Meanwhile, small and regional banks are bracing for a second wave of lending problems that will likely wreak more havoc on an industry trying to rehabilitate. The threat, however, is unavoidable, and many more retailers will fail.

It’s important to understand that before this recession, the retail market was massively oversaturated. In early 2008, North American merchants operated more than 200 square feet of brick-and-mortar retail space for every man, woman and child in the United States. By some estimates, it was twice the amount needed to meet demand. Compounding the problem, this holiday shopping season witnessed a 15% increase in Internet sales over the previous year, according to a study conducted by MasterCard.

By this time last year, nearly 150,000 individual stores had shuttered from the weakened economy. Many of those were mall-based chain stores crippled by the pressures of the economy and the Internet. The recession had prompted consumers to curtail discretionary spending and seek greater value for their retail dollar — something traditional shopping malls seldom offered.

At the industry’s peak, 140 new malls opened each year in the United States. But in the past 36 months, not a single enclosed mall has been built. Instead, big-box strip centers with adjacent discounters and restaurants, as well as open-air lifestyle centers with streets, parks and residential are stealing tenants and customers in droves. Scores of traditional department stores that once anchored every major mall in the nation have dwindled to a handful of operators, leaving millions of vacant square feet and landlords scrambling for solutions.

Macy’s, Dillard’s, Bon-Ton, Sears and JCPenney are among the few remaining anchors, as the market segment rapidly consolidates and closes poor performers. Many malls today are struggling to survive with occupancy rates significantly below 90%. All but a few top-tier premium centers with specialty anchor stores and high-end demographics remain strong.

By most estimates, the majority of malls with occupancy rates currently below 85% will fail before the economy recovers. A new era of consumer frugality, reduced credit spending and the Internet is forcing retailers to rethink their strategies and find new ways to remain viable.

The high overhead and vast expanses of a traditional mall business model no longer fits today’s formula for success. New consumer spending habits and Internet sales are forcing down the average sales per square foot. Soon, there will be fewer malls, smaller specialty stores, and chains will reduce their number of stores per market. As the Internet continues to grab market share, brick-and-mortar stores must find a new role in a transforming industry.

The Death of the Mall

Crestwood Court in St. Louis once was its area’s premier shopping mall. Today 40% of its stores are empty. Mall managers began offering vacant space to local artists, a theater company and dance troops.

In hundreds of other malls across the country, space that previously commanded premium rents, temporary Halloween and Christmas stores, community colleges, libraries, flea markets and even roller rinks can now be found.

Empty anchor stores are housing electronics and home-improvement stores — grocery stores in some cases, because the malls need the traffic. Lease agreements typically prohibit these kinds of anchor tenants, but the landlords are desperate and left with no choice. Retail and commercial real estate analysts now classify enclosed malls into three categories.

At the top of the scale, A-level malls are normally in wealthier areas with high-end specialty anchor tenants such as Nordstrom, Neiman Marcus, Bloomingdale’s or Saks Fifth Avenue. There are few vacancies in the anchor spots, and they have an internal occupancy rate above 95%. While these malls have taken a hit from the recession, they are a rare exception to the rule and generally considered strong enough to survive.

The B-level malls were once strong contenders among middle-class neighborhoods but have lost at least 10% of their internal merchants and are at risk of losing an anchor tenant. These centers are struggling to remain viable. Some are consolidating vacant stores into larger empty spaces to minimize the appearance of closures. They then offer the space to larger non-traditional mall merchants, such as book stores and electronics stores.

At the bottom of the list are the C-level malls, which have at least one empty anchor space and an internal vacancy rate of 15% or more. Many of these centers are older and not adjacent to highway exits. They try to lure non-traditional mall merchants such as grocery stores to fill the footprint and restore traffic. When a large tenant cannot be signed, they settle for trade schools, karate schools, flea markets, holiday stores and other transient enterprises. These are most vulnerable to complete failure, and in some cases have done so already.

In communities where a mall has closed entirely, what remains is an economic black hole that ripples for square miles. Many malls built as recently as the late 1990s have become regional shopping centers with symbiotic businesses subsisting on the street traffic, such as fast food, auto service centers, apartment complexes, gas stations and more. The areas became micro economies onto their own and in many cases are now at risk of losing not just businesses, but substantial real estate value throughout the region.

Wider Economic Implications

Retail’s downsizing has placed enormous pressure on an already crippled banking industry. Default rates for commercial real estate are rising sharply, and banks are beginning to foreclose more rapidly on abandoned retail space, which the industry has dubbed “zombie buildings.”

While banks are loosening their grip on residential lending, commercial loans generally have terms of five to seven years. Many of those notes issued at the peak of the real estate bubble are now coming due. This year alone, $500 billion will be owed from the massive overbuilding of the middle decade, and that number will not drop off until after 2012, according to the Federal Reserve.

Some analysts predict this will trigger a massive aftershock in the banking crisis, affecting many smaller and regional lending institutions that escaped the wrath of the residential storm. A recent report from PriceWaterhouseCoopers predicts the problem will persist for several years.

Smaller banks have a harder time absorbing multi-million-dollar losses, which larger banks can write off. First Place Bank, based in hard-hit Warren, OH, is among many smaller banks bracing for the impact. With substantial holdings in retail developments, the bank plans to manage each loan one at a time as they come due, said Eric Diamond, senior vice president. “As these term loans end, we will try to extend just to keep them alive,” he says. “This will give us more time to absorb any total losses from foreclosures.”

Analysts are calling this approach “extend and pretend,” accusing banks of pretending that real estate values will return in time to recover their value. But Diamond argues that this approach makes no such assumptions and merely spreads his risk over a longer period of time. He anticipates that value-to-loan ratios will not normalize before 2012.

The wider effect, however, is that more banks will fail, and for the next few years remaining banks will have fewer funds available for new projects. As federal regulators try to tighten restrictions on commercial loans, banks are being forced to extend loans they never would have accepted in normal times. This is troubling for regulators who want to put the days of marginal deals behind them.

Retail is not entirely responsible for the next wave of banking problems. Office buildings, hotels and apartment buildings built in this decade also contribute to the mix as those industries are suffering as well, and they are all faced with the intrinsic problem that supply has outpaced demand.

Reengaging Retail Consumers

Consumers today shop much differently than they did just a decade ago. The weak economy and reduced credit spending have forced shoppers to be more value conscious. The Internet now provides an easy price check that increases competition and forces merchants to lower prices and reduce overhead. As a result, the retail leaders today are major discounters such as Wal-Mart and TJX, owner of T.J. Maxx and Marshalls. Many traditional mall shoppers have begun migrating from department stores to moderate apparel and discount stores, such as Kohl’s, Target and Costco.

Outlet malls that have emerged in the past decade struck a chord with shoppers until savvier consumers began to realize they were duped with inferior goods manufactured to resemble premium merchandise. Nonetheless, the better outlet malls are weathering the storm and have joined the ranks of discounters.

The advent of broadband Internet service has ushered in a shopping experience that can rival seeing and touching merchandise in person. For many shoppers a buying decision is now made online before they step foot inside a store, lessening the need for large in-store inventories.

Because of this, the days of wide aisles packed with merchandise are numbered. Retailers are learning to downsize their operations and do more with less. The emergence of open-air lifestyle centers made to resemble old town squares has addressed this issue.

For the merchants, they offer a smaller footprint, reduced rent and overhead, and the ability to draw in customers for reasons other than shopping. For shoppers, lifestyle centers provide more convenient parking, a mix of amenities and more trend-forward aesthetics then traditional malls.

High-end merchants like Saks Fifth Avenue and Neiman Marcus are struggling most with America’s belt tightening. Before the holiday shopping season, Neiman Marcus began pressing suppliers for designer goods with lower price points. It was a dramatic shift for a chain that promotes $100,000 Christmas gifts, and has been nicknamed “Needless Markup” by consumers.

For a company that once touted Bergdorf Goodman as its most profitable store by square foot revenue, there is clearly a swing in consumer preference. CEOs from both Neiman’s and Saks have promised more price cuts in the year ahead, and neither believe there will be a mass return to luxury anytime soon.

As brick-and-mortar retailers begin to understand the need to reduce square footage, they also need to provide a unique in-store experience that people can’t get from the Web. Electronics giant Best Buy, for instance, now dedicates a portion of its showrooms demonstrating new technologies to draw in the foot traffic.

Still, brick-and-mortar stores play a valuable role. They display and demonstrate brand quality and provide personal customer service. But retailers also understand that customers who walk into a store are five times more likely to spend than if they were browsing the website.

Going forward, successful retailers will need to provide the right mix of online and in-store products and services without the costly overhead of large traditional malls. Merchants need to be more creative, appeal to specific demographics and provide differentiating value for their target audience. The days of frivolous consumerism are likely behind us, as Neiman’s and Saks have quickly discovered. And most industry analysts believe that American shoppers will remain cost conscious for the better part of the next decade.

Peter N. Schaeffer, partner, Carl Marks Advisory Group LLC (CMAG), has more than 25 years of retail and consumer industry experience. Previously, Schaeffer was a managing director in the New York office of Giuliani Capital Advisors, was a senior equity research analyst at Donaldson, Lufkin & Jenrette Securities Corp., where he covered retail and consumer stocks, and was a retail equity analyst with Dillon Read & Co. He also spent four years as a global industry leader for Retail and Consumer Products Investment Banking at Ernst & Young Corporate Finance. Schaeffer has extensive retail management experience as a senior executive with Bloomingdale’s Inc. and Macy’s Inc., and as executive vice president of the American division of a Dutch retailer.

He has served on the board of advisors of several private retailers and is considered an expert in the field by the media. He received a B.A. in Retail Management and Marketing from Drexel University. Schaeffer is a recipient of the Dewar’s Scotch Doers Award, was selected by Crain’s New York Business for its premier “40 Under 40” issue, and has been included in “Who’s Who in the East” since 1996.