Retrofitting retail users in a post-COVID-19 world

Almost half of retail rent was not paid in April and May, according to the real estate business intelligence firm Datex Property Solutions.

David C. Camp, Esq.
Shareholder, Senn Visciano
Canges PC, dcamp@sennlaw.com

COVID-19 has universally impacted all industries, and retail commercial space is no exception. Often when a disaster hits the global economy, commercial real estate feels the effects later than other industries; however, due to both the increased interconnectedness of our world and the uniquely vast, instantaneous and deep effect of COVID-19, commercial real estate was disrupted immediately. This article will examine that disruption and consider some potential responses retail property owners in Colorado are considering.

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Unprecedented strain. First, COVID-19 has caused an unprecedented strain on retail and restaurant space in Colorado. Before the pandemic, the Colorado commercial real estate market was the strongest it had been in years. At the start of 2020, retail vacancies were at a low of 6.6% with a record-breaking average asking lease rate of $19.92 per square foot. The full impact of COVID-19 on retail space in Colorado has not yet been experienced and will be difficult to ever fully quantify, but anyone who recently has driven around Denver or other retail-heavy areas can tell you that the strong market from early 2020 has quickly turned. On a national level, U.S. real estate investment trust property indices have decreased 48% in retail space over the last year compared with a 17% decrease in office space.

Erin L. Leonard, Esq.
Associate, Senn Visciano
Canges PC, eleonard@sennlaw.com

The decrease in retail space also has resulted from partial or total closures of chain retailers and restaurants. The closures run the gamut of retailers from department stores such as Macy’s and J.C. Penney’s to smaller international retail and restaurant chains such as GNC, Pier 1 Imports, Rubio’s, Men’s Warehouse, Signet Jewelers, Game Stop, Stein Mart, Bed Bath & Beyond, and Gap, to name a few. All of those tenants (and more) have closed locations in Colorado, creating a ripple effect on surrounding retail and residential occupants, as well as landlords attempting to fill the large vacancies left behind.

Many tenants in restaurant and retail space have sent notices to landlords asserting a right to unilaterally waive, delay or suspend rent or other lease provisions such as operating obligations citing force majeure clauses, or government ordered closures or regulations. As many articles have noted, these force majeure provisions often will not apply, whether as a result of exclusions of monetary obligations from force majeure relief or because this vast pandemic and/or related government orders were not specifically addressed by force majeure lease language. Other tenants have taken a less confrontational approach and reached out to landlords with a cooperative request for help or relief. Many landlords bowing to reality have agreed to provide such relief. Similarly, leases with a percentage rent component obviously are in dire circumstances and to receive any form of payment, landlords have had to either temporarily or permanently modify the payment terms of the lease. Tenants’ inability to pay rent has resulted in landlords not receiving their anticipated lease returns, thereby putting landlords in a bind on their own loans and success rates. As illustrated in the chart, almost half of retail rent was not paid in April and May, according to the real estate business intelligence firm Datex Property Solutions.

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There has been an increase in rent collection from mid-June to October in Colorado, largely due to the more “flexible” regulations of the Colorado Governor’s office, which generally allow for the reopening of restaurants, retail shops and offices, subject to restrictions, of course. However, these regulations are by their nature changeable, subject to weekly variation based on infection rates. As of this date, additional restrictions may be imminent.

Second, COVID-19 has expedited the need for owners of retail and restaurant space to consider converting their property into some other use.

Conversion to industrial or warehouse use. Before the outbreak of the pandemic, brick-and-mortar shops and e-commerce already competed for consumer attention, but governmental orders during COVID-19 have forced these shops to reduce hours and occupancy caps or temporary close, all of which results in reduced foot traffic and layoffs. These consequences of governmental orders have intensified such competition and tilted the field in favor of office and industrial uses. As a result of these governmental orders and overall economic conditions arising from COVID-19, many retail shops already have permanently closed. At the same time, as operating retail commercial space has gravely decreased in the last year, industrial space has increased over 14% as of April, according to U.S. REIT, and this number is likely much higher now. So, while physical stores may be (temporarily?) less desirable, the demand for data centers that power online shopping and “last-mile” warehouses that enable delivery is aggressively growing. As a result, many retail property owners are looking to convert all or a portion of their property to industrial use or to quasi-retail uses (such as pickup/delivery/storage or final-mile distribution centers) to take advantage of the boom of e-commerce. There are many challenges to consider in such conversion, such as: co-tenancy obligations, costs to convert a retail buildout to that required for industrial-type uses, neighboring properties objecting to warehouse or nonretail use, zoning and other municipality ordinances, to name a few. Although the conversion from retail space to industrial space may be initially quite costly and industrial rents historically are lower than retail rents, the benefits may outweigh such costs (including reduced buildout costs for many industrial users). These conversions will only become more attractive if another round of COVID-19 regulations sweeps through Colorado or if the longer-term effect of the recent lockdowns decisively turns people away from in-person shopping to e-commerce.

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Conversion of retail space to office space. In the past, many retail space landlords have elected to convert retail space into office space during times of difficulty for retail projects. However, this may be a riskier option in a post COVID-19 world. Experts say 62% of employed Americans worked from home in April and many companies are telling employees to stay out of the office through mid-2021 or beyond. Other companies, whether voluntarily or because of governmental fiats, are only permitting 50% or less of their employees to be in the office at one time. These scenarios do not bode well for converting retail space into office space. However, some have predicted that, at least in Denver, the number of tenants moving out of office space could be balanced out by the number of companies’ desiring to expand their space to effectively implement social distancing rules and allow their entire workforce to physically work from the office. At first glance, this prediction seems highly doubtful given the general feeling of trepidation as to a future of office users beyond COVID-19. Landlords seeking to convert retail to office will find many (but not all) of the same challenges listed above for warehouse/industrial conversions (co-tenancy obligations, parking concerns, zoning compliance, etc.).

Keeping Current Retail Tenants

Many retail landlords will not want to or will not have the ability to convert their retail property to another use, so instead they will seek to stay the course and keep their retail properties thriving (or at least open). As Colorado continues to reopen in different phases, retail and restaurant spaces are slowly recovering. However, should COVID-19 and its associated regulations reemerge in Colorado the way they first emerged in March, then many of these businesses will struggle and landlords may be stuck with a vacant space generating little interest from new retail tenants. Should the federal government fail to renew or create a new stimulus package for these small businesses, many of these small businesses have said they will inevitably fail. Here are a couple of strategies to help keep a retail development afloat:

Comply with and exceed health and safety guidelines. In addition to compliance with regulations, many landlords are recognizing the need to implement rules in their commercial buildings to respond to changes demanded by customers and tenants. Many commercial building landlords have implemented frequent deep cleaning protocols and sanitizing practices as well as touch-free technologies, from automated bathroom doors to motion-censored faucets, and from soap and paper towel dispensers to elevators programmed to avoid or reduce multiple occupancy. Another change to office and retail spaces likely will be the resurgence of fully enclosed cubicles or ceiling-height partitions between employees as opposed to the open floor plans that have become popular in the last decade.

Innovation of rent payment and use of space. Many landlords of retail and restaurant spaces have attempted to restructure or ease rental obligations for tenants in innovative ways. For example, some landlords have offered unfettered rent abatement, while others have simply deferred rental obligations or traded lease term extension in exchange for reduction or temporary abatement in rent. Other landlords have offered free validation of parking, reduced or abated operating expenses, or even early termination of the lease. Landlords with multiple tenants would benefit from developing a decision-making matrix or process to address requests for relief. They might consider factors such as creditworthiness, the tenant’s long-term prospects (specific issues relating to the tenant entity and whether the tenant’s use or business will thrive in the long term), renewal probability, default probability and building occupancy rate. The goal for landlords is to give concessions only to tenants who are likely to make a return on the landlord’s investment.

In addition, landlords and restaurant tenants have worked together to obtain permits from municipalities to expand the physical space of the dining room so as to accommodate more patrons while still maintaining a safe social distance – most commonly enlarging seating areas into parking lots or even public streets. However, as weather conditions change, the next challenge for landlords will be to continue that expansion by creating a habitable space that still complies with governmental regulations to reduce the spread of COVID-19. Restaurant tenants and landlords also are starting to consider the additional changes that may be necessary, such as the expansion of food prep areas and pickup stations, as well as additional parking for pickup and delivery services, should restaurants be forced to permanently emphasize take-out sales.

While Colorado commercial real estate is no longer as frozen as it was March, April and May, it will be a long recovery to return to prepandemic highs as retail and restaurant tenants have been among those most hurt by COVID-19 restrictions. These headwinds will continue, but retail and restaurant uses may be able to rebound through innovation, cooperation, communication and maybe even compromise (!) between landlords and tenants.

Featured in CREJ’s November 2020 issue of Retail Properties Quarterly

Edited by the Colorado Real Estate Journal staff.