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Jun, 01 2005

AN ALTERNATIVE TO LEASING

With mall culture finally establishing itself in India, the retail and real estate industry is fast adapting to the changing needs of the market. High rentals not withstanding, retailers and mall developers are mutually agreeing for the concept of reven

MALLS in India have always been a subject of interest to a large strata of the society. Be it retailers, mall developers, real estate builders or end users, malls have never failed to draw attention. And why not? From 35 to 40 operational malls currently occupying approximately 6 million sq.ft (approx. 60 lakh sq.ft) of retail space, India is expected to have over 220 new malls by the end of 2006, thereby further adding retail space to the tune of 35 to 40 million sq.ft (over 400 crore approx). Of the 220 malls expected to be inaugurated, about 50 per cent are expected to come up in the six metros, NCR, Mumbai, Bangalore, Kolkata, Hyderabad and Chennai. By 2010, mall developments are anticipated to spread across 60 cities in the country.

Experts in the field have started sounding warning bells on whether these cities can sustain so many malls, given the high cost of real estate, said to be among the highest in the world and low levels of household expenditure, estimated to be among the least in the world.

Challenges for real estate operators

Clearly, malls are the business of the moment, but there are some basic issues that the retail and real estate industry needs to address, one of them is high rentals. Today most of the malls seem to have outpriced themselves. Says Mr Munish Kumar, head, research and consulting group, Chesterton Meghraj International Property Consultants, “Rentals are very steep in malls in India.”

While affordable rentals differ across retail categories, few retailers can afford to pay more than 8 to 10 per cent of their turnover for rent, the figure comes down to around 5 to 6 per cent when dealing with super markets where gross margins are typically 10 to 12 per cent.

Says Mr Jaydeep Shetty, chief- new business, lifestyle retailing, Pantaloon Retail India Ltd, “When the mall wave commenced in India, developers of real estate exploited the huge demand versus low supply situation and pitched themselves at the highest prices that the market could take.”

Several food retail chains have pulled out of the malls during the past few months. Café Coffee Day opted out of Ansal Plaza mall, Pizza Hut shut shop in Sahara mall, Gurgaon, while Nirula's bid adieu to MGF mall in Gurgaon. What prompted these retailers to do so at a time when malls are seen as the preferred destination for retailers?

Fast growth not withstanding, high rentals is one of the reasons that is forcing the retail chains to vacate from prime locations in metros and instead park themselves in smaller towns with franchisees.

Mark Pi International, the Chinese fast food chain represented by Track Services in India, which plans to go national this year has taken a conscious decision to open its outlets in mid-sized towns and bypass the top metros. The company has also decided to expand its presence only through the franchise route.

“We had to pull out of MGF Mall ,as there were too many players in food and beverage operations as against planned, hence the sale continued to drop, while, as it was a rent deal, the rent remained. It just was not viable beyond a particular point,” says Mr Vikas Attri, technical advisor, Nirula’s.

“We are not comfortable while paying the rent because we feel that they are too high and are definitely not justified,” says Mr Neeraj Katoch, head, franchise operations, Domino’s. However, Mr Rajeev Piramal, vice president, corporate and strategic planning, Piramal Holdings Limited holds a different opinion on the subject. “No, malls are not overpriced. Price is a function of the market, and with the kind of facilities retailers have in the malls, they get the best value and it would be wrong to say that mall developers are overcharging,” he argues. According to him, even smaller brands that are planning expansion have a choice with the number of malls coming up in India.

High rentals and its consequences

The main reason for high rentals in India is the high super to carpet area ratios, which mean that the retailers or end users have to pay rent for not only the space they are using (carpet area), but also for the common area. As per Chesterton Meghraj International Property Consultants, ‘in some of the newly developed malls in India, the super to carpet area loading ranges from 50 to 100 per cent, which means very high rentals for the common spaces as well that has to be paid by retailers.’

Leasing space or outright purchase in malls by retail formats has been the norm till now. However, there is a third alternative emerging in organised retail in India, which is the revenue sharing model. In a revenue sharing model, the retailers give a minimum guarantee to the mall owners, which generally ranges from 40 to 60 per cent of the rentals for the space,” says Mr Kumar. Usually revenue sharing is a certain percentage of the annual turnover of the retail format, and differs from format to format. The methods adopted are pure revenue sharing, minimum guarantee plus revenue sharing and minimum guarantee or revenue sharing, whichever is higher. The minimum guarantee is to the extent of exposure to the real estate costs.

Retailers like McDonald’s, Shoppers’ Stop, Pantaloon, Domino’s and Nirula’s are in revenue sharing agreements at the malls maintained by Parsvnath, Ansals and Sahara. Players and industry observers are positive of this arrangement soon taking root. Barista has an agreement with Inox, as does McDonald’s. Inorbit has entered into minimum guarantee plus revenue sharing and minimum guarantee or revenue sharing, which ever is higher with some leading brands like Lifestyle and Shoppers’ Stop. Says Mr Sanjay Badhe, director, operations, Shoppers’ Stop, “Revenue sharing model is an international concept. It is a mix of mall owners getting involved in business. Mall owners make a commitment and carry out marketing and other activities and hence rightfully deserve a part of the rent.”

As per Mr Attri, “As more mall operators find it increasingly difficult to get good brands at high rents, we are moving towards a percentage of sales deal.”

“Moreover, mall owners get a fixed percentage of share from the profit or sales. Thus in a way, both the mall owners and retailers share the risks of business equally, and hence are equally benefited,” avers Mr Kumar. “When Central mall was conceived by Pantaloons, it was conceived as a market epicentre and not just a fashion specific building. We thought we should work a model that is a win-win for both the retailer and to the mall manager. The concession model guaranteed that the minimum guarantees covered the fixed overhead that the mall ran and the balance is a variable part of the sales revenue. Central also charges purely on carpet utilisation,” explains Mr Shetty.

But what are the conditions that need to be fulfilled in this model? Normally it varies from retailer to retailer. For example, Nirula’s ask for long lease, and that all investments, other than furniture, equipment and signage should be made in totality by the developer. Dominos asks the mall owners to do the interiors for them and in turn, pay them a percentage of the turnover.

Genesis of the concept

One question that emerges is why the revenue sharing model? What is the need to follow this model rather than the conventional leasing model? As said above, the rentals are comparatively higher in malls, specifically for small retailers. On top of that, the conversion factor (number of buyers vis-a-vis the total visitors who visit these stores) is quite low at around 40 to 45 per cent. Most people just frequent these places either to check out the place, enjoy the air conditioning on a hot day or just to have fun. Says Mr Kumar, “It is observed that high footfalls to the shopping malls are eventually not resulting in comparative conversions, as most of the people go to these malls for leisure and entertainment purposes, and not actually spending money on shopping.”

Also malls give anchor tenants space at a rate lower than for the rest of the mall. This is so because the anchor occupies a sizeable percentage of the total usable area and is expected to attract a variety of consumers. In short, it is the key to increasing foot traffic. Also, retail space rental accounts for a major chunk of the higher operation costs in organised retailing. Development of suburban shopping malls, superstores and multiplexes has riposted these high rentals.

There are just a handful of players large enough to anchor a mall. Hence, a mall developer has to approach every available retailer to get him to anchor his mall, thus shifting the balance of power in favour of the retailers. Says Mr Piramal, “There are a limited number of retailers whom every mall targets.”

Faced with a severe anchor crunch, mall developers have to bend over backwards to facilitate anchors, some of whom have reduced rentals by as much as 60 per cent of the original lease rentals. Secondly, developers charge high maintenance prices from the secondary tenants. Since getting an anchor at a reasonable rental is difficult, a mall tries to hedge its bets with the other tenants by factoring in an additional component to the rentals called the common area maintenance (CAM) charge. This is essentially the cost of infrastructural facilities, air-conditioning, energy, etc that a mall provides the tenant.

Says Mr Shetty, “Many retailers bought into high end addresses and paid correspondingly high rents. The mall owners and developers promised that they would spend on marketing and bring in customer footfalls. As it turned out, the mall manager looked at the entire rent as income and refused to part with anything as marketing expense, pointing that the prime location itself was enough marketing signage. To worsen their woes, sales margins barely covered rents for retailers, leave alone making a profit.”

Suffice to say, malls will lose tenants if they overcharge. How then can the parity between the two be restored? What should be the preferred rentals?

Again there is no fixed answer to this question. “The preferred rentals should be the normal market rental of that area with an addition of some percentage for the premium of the mall,” says Mr Katoch.

“Rentals cannot be calculated from the end users view point, otherwise the rent will always be zero. Developers have no choice but to load on the cost of land, permissions, construction cost, and their profits, while calculating expected rent,” says Mr Attri.

As rental expectations of the mall developer and the tenant are unlikely to match, the best way out would then be to enter into a revenue-sharing agreement. “Revenue sharing model will have to happen in the future. In fact, it will be a good option not only for the retailers but also for the mall owners,” says Mr Piramal.

A boon or bain

The revenue sharing model has its own advantages, the prominent being the sharing of risks and low rentals for the retailers. Says Mr Kumar, “Since the mall owner is getting a percentage share of the profits, he is equally benefited from the revenue sharing model.”

Mall developers hence try to conduct various events and festivals in the malls, so as to target maximum footfall and hence conversions. Malls developers have also been roping in the best designers and architects, both locally and from abroad to ensure that looks aren't compromised on.

Such agreements also have other benefits. They could reduce tenant turnover significantly and ensure that the mall remains well occupied. They could also prompt the mall developer to look for ways by which footfalls can be increased, as that would be to his advantage. The other advantage is the fact that given the over supply situation, which the market will certainly witness when it comes to mall space, arriving at a long term working arrangement, especially with high footfall tenants, certainly works in their favour.

For the retailer there is no established cost, which has to be paid to the developer, which works to their benefit. Maximising is imperative because malls have the responsibility of ensuring quality of space and the ability to bring in footfalls. Says Mr Badhe, “Instead of revenue sharing, it is performance revenue sharing that is important. If mall developer works towards ensuring high footfalls on weekends, then I know that this is the share of people I’ll get on a particular day.”

Yet, the concept has its own criteria. The arrangement is not put into practice with each and every tenant at the mall. A proper scrutiny is undertaken to understand the strengths of the format. The strength of the proposition is analysed and how will it add value to the mall. Also, mall owners only look out for the branded and well-known retail chains to go for this model, so as to attain maximum profit. Thus, the smaller retailers are not considered and hence do not benefit from the revenue sharing model. Secondly, the developers are actually looking at fixed rentals from their spaces, thus are quite hesitant about the revenue sharing model, whereas the retailers are willing to share their revenues from the operations with the developers, so as to have realistic rentals. So, the revenue sharing model only comes into picture when the retailers do not want to come to a mall fully on fixed rental prices. Adds Mr Piramal, “If the rentals are high as compared to the amount paid in revenue sharing, then revenue sharing is preferred by retailers, but the same is not true the other way round.”

Developers say that with greater supply of retail space, the retailers are likely to have thin margins forcing the developers to enter into revenue model where retailers pay a certain percentage of sales as rent. However this model calls for a strict monitoring of shop sales and developers like DLF still prefer leasing out the space. To fight the stagnancy in rentals developers are focusing on upmarket malls. Audit transparency is one area which needs due attention. There are many ways in which it can be done. Says Mr Kumar, “The audit transparency is maintained by mall manager, who is connected through LAN to all the retailers in a particular mall. The mall manager acts as a middle person between the mall owner and the retailer, and has full records of the sales and operating costs.”

Says Mr Katoch, “The mall management is sent a report based on our order report from our office.”

Says Mr Attri, “All brands have ethical accounting practices. Sales can be verified from time to time by the developer. Sales report may be sent on a monthly basis as well as sales tax returns, if required.”

Criteria for success

Malls require a lot of real estate, something not easy to find in a prime location. The high overheads and labour costs make their setting up an even more expensive proposition. The promoters of a mall must realise that they have to create a shopping destination. Globally, malls are built by real estate developers, who take the help of retail experts.

“However, in India, most mall developers are builders rather mall managers,” feels Mr Badhe.

It is essential that malls have the right tenant mix so that the clientele gets a good blend of products. Observes Mr Shetty, “Mall management is more a retail skill than pure real estate play. Most builders still would like to develop and sell properties and forget about it, rather than nurture it for the future.”

In a mall the footfall is driven by the activities, promotions and the overall experience that a customer has when he comes to a mall, a lot of which lies in the hands of the company which is managing the malls. Revenue sharing model keeps the mall management involved with the business and encourages them to help grow business. Alongside high footfalls, the location of the mall is also of prime importance. Says Mr Katoch, “Ours is a delivery business and depends a lot on the demographics of the locality rather than the so called footfalls in the mall. The footfalls gives us only the incremental business.”

Till now mall developers have traditionally been real estate businessmen looking to diversify. Most have not really bothered with the daily operations of the mall once the tenants are in. But now, they are realising the need to actively do so even as they understand how low footfalls could lead to an exodus of tenants. For that, they need to put a premium on quick, efficient and satisfactory service, both to consumers and to the retailers. Inorbit and Prestige Forum are already moving in that direction. They have installed footfall counters to map the entire mall and study exactly where customers head to and how much time they spend in different areas of the mall.

In the Indian context, success would involve being innovative and understanding the needs of the consumer. Since the scale is too large to build one-to-one relationships, the option is to create brand loyalty through promotions. Success will depend on selecting the right location, which will depend on the customer target and store positioning, focus on merchandise in terms of the selection of suppliers, quality of goods and correct pricing and managing the inventory to ensure that products are available.

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