Retailer Transparency and Landlord Agility

Shopping center and store landlords have been rudely surprised by the speed and breadth of their tenants' downward spiral in the economic implosion of the past year. The number of well-known retailers that have filed for bankruptcy protection ' Linens 'n Things, Circuit City, Mervyn's, KB Toys, and Steve & Barry's, to name a few of the most prominent ' is unprecedented in the retailing world since the Great Depression. These serial collapses are, in turn, wreaking parallel havoc in the real estate industry's malls and main streets across the country. Given the scale of our current national economic catastrophe, this result might not have been completely or even largely avoided by landlords, but, with more sophisticated tenant data, which could have been required in the landlords' form retail leases, the damage might have been mitigated by corrective measures taken earlier in the cycle.

Retail Performance

Landlords typically measure retail performance by requiring tenants to report gross sales (used in percentage rent formulas) and comparable store sales. Occasionally, retailers will report sales per square foot (however, the calculation for this metric varies, depending on whether the retailer includes the square footage of the stock room in the denominator). Much of this information, while somewhat helpful on a relative basis, is not meaningful in and of itself in analyzing the retailer's business, or otherwise evaluating or predicting the future success of the retailer. Alternatively, comparable store sales should be viewed in conjunction with gross margin, inventory turn and conversion rates. These metrics are used throughout the retailing industry, and indeed, often broadcast and shared through publications of trade associations, and reported quarterly to securities analysts. In turn, shopping center and storefront landlords and their own trade associations, such as the International Council of Shopping Centers, assume that the retailers themselves are intensively reviewing this wealth of information, and adjusting their business operations accordingly. In the real world, this is (sadly) sometimes not the case: Many retailers spend a large portion of their time and effort attending to their best stores, and the worst performers lag behind until meeting their ultimate and predictable fate. An old retail adage is the “80-20″ rule ' 80% of the total business is done in 20% of the stores.

If the landlord's portfolio does not include the better stores, what is a savvy landlord to do? This article argues that, if landlords had a better understanding of the nature and relative worth of the advanced-but-standard metrics for retail performance, compelling through more sophisticated lease provisions the production of that data, and then sharing it with other retail tenants in the same shopping centers and within retail industry product sectors, those landlords would be: 1) quicker to spot developing problems; 2) better able to gauge and then adjust the mix and relative square footage of co-tenancies in a mall or a neighborhood; 3) strengthened in their approach to troubled tenants with suggestions for performance improvement; and 4) equipped with more tools to create a productive retail environment, and even able to assess a monthly fee for publishing the organized data.

What Is the Norm?

For decades now, many retail leases, to the extent they required tenants to report financial results to landlords quarterly or annually, have only requested gross sales figures from a store tenant, in order to provide a threshold figure for the payment of additional fixed rent, on an annual basis. These provisions, which permit a landlord audit of sales books and records and tax returns, are replete with lengthy definitions of “gross sales” for a “lease year.” The sophisticated or well-represented tenant seeks in negotiation to exclude therefrom many categories of income or exchange, e.g., returns to shippers or manufacturers or wholesalers; exchange of merchandise among stores and warehouses; free merchandise or other giveaway items in connection with promotions; accommodation sales or transfers to other retailers made at cost; proceeds from bona fide, close-out bulk sales or jobbers; income from sales of gift certificates; sales to employees at discounted prices; delivery charges; proceeds from the sale of store fixtures or equipment; proceeds of property insurance or other loss or damage claims; interest and carrying charges; uncollectible credit accounts; and fees paid to third-party credit guarantors such as credit card issuers.

This information, especially if audited, while deeply intrusive with regard to the tenant's gross sales, paradoxically does not give the landlord (or the lender) a realistic picture of the retailer's business. Certainly, one lesson landlords should learn from this economic downturn is to take a critical view of their tenants' businesses.

Accordingly, while there is a plethora of data captured by the retailer at point of sale that could be meaningful to the landlord, this article focuses on the value to the landlord (and lender) of three additional data points: 1) gross margin; 2) inventory turn; and 3) sale conversion rates. This data, together with profit and loss statements, comparable store sales and uniform measurement of sales per square foot, provides the landlord with a truer measure of the retailers' business, and thus prods the landlord to take action when needed.

It would seem, then, that the problem is not an excess of tenant confidentiality, in suggesting changes to the terms of trade in the variety and frequency of economic information required to be exchanged between retail tenants and landlords. Rather, the problem is the lack of imagination of landlords in requiring such information, and in processing that information when received in all its variety.

Why Other Retail Sales Metrics Are Important

Beyond the number of annual gross sales reported under the percentage rent provisions, profit and loss statements, submitted quarterly if not monthly, and if sufficiently detailed in line item entries, would identify on a “real-time” basis the merchandiser's profitability and thus, the likelihood of its continued success. Retailers, achieving their sales expectations but at low margins, will not be profitable for themselves or their landlords, and at some point will consider rationalizing unprofitable real estate.

Comparable store sales seem, at first blush, to be another such tool, one so readily understood that it is regularly reported in the business sections of daily newspapers, as well as in the more specialized trade press: Starbucks (or Sears, or Wal-Mart) has reported that its comparable store sales increased/decreased across the nation. In actuality, that tool is a blunt instrument. Such sales are truly meaningful only when reported in conjunction with gross margin, and inventory turn. Moreover, leases should require retailers to report to the landlord comparable store sales and sales per square foot, including the stock room in the denominator. That way, it is a cleaner “apples to apples” sales comparison for the landlord.

Gross margin is simply Sales less Cost of Goods Sold (“COGS”). Many retailers will tweak the COGS formula, adding or subtracting certain components related to the manufacturing, transportation and/or warehousing of goods, but the basic formula for COGS is: Inventory at the beginning of the year plus purchases or additions during the year equals goods available for sale; that number, minus inventory at end of year, equals COGS. The calculation and reporting of COGS as a percentage of sales and gross margin on a monthly basis allows landlords to evaluate the “quality” of the retailers' sales. Conversely, if COGS as a percentage of sales and gross margin is not reported to the landlord, the landlord does not have a basis to know whether the store is a discount or off-price establishment, notwithstanding the lease prohibition. Deteriorating gross margins on a consistent basis could mean that the retailer is using the store as a “dumping ground” for excess inventory or that the store is constantly on promotion. Either of those conditions could harm surrounding retailers ' and ultimately the real estate.

Inventory turnover is the number of times a retailer sells its average investment in inventory each year. Formulaically, inventory turnover equals net sales for the period divided by the value of the average stock for the same period. Most retailers average two to four turnovers (“turns”) a year. The higher the velocity of turns, the more successful the retailer is at converting inventory to cash, and the “fresher” that retailer looks in the marketplace. A retailer who is not turning inventory fast enough will not only look stale to consumers, but ultimately will have to be promotional ' if not in actual liquidation mode ' in order to raise cash. If measured on a relative basis, inventory turn could indicate whether the retailer has missed the mark on product assortment or price, or on a deeper level, whether the brand has lost its luster in the marketplace. All of these factors should be considered by the landlord during lease renewal or expansion negotiations. Stale inventory often leaves the store in the “unloved” category (remember the 80-20 rule), which will result in less store visits by management and ultimately, the store receiving less “Lot” merchandise. It becomes a self-fulfilling prophecy, leaving the landlord with a dog of a store.

Conversion rates are, if anything, even more easily grasped by the lay mind than comparable store sales. Conversion rate is the percentage of customers that actually make a purchase out of the total number of people that enter the store. The customers are mechanically counted upon passage through the retailer's entryways and then measured again by the number of customer transactions captured at the registers. If the monthly customer traffic is the same or even occasionally spiking, depending on the season, but either the sales are down, or the units per transaction are down, or the gross margins are down, then perhaps it means that the retailers' product assortment and/or sales force are not “spot on.” While there is little a landlord can do to remedy either of these situations, nonetheless having like information for stores throughout a mall or strip center would enable the landlord to calibrate the effectiveness of center-wide promotions with the measurable increase of overall center attendance. With further analysis, among categories of merchandisers (apparel, or books and DVDs and CDs, or watches and jewelry, or white goods), such information yields valuable information about what promotional activities attract customers, and further allows coordination of sales or other promotional events among retailers serving the same demographic with different products. It also yields information about peak sales demand across a broad spectrum, thereby allowing retailers to staff their stores accordingly.

Other Metrics

Beyond gross margin, inventory turn, and sale conversion rates, what other metrics might be illuminating to landlords if required to be reported in retail leases?

Periodic notification of significant capital events might also be formally required of tenants in their leases, such as credit downgrade, an above-threshold drop in market capitalization, changes in upper management ranks, the number of store closings regionally or nationally, or any other matters that may affect the business and are reportable under Form 8K filed with the Securities and Exchange Commission (“SEC”).

As might have been noted above in the discussion of percentage rents, information on Internet sales may need to be included in “gross sales” if such sales are effected. Typically, landlords do not include in “gross sales” any Internet sales, because those sales are usually filled out of a separate warehouse designated solely for the Internet. However, if the retailer does not maintain a separate warehouse for Internet sales and instead fulfills Internet orders from its stores, should those sales be included in gross sales? Not only should Internet sales be reported to landlords on a regular basis, but they also should be delineated by state so that landlords can measure its demographic demands against that of its retailers. For example, if retailers are consistently reporting heavy Internet sales from a geographic area or state that is underserved by a brick and mortar shopping center or mall, a landlord can use that information in planning its next development.

Retailers who are wholesalers should be required to disclose which other retailers in the mall, strip center, and/or metropolitan area are carrying their current (and perhaps competing) product lines. With information supplied by those tenants under leases with provisions recommended herein, the landlord is in a position to provide feedback to the wholesaler/retailer in the event that this vendor is “over-assorted” in the mall, or center, or relevant geographical area. This is important in order to keep the mall's merchandise fresh and varied both from the retailers' perspective and from the landlords' perspective.

Data on personnel transfers and reductions, if supplied monthly to the landlord in accordance with a retailer's lease, would not only be a leading indicator of the health of the business, but, with sufficient detail (or at least an excuse to inquire), a landlord may be able to secure new jobs for such personnel (not discharged for cause, and if willing and still residing in the area), and facilitate the re-hiring of those persons at another site in the same general sales community. A mall may not be a company town, but the quick re-employment of skilled staff who know the community, and can be taught the merchandise, is a gain for the landlord, the hiring tenant and the relocated employee.

With such a wealth of information in hand, both with regard to individual brands/franchises and with regard to merchandise types, landlords having statistically significant amounts of such information would also now be in position to share data on sales, gross margin, conversion rate, and other such information with other retailers for a fee. For a parallel, real estate lease brokerage firms have long distributed quarterly to their customers summaries of sophisticated mathematical analyses of significant trends in their local or regional marketplaces, classified by neighborhood, or municipality, or lease type, and such data would be extremely useful to landlords (and to tenants wanting to check out the competition), in their near-term negotiations and long-term occupancy planning. It is not hard to see how the types of retail data described here might be equally useful, and “early adaptors,” in Darwinian terms, would seem to have the best chance of survival.

Conclusion

The name of the first landlord to demand a percentage rent clause from a retail tenant may be lost to history, but at some point there was a first, and now the clause is both ubiquitous within landlord standard forms and commonly accepted by tenants. A landlord with desirable retail space should be able to bargain for the inclusion of one or more of the metrics discussed here as the price of admission to such space, and once that happens and is repeated with a second lease, there will ultimately come again a tipping point where the inclusion of such economic data reporting clauses becomes the new norm. The multi-center landlord dealing with a multi-store national or regional tenant should be able to introduce a revised standard lease even more quickly, after establishing the precedent for agreement.

Thereafter, the national organization and distribution or sale of this data to industry observers may take longer, but would seem very likely to follow in due course. That would be an extra; however, the primary goal of such novel and inventive provisions would be to allow the retail landlord to better understand his customer, and that customer's economic health, in real time.

David Richards is a real estate partner in the Newark, NJ, office of McCarter & English, and former Chair of the Real Property Section of the American Bar Association. Jamieson Karson, former CEO of the shoe retailer Steve Madden, is a special counsel with the firm.

Shopping center and store landlords have been rudely surprised by the speed and breadth of their tenants' downward spiral in the economic implosion of the past year. The number of well-known retailers that have filed for bankruptcy protection ' Linens 'n Things, Circuit City, Mervyn's, KB Toys, and Steve & Barry's, to name a few of the most prominent ' is unprecedented in the retailing world since the Great Depression. These serial collapses are, in turn, wreaking parallel havoc in the real estate industry's malls and main streets across the country. Given the scale of our current national economic catastrophe, this result might not have been completely or even largely avoided by landlords, but, with more sophisticated tenant data, which could have been required in the landlords' form retail leases, the damage might have been mitigated by corrective measures taken earlier in the cycle.

Retail Performance

Landlords typically measure retail performance by requiring tenants to report gross sales (used in percentage rent formulas) and comparable store sales. Occasionally, retailers will report sales per square foot (however, the calculation for this metric varies, depending on whether the retailer includes the square footage of the stock room in the denominator). Much of this information, while somewhat helpful on a relative basis, is not meaningful in and of itself in analyzing the retailer's business, or otherwise evaluating or predicting the future success of the retailer. Alternatively, comparable store sales should be viewed in conjunction with gross margin, inventory turn and conversion rates. These metrics are used throughout the retailing industry, and indeed, often broadcast and shared through publications of trade associations, and reported quarterly to securities analysts. In turn, shopping center and storefront landlords and their own trade associations, such as the International Council of Shopping Centers, assume that the retailers themselves are intensively reviewing this wealth of information, and adjusting their business operations accordingly. In the real world, this is (sadly) sometimes not the case: Many retailers spend a large portion of their time and effort attending to their best stores, and the worst performers lag behind until meeting their ultimate and predictable fate. An old retail adage is the “80-20″ rule ' 80% of the total business is done in 20% of the stores.

If the landlord's portfolio does not include the better stores, what is a savvy landlord to do? This article argues that, if landlords had a better understanding of the nature and relative worth of the advanced-but-standard metrics for retail performance, compelling through more sophisticated lease provisions the production of that data, and then sharing it with other retail tenants in the same shopping centers and within retail industry product sectors, those landlords would be: 1) quicker to spot developing problems; 2) better able to gauge and then adjust the mix and relative square footage of co-tenancies in a mall or a neighborhood; 3) strengthened in their approach to troubled tenants with suggestions for performance improvement; and 4) equipped with more tools to create a productive retail environment, and even able to assess a monthly fee for publishing the organized data.

What Is the Norm?

For decades now, many retail leases, to the extent they required tenants to report financial results to landlords quarterly or annually, have only requested gross sales figures from a store tenant, in order to provide a threshold figure for the payment of additional fixed rent, on an annual basis. These provisions, which permit a landlord audit of sales books and records and tax returns, are replete with lengthy definitions of “gross sales” for a “lease year.” The sophisticated or well-represented tenant seeks in negotiation to exclude therefrom many categories of income or exchange, e.g., returns to shippers or manufacturers or wholesalers; exchange of merchandise among stores and warehouses; free merchandise or other giveaway items in connection with promotions; accommodation sales or transfers to other retailers made at cost; proceeds from bona fide, close-out bulk sales or jobbers; income from sales of gift certificates; sales to employees at discounted prices; delivery charges; proceeds from the sale of store fixtures or equipment; proceeds of property insurance or other loss or damage claims; interest and carrying charges; uncollectible credit accounts; and fees paid to third-party credit guarantors such as credit card issuers.

This information, especially if audited, while deeply intrusive with regard to the tenant's gross sales, paradoxically does not give the landlord (or the lender) a realistic picture of the retailer's business. Certainly, one lesson landlords should learn from this economic downturn is to take a critical view of their tenants' businesses.

Accordingly, while there is a plethora of data captured by the retailer at point of sale that could be meaningful to the landlord, this article focuses on the value to the landlord (and lender) of three additional data points: 1) gross margin; 2) inventory turn; and 3) sale conversion rates. This data, together with profit and loss statements, comparable store sales and uniform measurement of sales per square foot, provides the landlord with a truer measure of the retailers' business, and thus prods the landlord to take action when needed.

It would seem, then, that the problem is not an excess of tenant confidentiality, in suggesting changes to the terms of trade in the variety and frequency of economic information required to be exchanged between retail tenants and landlords. Rather, the problem is the lack of imagination of landlords in requiring such information, and in processing that information when received in all its variety.

Why Other Retail Sales Metrics Are Important

Beyond the number of annual gross sales reported under the percentage rent provisions, profit and loss statements, submitted quarterly if not monthly, and if sufficiently detailed in line item entries, would identify on a “real-time” basis the merchandiser's profitability and thus, the likelihood of its continued success. Retailers, achieving their sales expectations but at low margins, will not be profitable for themselves or their landlords, and at some point will consider rationalizing unprofitable real estate.

Comparable store sales seem, at first blush, to be another such tool, one so readily understood that it is regularly reported in the business sections of daily newspapers, as well as in the more specialized trade press: Starbucks (or Sears, or Wal-Mart) has reported that its comparable store sales increased/decreased across the nation. In actuality, that tool is a blunt instrument. Such sales are truly meaningful only when reported in conjunction with gross margin, and inventory turn. Moreover, leases should require retailers to report to the landlord comparable store sales and sales per square foot, including the stock room in the denominator. That way, it is a cleaner “apples to apples” sales comparison for the landlord.

Gross margin is simply Sales less Cost of Goods Sold (“COGS”). Many retailers will tweak the COGS formula, adding or subtracting certain components related to the manufacturing, transportation and/or warehousing of goods, but the basic formula for COGS is: Inventory at the beginning of the year plus purchases or additions during the year equals goods available for sale; that number, minus inventory at end of year, equals COGS. The calculation and reporting of COGS as a percentage of sales and gross margin on a monthly basis allows landlords to evaluate the “quality” of the retailers' sales. Conversely, if COGS as a percentage of sales and gross margin is not reported to the landlord, the landlord does not have a basis to know whether the store is a discount or off-price establishment, notwithstanding the lease prohibition. Deteriorating gross margins on a consistent basis could mean that the retailer is using the store as a “dumping ground” for excess inventory or that the store is constantly on promotion. Either of those conditions could harm surrounding retailers ' and ultimately the real estate.

Inventory turnover is the number of times a retailer sells its average investment in inventory each year. Formulaically, inventory turnover equals net sales for the period divided by the value of the average stock for the same period. Most retailers average two to four turnovers (“turns”) a year. The higher the velocity of turns, the more successful the retailer is at converting inventory to cash, and the “fresher” that retailer looks in the marketplace. A retailer who is not turning inventory fast enough will not only look stale to consumers, but ultimately will have to be promotional ' if not in actual liquidation mode ' in order to raise cash. If measured on a relative basis, inventory turn could indicate whether the retailer has missed the mark on product assortment or price, or on a deeper level, whether the brand has lost its luster in the marketplace. All of these factors should be considered by the landlord during lease renewal or expansion negotiations. Stale inventory often leaves the store in the “unloved” category (remember the 80-20 rule), which will result in less store visits by management and ultimately, the store receiving less “Lot” merchandise. It becomes a self-fulfilling prophecy, leaving the landlord with a dog of a store.

Conversion rates are, if anything, even more easily grasped by the lay mind than comparable store sales. Conversion rate is the percentage of customers that actually make a purchase out of the total number of people that enter the store. The customers are mechanically counted upon passage through the retailer's entryways and then measured again by the number of customer transactions captured at the registers. If the monthly customer traffic is the same or even occasionally spiking, depending on the season, but either the sales are down, or the units per transaction are down, or the gross margins are down, then perhaps it means that the retailers' product assortment and/or sales force are not “spot on.” While there is little a landlord can do to remedy either of these situations, nonetheless having like information for stores throughout a mall or strip center would enable the landlord to calibrate the effectiveness of center-wide promotions with the measurable increase of overall center attendance. With further analysis, among categories of merchandisers (apparel, or books and DVDs and CDs, or watches and jewelry, or white goods), such information yields valuable information about what promotional activities attract customers, and further allows coordination of sales or other promotional events among retailers serving the same demographic with different products. It also yields information about peak sales demand across a broad spectrum, thereby allowing retailers to staff their stores accordingly.

Other Metrics

Beyond gross margin, inventory turn, and sale conversion rates, what other metrics might be illuminating to landlords if required to be reported in retail leases?

Periodic notification of significant capital events might also be formally required of tenants in their leases, such as credit downgrade, an above-threshold drop in market capitalization, changes in upper management ranks, the number of store closings regionally or nationally, or any other matters that may affect the business and are reportable under Form 8K filed with the Securities and Exchange Commission (“SEC”).

As might have been noted above in the discussion of percentage rents, information on Internet sales may need to be included in “gross sales” if such sales are effected. Typically, landlords do not include in “gross sales” any Internet sales, because those sales are usually filled out of a separate warehouse designated solely for the Internet. However, if the retailer does not maintain a separate warehouse for Internet sales and instead fulfills Internet orders from its stores, should those sales be included in gross sales? Not only should Internet sales be reported to landlords on a regular basis, but they also should be delineated by state so that landlords can measure its demographic demands against that of its retailers. For example, if retailers are consistently reporting heavy Internet sales from a geographic area or state that is underserved by a brick and mortar shopping center or mall, a landlord can use that information in planning its next development.

Retailers who are wholesalers should be required to disclose which other retailers in the mall, strip center, and/or metropolitan area are carrying their current (and perhaps competing) product lines. With information supplied by those tenants under leases with provisions recommended herein, the landlord is in a position to provide feedback to the wholesaler/retailer in the event that this vendor is “over-assorted” in the mall, or center, or relevant geographical area. This is important in order to keep the mall's merchandise fresh and varied both from the retailers' perspective and from the landlords' perspective.

Data on personnel transfers and reductions, if supplied monthly to the landlord in accordance with a retailer's lease, would not only be a leading indicator of the health of the business, but, with sufficient detail (or at least an excuse to inquire), a landlord may be able to secure new jobs for such personnel (not discharged for cause, and if willing and still residing in the area), and facilitate the re-hiring of those persons at another site in the same general sales community. A mall may not be a company town, but the quick re-employment of skilled staff who know the community, and can be taught the merchandise, is a gain for the landlord, the hiring tenant and the relocated employee.

With such a wealth of information in hand, both with regard to individual brands/franchises and with regard to merchandise types, landlords having statistically significant amounts of such information would also now be in position to share data on sales, gross margin, conversion rate, and other such information with other retailers for a fee. For a parallel, real estate lease brokerage firms have long distributed quarterly to their customers summaries of sophisticated mathematical analyses of significant trends in their local or regional marketplaces, classified by neighborhood, or municipality, or lease type, and such data would be extremely useful to landlords (and to tenants wanting to check out the competition), in their near-term negotiations and long-term occupancy planning. It is not hard to see how the types of retail data described here might be equally useful, and “early adaptors,” in Darwinian terms, would seem to have the best chance of survival.

Conclusion

The name of the first landlord to demand a percentage rent clause from a retail tenant may be lost to history, but at some point there was a first, and now the clause is both ubiquitous within landlord standard forms and commonly accepted by tenants. A landlord with desirable retail space should be able to bargain for the inclusion of one or more of the metrics discussed here as the price of admission to such space, and once that happens and is repeated with a second lease, there will ultimately come again a tipping point where the inclusion of such economic data reporting clauses becomes the new norm. The multi-center landlord dealing with a multi-store national or regional tenant should be able to introduce a revised standard lease even more quickly, after establishing the precedent for agreement.

Thereafter, the national organization and distribution or sale of this data to industry observers may take longer, but would seem very likely to follow in due course. That would be an extra; however, the primary goal of such novel and inventive provisions would be to allow the retail landlord to better understand his customer, and that customer's economic health, in real time.

David Richards is a real estate partner in the Newark, NJ, office of McCarter & English, and former Chair of the Real Property Section of the American Bar Association. Jamieson Karson, former CEO of the shoe retailer Steve Madden, is a special counsel with the firm.