Decline of malls could hurt Dillard's.

THE ENCLOSED SHOPPING MALL IS ON track to join Main Street in the annals of retail history, and that could mean more problems for Dillard's Inc. of Little Rock.

Nearly all of Dillard's 328 stores anchor the kind of malls that are rapidly being usurped by "lifestyle centers," which typically feature open-air streetscapes and easy parking access to stores.

The shopper preference is unmistakable:

* Mall traffic was down 10 to 14 percent in 2007 compared with 2006, said Britt Beemer, founder and chairman of America's Research Group of Charleston, S.C. Meanwhile, traffic at open-air centers was up by double digits.

* More than 300 malls have closed in recent years, according to Deadmalls.com, a Web site that tracks ghost malls.

* The Mall at Turtle Creek in Jonesboro was the only enclosed mall that opened in the United States in 2006, and that was one more than in 2007, according to the International Council of Shopping Centers in New York. No developer has announced plans for an enclosed mall in 2008 or the first quarter of 2009.

* Ten open-air malls opened in 2007, 10 more are planned for this year and one has been announced for 2009, according to the ICSC.

* A third of shoppers at lifestyle centers say those are now their primary places to shop, according to Beemer.

Obviously, Dillard's can make the move into lifestyle centers, and it is. Spokeswoman Julie Bull said the department store chain already has about 20 stores in open-air centers, and none of the nine Dillard's stores that will open this year will be in an enclosed mall.

"These are very compelling centers for us because they are being built in areas where our customers are shopping, dining and working," Bull said.

But unlike most other retail chains, Dillard's owns most of its stores rather than leasing. And the value of those assets is closely tied to the value of malls. Dillard's owned 241 of its stores as of Feb. 3, 2007, the end of its last fiscal year, and about 55 percent of its $5.4 billion in reported assets was tied to buildings and leasehold improvements.

"If I were Dillard's, I would quickly divest myself of that land as soon as possible," Beemer said. "Over the long run, I think it's going to be less and less valuable."

Other mall-based retailers are seeing their real estate value fall.

On Jan. 14, Credit Suisse reduced its rating on Sears Holding Corp. of Hoffman Estates, Ill., from "outperform" to "underperform" partly because of the declining value of Sears' real estate.

"Our Outperform rating originally was based on free cash flow and asset value," wrote research analyst Gary Baiter. "Unfortunately, over the past few months, we believe the largest piece of that value, real estate, has declined materially."

Lifestyle Success

The shopper of tomorrow will be at the lifestyle center, which may feature multi-screen movie theaters and upscale restaurants as well as retail stores, Beemer said. Most of the people shopping at the new centers are under 40, he said. "What that's done is taken this younger shopper out of the malls entirely," he said. "What it means is the children of these younger people are not going in the malls when they are growing up."

Consumers contend that shopping at the lifestyle centers, where they can typically drive up to an individual store, is more convenient than going to a mall, which has the parking lots on the perimeter of the building.

"I don't want to park in a big parking lot," Beemer said. "I don't have to walk through a mall to get to the store, walk back through the mall to get to my car."

Shoppers also complain that stores in malls look too much alike, he said.

"So the lifestyle centers, which are entertainment- and food-based, they're a much more changing environment, which has an advantage over the malls," Beemer said.

The lifestyle centers are becoming not only a place to shop, but to spend leisure time, said Erin Hershkowitz, a spokeswoman for the International Council of Shopping Centers.

"It offers streetscapes, benches, fountains," she said. "It's a very pedestrian-friendly environment."

Dillard's Real Estate Value

Declining mall traffic hurts the value of a mall, which in turn could impact Dillard's value as mall anchors, Beemer said. As shoppers vote with their feet, vacancies in malls nationwide are starting to climb.

The vacancy rate for neighborhood and community shopping centers rose to 7.5 percent during the fourth quarter of 2007, the highest level since 1996, according to a report by Reis Inc. of New York.

While the weakness in neighborhood and community shopping centers has been evident for some time, regional malls have lagged behind because of the difference in tenant mix and lease terms, Sam Chandan, chief economist for Reis Inc., said in a report released on Jan. 18. But even for regional draws, "initial signs of stress are now emerging," Chandan wrote.

The mall vacancy rate in the fourth quarter of 2007 increased from 5.5 percent to 5.8 percent, bringing the national vacancy rate to its highest level in three years.

[GRAPHIC OMITTED]

In 2008, Chandan expects to see rents in malls rise slowly or even decline in some parts of the country. "A slowly rising national vacancy rate will dominate regional mall trends," he wrote.

A mall's value is based on its occupancy rate, said Al Williams, a principal of Excess Space Disposition Inc. of Huntington Beach, Calif., which specializes in selling real estate and restructuring leases for retailers nationwide.

"I think we're still in a pretty dynamic retail environment," Williams said. "Clearly, it varies from market to market. But we're entering into some interesting times with everything that's going on with the economy."

Occupancy levels in a mall could be further reduced if consumers cut back on spending, he said.

"The value of a mall is basically created by a multiplier of its rent rolls," Williams said. "So if occupancy levels are high, if you were looking to sell the real estate you would be able to achieve a higher sales number versus if you had a lot of vacancies in any particular mall. That could potentially have a material effect on the ultimate selling price for the mall."

In the short term, though, he said he hasn't found anything to indicate the value of shopping malls declining.

But that might change in a year or two.

Bull, Dillard's spokeswoman, wouldn't comment on the value of the company's property. The value listed on the asset sheet isn't necessarily the amount Dillard's might get if the property was sold, she said.

Bull said the value is tied to the historic cost, which could be more or less than the property's appraised value.

A department store's real estate is not as desirable an asset as it was a few years ago, said Nell Stern, a senior partner at McMillan-Doolittle LLP, a retail consulting firm in Chicago.

Still, Stern said, department stores are probably sitting on property that has appreciated considerably from its original purchase price.

"In a portfolio of real estate, you're very likely to have a few locations that are highly desirable and a lot that just aren't," he said.

Dillard's Sales

Since 2002, Dillard's same-store sales, sales in stores that have been open a year or more, have declined each year or remained flat. Beemer said sales could be off because mall traffic is down.

"The stores that have been growing have not been mall-based retailers," Beemer said, pointing to Wal-Mart Stores Inc. and Target Corp. as examples.

Kohl's Corp., which mainly locates outside malls, also saw its same-store sales rise each year between 2002 and 2007, except for fiscal 2003 when the numbers were off 1.4 percent.

Bull said Dillard's declining sales could be blamed on a variety of reasons other than mall traffic patterns.

Beemer said shoppers aren't going to the malls because they think they can find what they want cheaper elsewhere.

"They don't look at a mall as a money-saving environment, which obviously is a huge problem today when times are tougher," he said. "People want to go to a shopping environment that saves them money."

By Mark Friedman

[e-mail]

Dillard's Inc. Real Estate Holdings

All dollar figures in thousands

Fiscal year end                         Feb. 3, 2007   Jan. 28, 2008

Number of stores owned                           241             227
Owned buildings on leased land                    20              18
Land and land improvements                   $89,451         $90,879
Buildings and leasehold improvements      $2,944,022      $2,792,417
Less accumulated depreciation and
  amortization                           -$2,141,523     -$2,053,419
Total assets                              $5,408,015      $5,516,919
Shareholder's equity                      $2,586,953      $2,340,541

Fiscal year end                        Jan. 29, 2005   Jan. 31, 2004

Number of stores owned                           264             257
Owned buildings on leased land                    NA              NA
Land and land improvements                  $102,098        $100,726
Buildings and leasehold improvements      $2,755,565      $2,685,628
Less accumulated depreciation and
  amortization                           -$1,977,862     -$1,873,043
Total assets                              $5,691,581      $6,411,097
Shareholder's equity                      $2,324,697      $2,237,097

Fiscal year end                         Feb. 1, 2003

Number of stores owned                           258
Owned buildings on leased land                    NA
Land and land improvements                  $104,848
Buildings and leasehold improvements      $2,748,225
Less accumulated depreciation and
  amortization                           -$1,764,107
Total assets                              $6,675,932
Shareholder's equity                      $2,264,196

Source: Dillard's Inc. annual reports. NA. Not Available