Demystifying Decision Making for Retail Real Estate

One of the largest and most diverse sectors of the commercial property market is retail real estate. In the last decade, this segment has undergone a significant transformation. Retail real estate is primarily available in three key formats — high street retail, community shopping centers and retail malls. These retail properties, situated in multiple locations, help increase a company’s visibility and create a diversified business.

Setting up a Store

The first step in setting up a store is deciding whether to lease or buy a property. This decision is taken after performing a cost-benefit analysis that considers multiple parameters such as the opportunity cost, the upfront costs, the duration of the need, and the fixed and variable components of the cost. Leasing retail spaces is preferred as it involves fewer upfront costs and multiple tax deductions in the form of lease payments, property taxes, insurance, utilities and maintenance. In addition, as lease terms are in the range of 10 to 20 years, lessees have greater flexibility to change locations in the future.

Sub-leasing retail spaces is another practice being adopted by leading food and retail chains around the world as it is an effective way to earn additional revenue. In such situations, the company acts in the power of a tenant as well as a landlord. A sub-lease agreement is signed between an original tenant and a sub-tenant.

The Decision-Making Process

At the end of a contract’s tenure, companies have to take a decision on whether to renew the lease, terminate it, buy a store or sub-lease the property to another company. The decision is ultimately taken depending on specific factors that a company has to keep in mind.

Renewing the Lease

Companies take the decision to renew a lease in the following circumstances:

• When the store is profitable, or earns a minimum expected amount of revenue
• When leasing rates are lower than the purchase price
• When no alternative locations are available within the vicinity

Deciding to Sub-Lease

Companies can decide to sub-lease a store in certain circumstances, such as:

• To recover the cost of maintenance and keep the property in productive use
• When the company witnesses a general decline in traffic in its brick-and-mortar stores due to greater online sales
• When the store fails to generate the minimum revenue as prescribed by the company

Terminating the Lease

In the following situations, retail chains find it a more prudent decision to end a lease:

• When the store’s profitability is either lower than expected or it does not earn the expected amount of revenue, and there is no option to sub-lease the store
• When the demographics of the area are not favorable (for example, a high-end brand in an economically weak neighborhood)
• When the store is in a highly competitive retail environment and finds itself unable to keep pace with its competitors

Buying the Property

Retail chains sometimes find that purchasing the property is a better option that renewing the lease. This can be due to a host of factors, some of which are:

• When the store is located in a prime locality
• When the store is primarily intended as a marketing and advertising facility for the company rather than a purely retail location
• When the company finds itself able to leverage substantial support infrastructure within the region
• When the cost of leasing in certain areas is very high, companies find that purchasing the property makes more fiscal sense in the long term
• When demand outgrows the capacity of the store in a particular area, the company may buy a bigger store within the same neighborhood

Conclusion

As retail is dependent on the overall performance of the establishment, it is a relatively riskier asset class for investments. However, these high risks are also accompanied by high returns when compared to a residential asset. Globally retail stores continue to face difficulties due to the growth of e-commerce and it is incumbent for companies to look at the long-term and strategize their retail real estate decisions more carefully. Nevertheless, the impact and value of a brick-and-mortar retail location cannot be understated, and a well-positioned store can continue itself not merely successful, but a valuable asset to the company.