord; that is, measuring gross sales and not just profitability. It is clear that many franchisors have few, if any, company-owned locations and while they might be sympathetic to the plight of their shopping centre-based franchisees, they find that a decision to relocate stores to lower turnover but more profitable locations outside shopping centres will be detrimental to their gross revenues.

Ultimately the hard decisions will need to be made by franchisors. It will be critical to educate franchisees to the reality that when the lease comes up for renewal the terms and conditions may be such that the economic model is not viable and the business and the franchise will vacate the premises and the franchise will come to an end. This will result in crystallising losses for franchisees that may have been unable to recoup the capital paid to set up the franchise, and for the franchisor a drop in royalty revenue caused by the loss of a unit.

While this outlook is potentially gloomy there is no doubt that if retail sales soften at the same time as costs rise and these effects cannot be passed on to consumers by way of price rises, the reality of store closures must be planned for by franchisors.

If these store closures are a result of excessive rentals, not just the evolution of the retail species and the survival of the fittest, the excessive occupancy costs will be seen across all retail segments and stores will close.

To counter this potential for store closures franchisors should reassess the role of marketing and advertising in their business mix and learn how to operate outside shopping centre locations.

Landlords are realists

Shopping centre owners, managers and leasing executives are also aware that as retail sales soften, rents will inevitably follow, and while these executives will resist winding back rentals, economic downturns which result in vacancies occurring in shopping centres will be followed by at least a flattening in rental growth.

From the retailer’s perspective the development of a capability that can allow expansion of the retail network outside the shopping centre environment gives the franchisor options to continue to expand the business while rejecting leasing arrangements which economic models show are simply non-viable. Retailers that have been able to demonstrate this ability include operations like Subway , Bakers Delight , Boost Juice , Nando’s and Hairhouse Warehouse . These companies have spent considerable time and effort in their branding and marketing program to create a model that survives in strip and CBD retail locations. Shopping centre owners are also acutely aware that the economic health of their tenants is important to sustain the long-term value of the shopping centre as a real estate asset.

While it is not well known, some major shopping centres have had a commitment for many years to improving their tenants’ expertise by conducting retailing, merchandising and marketing workshops. However, as one Westfield manager comments:

“The unfortunate thing is that we put these sessions on and very few retailers turn up. It certainly makes the job much harder when we can bring to the table some valuable information but the opportunity to improve is ignored by the retail tenant.”

Westfield, for example, also offers regular international retailing excursions designed to expose retailers to new trends and concepts with a view to improving their expertise, and hopefully, retail sales.

As is clear to all parties the future of shopping centres and franchisors, franchisees and other tenants is inextricably bound together. Retail sales are a function of traffic and rents ultimately are dictated by the percentage of revenue each retail concept can stand. The best way to align the interests of landlords and tenants is for both landlord and tenant to work more closely together to drive traffic into the centre in every increasing numbers. This will create a retail environment that is conducive to spending. The reality is that tenants need shopping centres and shopping centres need tenants, so it is in the interests of both groups to sustain the health of both ends of this symbiotic relationship, while franchisors should develop the option to walk away from profitless leases.

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