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Industrial Tenants Could Save Retail If Owners Do Their Homework

Retailers considering switching to industrial may want to recheck their contracts.

In the midst of thousands of store closings, retail landlords scrambling to replace tenants that have gone out of business in the last few months have a beacon of hope: industrial.

Demand for e-commerce services has skyrocketed during the coronavirus pandemic and the demand for warehouse space has risen along with it. As a result, owners of some struggling retail spaces are considering converting their properties into industrial warehouses or distribution centers.

But before they make this switch, they may want to call a lawyer. 

“Fulfillment center tenants could be the answer to retail owners’ prayers, but they have to proceed with caution,” said Daniel E. Rottenberg, a director at Goulston & Storrs, a law firm that represents lenders, developers, building owners and other players across the real estate industry. “There are dozens of potential pitfalls, from zoning to tax law, that owners need to carefully consider.”

While almost no aspect of commercial real estate has been left unscathed by the coronavirus, retail was hit especially hard. Retailers across the country are resorting to legal action to get out of their leases, and major companies like J.C. Penney and Lord & Taylor are filing for bankruptcy protection

“The retail industry is undergoing what appears to be a reset that began before the pandemic,” Rottenberg said. “Landlords who were looking to add a mix of restaurant and experiential tenants are now facing unprecedented declines in foot traffic. Owners now need to backfill spaces vacated by shuttered tenants, and pivoting to industrial, the one asset class that seems to be thriving right now, offers them a unique opportunity.” 

Rottenberg said that converting retail space to warehouse space doesn’t require the same comprehensive overhaul that a residential mixed-use conversion requires. The sprawling, high-ceilinged designs of former J.C Penney or Lord & Taylor stores can be easily transformed into spaces to house rows of boxed products waiting to be shipped. Plus, if the stores were once mall anchor tenants, then they likely already have the large parking lots they need to accommodate box trucks.

Also, not only can the switch be done incrementally, but it can be reversed if retail picks back up and property owners want to welcome retail tenants again.

“Retail centers are geographically well-positioned to be closer to the customers who are buying products online and increasingly expecting next-day or same-day deliveries,” said Jessica M. Caamano, an associate at Goulston & Storrs. “There may even be opportunities for short-term, scalable, online exchange-driven distribution center users or for takeout and delivery-only restaurateurs.” 

However, the Goulston & Storrs team said that despite all the positives, a pivot to warehouse or distribution centers has potential legal and operational hurdles. Owners and investors need to do their research, speak with a lawyer and make sure their property is right for this type of conversion.

A distribution or warehousing use is often considered a separate category of use under municipal zoning regulations. The new use may not be allowed or may require a lengthy entitlement effort. Along with that, retail tenants who remain in business may have leases that prohibit warehouse or distribution center uses, or these new uses might not satisfy co-tenancy requirements.

Similarly, shopping centers that are subject to REAs with co-located big-box stores, grocery or other anchor stores may be prohibited from converting to a distribution center use, since it could be in direct competition with those existing retailers’ business models, said David A. Lewis, another associate at Goulston & Storrs.

Lewis also recommended that retailers take a close look at their loan documents before making the switch to industrial, since some loan documents may prohibit changes in use or leases to non-retail tenants. 

“Lenders may be wary of a fad, stopgap or a use that could be perceived as value-diminishing,” Lewis said.

Caamano added that property tax assessments could be based on the assumption that shopping centers will be leased to higher-value retail tenants versus a distribution center, which might reap a lower dollar amount per square foot. As a result, if an assessor does not get the opportunity to change the building’s valuation quickly based on its new use, the owner may end up paying the outdated, higher tax bill. 

Also, Lewis said that retail tenants are often willing to pay common area charges that might not be important to distribution tenants — like advertising, programming, landscape maintenance — because they are not concerned about attracting and retaining shoppers.

Rottenberg said that none of this means that retail property owners should abandon the idea of pivoting to industrial, they just have to be sure to do their research and approach this shift carefully.

“Owners should consider consulting with an experienced real estate attorney, who could walk them through any potential obstacles they may face,” Rottenberg said. 

This feature was produced in collaboration between the Bisnow Branded Content Studio and Goulston & Storrs. Bisnow news staff was not involved in the production of this content.