It is not often that we see history unfolding before our eyes. News, yes, we have plenty of that. But seeing a real, live shift in how business is done, complete with the exit of many household-name firms from the scene, is to witness history, nothing less.

The list of retail bankruptcies in the past 24 months includes everything from trendy retailers which catered to an ever-shifting millennial market, to “walking dead” retailers whose time had passed but were unable to figure out how to adapt.

Bricks and Mortar on the Skids

In a recent interview with Bloomberg, Jason Mudrick, principal of hedge fund Mudrick Capital, encapsulated the status of retail:

“Retail is a mess. This is not cyclical, it’s systemic. The economy has been good, so the consistent drop in gross sales of ‘traditional’ retailers has been at a time of high consumer confidence and increased consumer purchasing power. Unemployment is low. All the trends should result in halcyon days for retailers. Something is going on. It’s history being made before our eyes.”

To make sure we understand the irrevocable nature of the trend, he posed two questions, to which the answers seem obvious: 1) In 10-20 years, do you see more people shopping online, or fewer? 2) Do you think “big e-commerce” is just a fad? His conclusion is that we are witnessing the “Amazon Effect,” and it is here to stay.

The Body Count

The casualties of the retail tankage read like a Who’s Who of retail favorites. A partial casualty list, their specialty, and the reported number of stores closed, tells the story:

Sports Authority (“big box” sporting goods - 460), American Apparel (integrated apparel manufacturer and retailer - 110), rue21 (teen clothing - 400), Aeropostale (casual apparel - 113), Wet Seal (contemporary women’s clothing - 171), Gymboree (children’s clothing - 375), Limited (women’s clothing - 250), BCBG Max Azria (women’s fashions - 118), Vanity Shop of Grand Forks (young women’s fashions - 140), Payless Shoe Source (discount shoes - estimated 400), Eastern Outfitters (outdoor sporting goods - 48), Radio Shack (consumer electronics - 1,000), Pacific Sunwear of California (beach-themed casual wear - 120), Anna’s Linens (bedding and discount household items – 252), Vestis (sporting goods, parent of Sports Chalet, Bob’s Stores, Eastern Mountain Stores – number of store closings not reported), Goodman’s Stores (department stores – 106), hhgreg (appliance, electronics and furniture retailer – 131).

The list is expanding monthly. The financial press is touting the potential demise of two more major retailers, Sears and J.C. Penney, both established well over a century ago.

Enter, the bankruptcy system

The chapter 11 bankruptcy process has traditionally been, in simplistic terms, the refuge for distressed companies to attempt to salvage their business – by first getting breathing room from creditors, followed by a plan of reorganization that provides for the pay-out of claims over time.

The bankruptcy environment, however, has not been friendly to retail. Today’s retail bankruptcies face two major obstacles.

First, a viable core business is the prerequisite for a successful reorganization. Businesses whose models are no longer viable cannot make it through the process of reorganization. To effectively reorganize, a company must be able to meet its current obligations going forward, and have something left over to pay pre-bankruptcy creditors. Retailers with shrinking per-store sales often cannot pass this threshold requirement.

A second and more daunting problem is that revisions to the Bankruptcy Code, effective in 2005, greatly restricted the power of bankruptcy courts to grant bankrupt commercial tenants sufficient time to decide whether to assume their existing leases or to reject them. (To “reject” a lease, in bankruptcy terminology, means to terminate the lease and surrender possession of the premises to the landlord.)

For retailers with dozens or even hundreds of locations, this is a weighty decision that is not made lightly. The current law requires, however, that this "assume or reject" decision be made within 120 days of the filing of the case, with the court having the limited ability to extend the time for a single 90-day period. Thus the window to decide which stores go, and which stay, is not more than seven months.

For many retailers, the company’s leases are often the greatest source of value. This puts an inordinate amount of pressure on the bankrupt retailer to make irrevocable decisions very quickly on dozens or hundreds of leases.

Management must decide which leases are to be rejected, which translates into stores closed, employees terminated, and inventory liquidated. Leases which are to be assumed means either continued operation of the location, or, if the lease is below market or otherwise desirable, assigning the lease for much-needed cash.

If the company assumes the lease, going forward it becomes permanently liable for performance of all of the lease terms. If it later is unable to pay the rent, or decides to close the location, it is liable for all of the rent due through the end of the term of the lease, subject to the landlord’s obligation to find a new paying tenant for the space.

It gets worse; with the general downward trend in retail, there are few other players waiting to pick up the locations.

Given all of these obstacles, many of today’s retail bankruptcies are not reorganizations, but are controlled liquidations. The company does a “slow burn,” not attempting survival but simply closing many locations with old-fashioned “going out of business sales.”

A retailer teeing up a chapter 11 case is well advised to, in the early days of the case, allocate the resources of management, counsel, and consultants to the make-or-break decisions regarding which stores go and which stay. That can help to avoid the squeeze as the deadline for assumption or rejection draws near. Even if a particular location is not viable for the retailer, early identification of such a location can, if the economics of the lease are right, lead to the successful assumption of the lease and assignment, for a fee, to a new tenant. 

The effect on the real estate sector

The decline of brick-and-mortar stores, projected since the early days of the dot-com boom (remember that?), is coming to fruition. The retail distress caused by this seismic shift in consumer behavior is inevitably leading to distress in the real estate sector.

An April 2017 article in The Atlantic magazine, headlined “What in the World Is Causing the Retail Meltdown of 2017?” put it this way:

 “The simplest explanation for the demise of brick-and-mortar shops is that Amazon is eating retail. Between 2010 and last year, Amazon’s sales in North America quintupled from $16 billion to $80 billion. Sears’ revenue last year was about $22 billion, so you could say Amazon has grown by three Sears in six years. Even more remarkable, according to several reports, half of all U.S. households are now Amazon Prime subscribers.”

Bricks and-mortar retailing has been hit by a perfect storm of overbuilding, devastation of the retail sector, and systemic changes in how buying and selling are done.

According to real estate experts, “America built way too many malls.” A report by real estate consultant Cowan and Company rolls out the following data:          

  • There are about 1,200 malls in America today. In a decade, there might be about 900. That’s not quite the “the death of malls.” But it is a decline, and it is inevitable.
  • The number of malls in the U.S. grew more than twice as fast as the population between 1970 and 2015.
  • By one measure of consumerist plentitude — shopping center “gross leasable area” — the U.S. has 40 percent more shopping space per capita than Canada, five times more than the U.K., and 10 times more than Germany.

According to the real-estate research firm Cushman and Wakefield, mall visits declined 50 percent between 2010 and 2013, and they’ve kept falling every year since.

According to a “voice from the inside” of the new bad old days of retail, Urban Outfitters CEO Richard Hayne: “the unprecedented expansion of retail created a bubble, and like housing, that bubble has now burst.” Hayne adds, "We are seeing the results: Doors shuttering and rents retreating. This trend will continue for the foreseeable future, and may even accelerate.”

As the demise of traditional retailing continues unabated, the only questions are who is next, and who will be left standing. The big ripple through the shopping center market caused by widespread retail closures has not yet reached full strength, but it is well underway.

There are reports of creative landlords responding to the retail downturn by repurposing former retail space. The new uses include upscale dining (in place of food courts), entertainment venues (theaters, bowling, water parks and trampoline parks), auto sales, apartments, schools, health care, and fitness centers. Some malls are even converting to residential use. Retail bankruptcies will continue and retail use of real estate will probably decline, but alternative uses will likely increase.  Stay tuned.

By David M. Reeder

Valensi Rose PLC represents companies reorganizing under chapter 11 of the bankruptcy code, as well as commercial landlords whose tenants have filed bankruptcy cases.