Retail | Late Cycle Lease Activity

04/30/16 10:09AM EDT

With 10k season largely over for the retailers, we can see how the underlying lease profile is changing for retail (we don’t get this disclosure in Qs or 8ks – only annually). The punchline is the we’re seeing lease terms stretch to a level we have not seen since the end of the last economic cycle. While not toxic, this is definitely a level that suggests to us that the group is either a) unit growth starved, or b) in search of margin – by stretching out the duration of its lease portfolio.

What does it mean to ‘stretch out the duration’?

First off, let’s calculate said ‘duration’. It really comes down to the ratio of rent minimums carried off balance sheet that are required to be paid over the next 1-2 years compared to what a company is obligated to be pay 5+ years out. Let’s not get too focused on the periods used, as the trajectory will be roughly the same for a given company regardless of the period in question.

For the retail industry as a whole – which is made up of 84 companies – we have a weighted average duration of 7.6 years. That’s meaningless on its own. We have to look at this relative to itself, which was only 7.0 years as we exited the Great Recession. It might not sound like much, but look at the chart below. 

Retail | Late Cycle Lease Activity - 4 20 2016 chart1

What Does It Mean When The Duration is Headed Higher?

Basically, it means a company is signing leases it really cannot afford. To avoid losing the property to a competitor, it is either…

a) Buying Into Escalating Rent Trajectory.  This means signing leases with low initial payments, but high (usually dd) rent escalators in the outer years. That way it can book revenue, low rent costs, and worry about paying ‘real’ market rents sometime down the road. This is akin to a family that makes $90,000 a year, and takes out an interest-only 5-yr arm in order to buy that $2mm ‘dream home’ (that probably needs work) in Summit NJ.

b) Buying Time. This basically means signing a lease years before the competition would even consider it. Usually a company will sign about 2-years out from the property open date. 3-years max. But sometimes we’ll see ‘growth’ retailers without the cash flow to compete for premium properties sign up for a property that’s not available for another 4-5 years. It’s pretty arrogant that any company – even the best retailer around – can predict which plot will be relevant more than one Presidential term down the road. Importantly, there’s no way of knowing who the co-tenants will be. So while you think you’re moving next to a Restoration Hardware or Tiffany, you end up next to Olli’s Bargain Basement or Hibbett Sports. This ‘risk’ manifests itself in a growing duration – and while it is a hypothetical number, it represents margin risk that is very real sometime in the not-too distant future.

What Happens For Those Companies Where The Lease Duration is Headed Lower?

Simply put, reverse all the negatives I just called out. A lower lease portfolio duration means that…

a) Pay More Today, Owe Less Tomorrow. That means long term liabilities come down, and current payments go up. Most would call this bearish as it relates to hitting estimates. But when a management team opts to pay more over the near-term instead of being up against a wall in 3-5 years, we call that proactive risk management. That’s akin to paying off high interest debt, or taking a 30-year fixed mortgage to a 15-year loan – higher payments, but lower interest cost, and lower long-term risk.

b) One point worth noting is that this would also happen to a company that has just run out of growth or is closing stores with longer-dated durations. Acquisitions can just as easily skew these numbers one way or another.

COMPANY CALLOUTS

Here’s an overview of the implied duration by retailer. One obvious pattern is that the specialty mall-based retailers hover between 5-6 years, while the department stores are almost all twice that level. Of particular note is Target at 20 years, and Kohl’s is 23 years! Let’s be clear about this…KSS is managing its liability profile in a way that assumes it is still actually selling product in its stores in another 20 years. We’d take the ‘under’ on that one.

 Retail | Late Cycle Lease Activity - 4 20 2016 LD CHART2

 Retail | Late Cycle Lease Activity - 4 20 2016 LD CHART3

 Retail | Late Cycle Lease Activity - 4 27 2016 Scatter chart4

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