Bank Financing and Bad Urban Planning Make the Retail Apocalypse Worse

You’ve probably seen it in your own neighborhood. Some restaurant or dry cleaner or hardware store closes because it can’t make rent, and the space just sits there, empty, for months. Years, even. The pandemic boarded up so many storefronts across America that it turned what was already a Retail Apocalypse into something out of “The Walking Dead,” fueling the “doom loop” that’s ravaging even the mightiest cities. Urban dwellers fled and offices emptied out, which means walk-in traffic at street-level storefronts has taken a dive. Retail vacancy rates in major cities have soared by as much as 30% since the pandemic began — and in some “superstar urban cores,” McKinsey & Company predicts, they could rise by another 26% this decade.

Still, as apocalypses go, this retail one is puzzling. If demand for storefronts is down, why don’t landlords just lower the rent and get a tenant in there? That’s supposed to be the magic of capitalism — its ability to auto-adjust to anything the world throws at it. But that’s not what is happening with vacant shops. Even before the pandemic, one study found, street-level retail spaces in Manhattan were remaining vacant for an average of 16 months. 

So if COVID isn’t to blame for all the shuttered stores, what is? Well, when a landlord doesn’t lower the rent to get a new retail tenant, it’s because that landlord can’t. The market that sets retail rents isn’t only between tenants and landlords. It’s also between landlords and the banks that finance the buildings. And the banks, in many cases, won’t let property owners lower their rents enough to fill their properties. The pandemic may have emptied out America’s storefronts, but it’s banks that are keeping them that way.

The owners of America’s retail spaces have always had a financial incentive to leave their storefronts empty. Unlike apartments, retail leases often last for years — which means landlords are looking for tenants who are a safe bet to stay put. “Because leases are long and eviction is costly, the value of waiting for a tenant with a high match quality for a particular space can be very high,” a recent paper by two NYU economics doctoral students found. In other words, it makes sense for retail landlords to be ultraconservative and leave a space fallow until they find the “right” tenant.

But retail landlords also have to contend with the banks that hold their mortgage. If they built or redeveloped the building themselves, the financing may have been contingent on maintaining a certain level of rent. Which means the bank has veto power if the landlord needs to, say, lower the rent in the wake of a global pandemic. “If your financing assumed $50 a square foot, and you go in and lease the space for $25 a square foot, you’re probably going to have to send the lease to the lender to approve,” says David Greensfelder, a commercial real-estate consultant.

So if you’re trying to lower the rent on your retail space, your bank may say no. And even if it says yes, it might demand you pay off a chunk of the mortgage up front, to account for the way you’re lowering the building’s value by lowering its rental income. In short, reducing the rent on your storefront might land you a tenant — but it could cost you big-time with your bank.

Of course, nothing is forcing banks to be all hard-assed about it. They’re free to renegotiate or refinance the terms of mortgages, given the extraordinary downturn facing retail storefronts. In some cases, according to real-estate brokers I spoke with, banks have apparently decided not to stand in the way of landlords in San Francisco who are offering shorter-term leases and lowering retail rents anywhere from 20% to 50%. One popular restaurant space in the city’s tech-heavy South of Market neighborhood that has been dark since 2020 is finally set to reopen this year as a bar and “entertainment concept” — but only because the landlord is offering the new tenant a below-market rate and improvements to the space.

 But examples like that are exceptions to the rule. These days, after the housing crash of 2008, most lenders are actually less open to letting landlords adjust rents to match the prevailing market. “As the Fed is doing more and more stress tests on lenders, lenders are less and less willing to say: ‘OK, we understand, we know what you’re doing, vaya con Dios,'” Greensfelder says.

And if your financing comes through what’s known as a CMBS — commercial mortgage-backed securities — you’re going to need even more Dios to vaya with. CMBS lenders — the commercial equivalent of the giant cesspools of residential mortgages that crashed the global economy back in ’08 — are far less likely than banks to modify the terms of individual loans. Before the pandemic, banks modified about 2% of their loans a quarter and CMBS lenders modified 0.1%. From 2020 to 2022, bank loan modifications got as high as 17%, but CMBS barely brushed up against 5%.

 In other words, lots of landlords are sitting on space they can’t rent, financed by deals they can’t alter. And the future will be full of even higher vacancy rates, higher interest rates, and lower rents. What’s a downtown property owner to do? “I can summarize it in two words,” Greensfelder says. “They’re fucked.”

There is actually one scenario in which banks are willing to give retail landlords a break on their mortgages. Unfortunately, it’s the kind of deal that makes cities worse overall. Banks often give better financing terms if a landlord can bring in what’s called a credit tenant — a national brand like a Starbucks or a Target. That’s because even if a big chain winds up shuttering a local store, the parent company is still around to pay the rent. “If a T-Mobile or a Verizon choose to close a store, the landlord knows they’re good for it,” says Larisa Ortiz, a managing director at Streetsense, an urban-planning consultancy.

You’d think everyone involved would be motivated to fill an empty storefront — landlords aren’t making money, cities aren’t getting taxes, and the neighborhood has an eyesore. But that eyesore may actually still be profitable to the landlord and the banks. “In SoHo, something vacant isn’t necessarily vacant,” says Ortiz. “Someone’s paying rent there, and the landlord’s perfectly fine with it. It’s a vacancy to the pedestrian, but not to the landlord.”

Multiple vacant storefronts on a city street with papered-over windows and a couple people walking past

Because of the
rules governing retail mortgages, banks and landlords often make money off of empty storefronts.

Justin Sullivan/Getty Images

The favoritism shown to credit tenants means that over time, neighborhood streets lined with locally owned yoga studios and bike-repair shops gradually transition to streets full of Sephoras and Banana Republics. The message banks give to retail landlords is clear: Either go big, or go home. Lorenzo Perez, an architect and real-estate developer in Phoenix, says that storefront landlords wind up thinking, “Shit, I’ve got this expensive space, and I don’t have the luxury or choice to go with cool, small operators, because my loan covenants or financing don’t allow it.” 

Banks are also making things worse by financing developers to build even more retail space, despite all the empty storefronts blighting American cities. That’s in part because many cities, aiming to create walkable neighborhoods, now require new apartment buildings to include space for retail on the ground floor. But those spaces will never rent, because the rent demands placed on them by the banks can’t be met by the market. Rachel Meltzer, an urban planning and economics professor at Harvard, has been tracking retail and rental data in America’s seven largest cities. Retail rents have flattened, she says, but the construction of retail space has not. “In LA and New York, they just kept building retail square footage,” she says. No one’s going to want it.

It’s tempting to think, “Well, big financial institutions have to do whatever they can to make a decent return on their investment.” I mean, banks are gonna bank, right? Lenders can’t afford to let building owners offer long-term leases for most storefront tenants, because almost 70% of retail businesses fail within five years. “If you have a credit tenant with a 10-year lease, arguably the building is worth more because there’s more stability,” says Kazuko Morgan, an executive vice chair at the real-estate giant Cushman & Wakefield. “A local tenant, or a startup that wants to do a five-year lease — that’s a much riskier proposition.”

Still, from an urban-planning standpoint, the way we finance retail space makes no sense. Vibrant cities need healthy neighborhoods, and healthy neighborhoods need diversity on the street — front stoops, art galleries, bodegas, florists, snooty coffee places. Not just Targets and Citibanks.

To reverse the Retail Apocalypse, landlords and cities need to start thinking differently about what retail does for them. When the developers of Culdesac, a car-free residential community in Tempe, Arizona, wanted to add a retail component to the town, they tried something new. Instead of expecting restaurants and pet stores to make it on their own, as dog-eat-dog businesses, Culdesac’s planners treated retail as an amenity — something essential to everyone’s well-being. That creates the opposite of a doom loop: By offering lower rents to small, interesting retailers on the ground floor, landlords can attract residents willing to pay higher rents on the upper floors.

“They filled up all these cool, bookable micro-retail spaces with mom-and-pop operators,” says Perez, who worked with Culdesac on its retail component. “They right-sized it, and they offered flexible lease terms.”

A few cities are trying to make things easier for retailers. San Francisco has loosened up regulations downtown and instituted a controversial vacancy tax to incentivize landlords to fill their empty storefronts. But most cities aren’t getting creative with their zoning codes. If we want to turn things around, local governments may have to step in with subsidies, or banks will need to give landlords more wiggle room.

“Something’s got to give,” says Meltzer, the Harvard urban planner. “Retail startups don’t want to open where there’s no one on the street. If left to the market, you just end up with these big vacant spaces.” The Retail Apocalypse has been a nightmare. But just like in the movies, the postapocalypse could be even worse.

Adam Rogers is a senior correspondent at Insider.

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