Many malls were struggling long before COVID-19. However, the pandemic has ratcheted up the pressure by decimating customer traffic and driving many key mall tenants into bankruptcy.

This is forcing U.S. mall REITs to get even more creative about how they use their real estate. Recently, sector leader Simon Property Group (NYSE:SPG) has had discussions with Amazon.com (NASDAQ:AMZN) about converting some department store space into fulfillment centers, according to The Wall Street Journal.

Expanding into mall space formerly occupied by department stores could help Amazon in its efforts to meet surging demand and reduce shipping times. Yet such an arrangement wouldn't bolster the prospects of the attached malls, making Simon's apparent interest appear like a desperation move.

Anchors away

The underlying reason why Simon Property Group is interested in finding alternative uses for mall space is that mall owners have experienced a surge of anchor store closures. Traditionally, most malls were built with anywhere between two and five (or even six) department stores with exterior entrances. These department stores were expected to draw traffic to the mall, some of which would filter down to the smaller "in-line" tenants within the mall.

A corridor inside a shopping mall

Image source: Getty Images.

Alas, department stores are a dying breed, due to changing consumer shopping patterns and most department store chains' failure to adapt. There were 670 full-line Sears stores as recently as early 2017. By this fall, there will be about 60. Meanwhile, J.C. Penney filed for bankruptcy in May, with plans to close more than 200 stores. Depending on the outcome of its bankruptcy auction, that number could rise significantly.

As recently as early 2018, there were 66 Sears stores and 66 J.C. Penney stores in Simon's malls. Altogether, those stores occupied more than 21 million square feet of space. Initially, Simon planned to redevelop most of the space that came available due to department store closures. For example, in October 2018, CEO David Simon said that the REIT planned to spend over $1 billion to redevelop 22 former Sears stores over the course of several years.

Today, the calculus is different. Due to the COVID-19 pandemic, it is harder to find new tenants to fill all of the cavernous department store spaces that are available. The cost of capital has also risen due to general uncertainty about malls' future prospects. Simon Property Group simply can't afford to invest tens of millions of dollars on redevelopment for every single department store box that becomes vacant.

Enter Amazon

In this context, partnering with Amazon has obvious appeal. Amazon has enormous financial resources and could thus pay for the build-out of its space, helping Simon limit capital expenditures. And while rents would probably be rather low, something is better than nothing -- and that income stream would be very secure, in light of Amazon's fortress balance sheet.

The rationale for Amazon is simple: the e-commerce pioneer has an insatiable need for fulfillment center space. Most malls occupy excellent locations within their markets, with easy access to major roads and highways. Setting up small-scale fulfillment centers in regional malls would enable Amazon to position fast-moving inventory closer to customers, cutting down on shipping times and delivery costs.

However, there's one key problem. Fulfillment centers won't drive a meaningful amount of mall traffic. Given the size of a typical department store, each fulfillment center would likely employ a few hundred people. That wouldn't be enough to meaningfully boost sales at in-line tenants. Traditional and alternative anchors like department stores, off-price stores, gyms, movie theaters, and family entertainment centers would drive much more traffic to the mall interior.

Managed decline?

Leasing space to Amazon for fulfillment centers could prove to be a double-edged sword. On the one hand, Simon Property Group would initially benefit from a modest amount of additional rental income with little or no up-front investment. On the other hand, replacing anchor space with tenants that won't drive much traffic to the mall will aggravate the existing trend of declining mall traffic. All else equal, that would lead to more store closures and lower rents for in-line space -- which generates most of a typical mall's income.

For malls that were thriving before the pandemic, it would be suicidal to lease space to Amazon rather than holding out for traffic-driving tenants. The extra near-term rental income wouldn't make up for the long-term loss of value as lower traffic causes in-line tenants to close or demand rent reductions.

By contrast, working with Amazon might make sense as a tool for managing the decline of malls that cannot be turned around at an acceptable cost. However, it would be a desperation move: a ploy to generate some extra income to keep the doors open for a few extra years. Ultimately, malls that rely on fulfillment centers to fill empty space now will likely need to be fully redeveloped within the next decade.