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WHAT IF KMART GOES?

Weighing impact of discounter’s potential demise

By Donna Mitchell

Kmart operates 1,800 stores, amounting to 150 million square feet.

Despite Kmart’s repeated assurances that it will emerge from bankruptcy by this summer, many in the retail real estate community have harbored darker thoughts: What if the discount retailer were to go out of business altogether?

At press time the industry was already holding its breath for an expected announcement of a second round of Kmart closures, with some predicting that 500 stores will close. The discounter shut 283 units last summer and said it will announce more closings this month.

If the whole chain were to go dark, as some believe will happen, 1,800 stores — amounting to nearly 150 million square feet of space, the collective size of Kmart’s portfolio at press time — would be plunked back onto the retail real estate market in one stroke. This, coming on top of such retail departures as Ames, Bradlees, Caldor and Service Merchandise, would throw the market off balance for at least one year and maybe much longer, according to some analysts.

“I think the worst-case scenario for retail real estate would be if Kmart were to liquidate,” said Scott A. Wolstein, chairman and CEO of Developers Diversified Realty Corp. and a member of ICSC’s Board of Trustees.

Moreover, the pain of a lost Kmart anchor at one shopping center could easily spread to nearby centers, said Ross Nussbaum, a Salomon Smith Barney retail REIT analyst. Landlords at those neighboring malls might hesitate to raise rents for fear of losing tenants to the center with the Kmart vacancy.

And it could happen. Some observe that the retailer has failed to find its own niche and is beyond the point of repair. Kmart has been squeezed out by Wal-Mart at the low end and by Target at the high end; both competitors have far more efficient inventory management systems.

“I’ve almost never seen a company disintegrate more rapidly,” said Howard Davidowitz, chairman of Davidowitz & Associates, a New York City-based retail consulting and investment banking firm. “I think they will liquidate.”

First, it failed to close enough poorly performing stores when it rejected the 283 leases last year, he said, and is therefore burning cash by keeping them open. Such tactics as introducing the Joe Boxer line of underwear will do very little to reverse its exodus of customers and declining sales, Davidowitz added. Kmart also played up a new line of merchandise for the holidays from Martha Stewart Living Omnimedia, which it hoped would draw shoppers into its stores for Christmas.

The United States doesn’t have room for a third discounter, let alone one with Kmart’s problems, opined George Strachan, a managing director who covers retail at Goldman Sachs, who joined Davidowitz and other analysts on a panel discussion about retail during ICSC’s New York Conference & Deal Making in December (see story, page 10).

Some other industry sources interviewed for this story were adopting a wait-and-see attitude about Kmart’s future. But no one doubts that there will be plenty more store closures, and the experience of Malan Realty Investors (27 Kmart exposures, accounting for 25 percent of total base rent) has not been lost on landlords. Bingham Farms, Mich.-based Malan Realty began to liquidate in August when Kmart closed three stores at its centers.

Even if Kmart’s demise does not wipe out another REIT, the impact on some landlords would be severe, notes Morgan Stanley. In terms of base rent exposure, Kimco Realty Corp., New Hyde Park, N.Y., leads the pack, according to an October Morgan Stanley report. At press time there were 47 Kmart stores in Kimco centers, accounting for 5.2 percent of its annual base rent (see table). New York City-based New Plan Excel Realty Trust follows, with 35 Kmart stores in its portfolio, from which it derives 4.2 percent of annual base rent. Ramco-Gershenson Properties Trust, Southfield, Mich., is third, with Kmart accounting for about 4.1 percent of annual base rent.

Kmart is the second-largest discount retailer in the United States, and its demise would leave a considerable void.

“It’s not healthy to have all these tenants going dark,” said James Koury, a senior vice president at Spaulding & Slye Colliers, a Boston-based real estate services firm. “Not for the industry and not for the consumer.”

Moreover, the void would be all the harder to fill, given the recent downfall of other discount retail chains. Healthy retailers, such as The Home Depot, Shaw’s Supermarkets and Wal-Mart, have already absorbed a significant number of these vacancies, so how much more can they take on, at least in the short term?

“If Kmart is the last one to go down, it will make it that much harder to potentially lease the spaces,” said Koury, describing how a Kmart liquidation would be felt on the local retail property markets level.

Kmart introduced a prototype store in White Lake, Mich., offering wider aisles and better lighting. But the struggling retailer can’t afford a full-scale rollout.

The ease of re-leasing any retail space depends on several factors, including the demand for a particular retailer in a local market and whether the former Kmart space is suitable for a potential replacement tenant.

Kmart stores typically span 80,000 square feet, which dims their appeal to Target or Wal-Mart, whose stores usually run at about 120,000 square feet. A Kohl’s or a supermarket — assuming a center doesn’t already have a food store — would be better suited to a Kmart store site, Koury said.

It is possible to subdivide a Kmart store for a smaller operator, such as Toys ‘R’ Us or Staples, he said. But few retailers need as much depth, so landlords stand to lose valuable leasable square footage.

“The bottom line is that there are very few tenants left to take their space ‘as is,’” Koury said.

Some REITS are taking steps to reduce their Kmart exposures. In October New York City-based Acadia Realty Trust sold two shopping centers for $16.8 million. One of them, the Manahawkin (N.J.) Village Shopping Center, is anchored by an 112,000-square-foot Kmart. Though none of the Kmart stores in Acadia’s portfolio had closed or rejected their leases at press time, the company thought it a good idea to reduce its exposure and at the same time profit from the sale of the two centers, said John Grisham, an Acadia spokesman.

“We are always looking at our tenant concentration,” Grisham said.

The sale of these shopping centers reduced the number of Kmart stores in Acadia’s portfolio to five, so the discount retailer now accounts for less than 5 percent of annual base rent. The remaining stores have sales of about $200 per square foot, which is at or above the average for Kmart, and their costs of occupancy are relatively low, at about 3 percent.

“In general, we think our Kmarts, with their good sales, low occupancy costs and below-market rents position us to profitably re-anchor these spaces long term,” Grisham said, noting that the spaces are attractive to prospective tenants.

Even retail REITs with relatively more to lose in a Kmart liquidation are keeping a calm outlook. Though Morgan Stanley deemed about 12 of the Kmart stores in Kimco’s portfolio to be troubled, that doesn’t bother Kimco, according to company spokesman Scott Onufrey.

“The remaining Kmarts in our portfolio are leased at or below market rent levels, and we could find new tenants for the sites if necessary,” he said.

To be sure, some REITs have good reason not to hit the panic button. Most Kmart leases are on older stores that are paying very low rents in the otherwise hot Northeast and Florida markets.

“They entered the major metropolitan markets in the 1960s and 1970s that other retailers had a hard time penetrating,” said Wolstein of Developers Diversified.

The 19 Kmart stores in the Developers Diversified portfolio pay an average of $3 per square foot, compared with the $10 to $15 per square foot they would fetch today. That represents untapped equity for Developers Diversified and other retail landlords, making the prospect of vacancies a happy one. Wolstein points out that such retailers as Bed Bath & Beyond, Best Buy, Borders Books and Music, and Linens ’n Things are actively seeking new store locations.

Still, one would be hard-pressed to find many market professionals happy to see Kmart disappear. Were that to happen, it could take up to four years to fill the void, opined Matthew Ostrower, a Morgan Stanley REIT analyst.

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