Retail Rethinks Real Estate

News of store closures and the mass move online has already created big changes for traditional retailers. As the industry’s evolution continues to make headlines, retail real estate is seeing something of a revolution. The battle cry? Right-size, reimagine and refocus.
 
According to data provided by CNBC, the shift is overdue: The U.S. has more retail store space per person than any other country at 7.3 square feet per person. This compares to 1.7 square feet per person in France and Japan. As a result of these challenges and others, the number of retailers citing risks associated with leasing and owning real estate increased by 28 percent this year.
 
Disappointing same-store sales, rising rents and the e-commerce creep have become retail’s Bermuda Triangle. Stores appear to be disappearing on every corner, and retail bankruptcies are being announced at levels not seen since the recession, according to Fitch Ratings. This type of fiscal turmoil threatens credit ratings and financing availability—hazards for businesses looking to diversify.

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However, where some see threats and crumble, others find opportunity and thrive. Many traditional retailers are looking to strategic acquisitions to propel their businesses into the digital age. Stores like Walmart are on acquisition sprees, picking up e-commerce brands like Jet.com and ModCloth to bolster their presence online. This type of deal is a win-win for both parties, allowing e-retailers to move offline and into their customers’ neighborhoods, while also making Walmart more competitive with Amazon.
 
Lease with Caution
 
Navigating the online and physical marketplaces is a balancing act that retailers are learning to master, and it’s worrisome for their landlords too. Among the 25 retail REITs analyzed in the 2017 BDO RiskFactor Report for REITs, nearly all (96 percent) cited tenants being unable to pay rent as a risk to their businesses, closely followed by falling rental rates at 92 percent. As a result of a retail landscape in flux, companies are experimenting with opting online entirely, or opening temporary pop-up shops to avoid committing to long-term leases. This leaves retailers free to provide in-store experiences to consumers, but provides challenges for building owners.
 
While e-commerce growth presents a challenge to store profitability and retail REITs, we may soon see more leasing activity from e-commerce players. According to a report by L2, a majority of venture-backed “pure-play” e-retailers raise funds with the intention of building physical stores. Warby Parker announced in late 2016 that the company intended to significantly expand its brick-and-mortar presence in the coming year. In addition, online menswear shop Bonobos shared that the business envisioned opening at least 100 stores by 2020. Perhaps most telling of this trend is Amazon’s move to open a variety of retail locations—from bookstores to grocery.
 
Don’t Discount Lease Accounting
 
While some industry players are grappling with disruptions to their store presence and business strategy, all companies have a common thread in that they will soon be required to adjust their balance sheets to the Financial Accounting Standards Board’s new guidance on lease accounting, Accounting Standards Update (ASU) 2016-02. Though the standard will touch many industries, it will place a greater burden on retailers. With a looming deadline—financial statements released after December 15, 2019, for public companies with an additional one year for private companies—one in 10 retailers cited lease accounting as a risk to business.
 
To prepare, lessees and lessors will need to implement lease classification changes that will likely impact portfolios and fiscal planning. Lessees will be required to record a right-of-use (ROU) asset and lease liability on balance sheets for all leases with terms longer than 12 months. Lease classification then determines the pattern of expense recognition. The International Accounting Standards Board estimates that roughly $3.8 trillion will be added to balance sheets across industries, with the retail industry seeing significant changes given their reliance on leasing. 
 
Gearing up for implementation, retailers should evaluate how the standard will impact key performance metrics and ensure investors and stakeholders are educated about the change to financial reporting and their real estate and management strategy. More broadly, given the challenging dynamics with real estate, we expect retail leaders and boards of directors will be closely examining store and leasing strategies in the year ahead to optimize their presence and portfolio.
 
This is an excerpt from BDO’s 2017 Retail RiskFactor Report. Click through to the full report to learn more about the top risks facing retailers this year: 2017 BDO Retail RiskFactor Report