Malls Go for Broke, May Still Go Broke

This post first appeared on Minyanville.

As retailers batten down the hatches for what most finally agree will be a nasty economic slowdown, their landlords are scrambling to keep the lights on.

The Wall Street Journal reports mall and shopping-center owners are turning to unconventional advertising methods to keep cash coming in the door. Ads are popping up on food-court meal trays, parking-lot stalls and even vacant storefronts.

InWindow and WindowGain, 2 new companies in the alternative ad space, have landed big names on their clients’ previously vacuous retail space: Comcast (CMCSA), SAB Miller and Verizon (VZ) are all signed up.

Although cash flow from these new avenues pales in comparison to traditional rental income, it’s better than nothing. Owners, however, are reluctant to lock in such ads for long periods of time; instead; they're hoping new tenants will somehow turn up.

In addition to buoying bottom lines, storefront ads help make malls feel less empty. “For lease” signs and empty windows don’t exactly make for a happy shopping experience. And consumers waffling over how to spend their dwindling discretionary dollars can't be constantly reminded of how bad things are - it isn't exactly good for business.

Big mall owners like General Growth Properties (GGP) and Boston Properties (BXP) are hoping the extra income will help cover mounting credit costs. Meanwhile, investors are fleeing equity of these and other publicly traded Real Estate Investment Trusts, or REITs, on fears they could default on their debt obligations. GGP trades at just above $3, down from more than $50 at this time last year. BXP has fared slightly better, taking a mere 35% haircut from over $100 to $65 now.

Since the beginning of the housing downturn almost 3 years ago, many have wondered whether commercial real estate would follow residential into the abyss. Professor Zucchi has long been saying that it’s just a matter of time.

The bullish case for commercial real estate argues the business is less prone to bubbles than the residential market, since asset prices are more directly tied to cash flow. Even if vacancy rates rise, commercial property values won’t take the drastic hit we’ve seen in residential, since there wasn’t a huge speculative run-up in the first place.

While this line of thought is logical, it ignores the structural similarities between the 2 markets. During the boom, both residential and commercial mortgages were funded by originators using cheap short-term debt to finance long-term loans at higher rates. Since that short-term debt could be rolled at low rates, spreads were wide and profits juicy.

Now that short term funding markets are frozen, even for credit-worthy borrowers, that business model is broken. Unable to tap new, cheap debt, property owners are turning to expensive bank lines of credit - or nothing at all. At best, this is squeezing margins; at worst, it's risking the viability of entire firms.

The ongoing economic slowdown, now far worse than most expected, won't help much either. Consumers are cutting back, retailers are closing stores and landlords will find rent harder and harder to collect.

Sayonara, strip mall mania.