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A SITE BETTER

Big-name retailers sought — for their real estate

BY JOEL GROOVER

The real estate underneath some big boxes and department stores is a hotter commodity than the goods on their shelves.

Wall Street is buzzing about a spate of headline-grabbing real estate plays, including Kmart’s $11 billion merger with Sears, a real estate consortium’s $1.6 billion buyout of Mervyn’s and a bidding war for the $3.5 billion assets of Toys ‘R’ Us.

“There is an evolution going on with regard to traditional retailers, particularly department stores and big boxes,” says James E. Maurin, CSM, chairman and CEO of Covington, La.-based Stirling Properties. “Companies like Toys ‘R’ Us clearly are asking the question, ‘Is this company worth more in a breakup of its real estate than its current value in the marketplace?’ ”

Struggling retailers now have powerful incentives to either sell their real estate or cash in on decades-old leases signed at below-market rents, says Howard Makler, chairman of Huntington Beach, Calif.-based Excess Space Retail Services, which specializes in real estate disposition and lease restructuring.

“Retail real estate is clearly at an all-time high in terms of value,” Makler said. “It is a unique time where, if you are a retailer who owns real estate or has long-term leases, those might be worth more than the retail operation itself.”

Favorable nods from Wall Street have helped bring the value of retailer-controlled property to the forefront. As Goldman Sachs analyst George C. Strachan noted in a recent report, Kmart’s phenomenal post-bankruptcy success has sparked a vogue for investing in retail stocks based on the latent value of retailers’ underlying assets.

After slashing operations and closing some 600 stores, Kmart emerged from bankruptcy in May 2003 with a much leaner real estate portfolio. The Troy, Mich.-based retailer’s stock re-entered the market at about $15 per share, but by November 2004 had soared to $109.

Meanwhile, Sears’ stock price shot up 32 percent in November after Vornado Realty Trust, a New York City-based REIT known for its retail real estate plays, acquired a $330 million stake in the company. The Kmart-Sears merger that was announced later that month “added an exclamation point” to the trend, says Maurin.

The net effect is that retailers now feel less pressure from Wall Street to continue operating second-fiddle stores, said Richard D. Hastings, a retail economist with Boca Raton, Fla.-based Variant Research Corp, an independent investment research firm.

“They’re more interested in getting out of unprofitable stores,” he said. “Now they see their own real estate assets as a source of shareholder equity.”

But some wonder whether the market can digest the shakeout. Michael B. Exstein, a Credit Suisse First Boston analyst, recently cautioned investors that a shrinking pool of major mall anchors (by his count, there were 33 in 1980, compared with 14 today) equals fewer buyers needing fewer stores.

“We believe that current estimates of the value of retailers’ real estate may be too optimistic,” he wrote.

Others say the era of dumbbell-shaped malls that live or die by their department stores is coming to an end. “Overall, the number of fast-growing retailers, even if it is small, will move into alternative and complicated locations and figure out how to make it work,” said Hastings.

“In the last 15 years,” said Maurin, “retailers and developers have gotten much more savvy about second- and third-generation space and what to do with it.”

Mall REITs, for example, continue to replace moribund department stores with traditionally off-mall boxes like Circuit City, Target and even Wal-Mart.

“That, generally speaking, is what you’ll see going forward,” said General Growth Properties CEO John L. Bucksbaum, SCSM. “I expect the pace to accelerate, because for so many years, you have had department stores that are producing low sales per square foot, but yet their stores, from an accounting standpoint, are providing earnings.”

General Growth, which now owns two Wal-Mart-anchored malls, aims to take advantage of the increased willingness of traditional anchors to sell their stores. The Chicago-based REIT is looking at whether to buy back about 50 anchor sites and put them to better use, such as divvying them up among more vibrant retailers.

“A 12,000-square-foot Cheesecake Factory can bring in as much dollar-volume business and traffic to the center as many 125,000-square-foot department stores,” said Bucksbaum.

Other REITs are targeting whole chains. Both Vornado and Acadia Realty Trust are reportedly among those vying for the ailing toy business of Wayne, N.J.-based Toys ‘R’ Us.

Joel L. Braun, Acadia’s chief investment officer and senior vice president of acquisitions, declined to discuss the negotiations, but did say that Vornado’s venture with Klaff Realty and Lubert-Adler Management will invest up to $1 billion in retailer-controlled real estate in coming years.

Last summer Acadia invested $23.2 million in the investment consortium that acquired the 257-store Mervyn’s chain from Minneapolis-based Target Corp. Mervyn’s will continue operating, Braun said, “but certain assets over time might be sold off.”

Not all the value in retailer-controlled property is locked up in land or stores. Leaseholds figure prominently in many acquisition strategies, says Braun.

Blowing the dust off an old Mervyn’s or Montgomery Ward lease, a young executive today might wince at the enticements that mall owners routinely granted the once-coveted anchors, such as 20 years’ worth of renewal options with no rent increases.

“Montgomery Ward had leases where it was actually better than free,” said Greg Mickelson, founder of Newport Beach, Calif.-based GM Realty Advisors, a full-service real estate advisory and development firm. “Their rent was less than their operating expenses — just for them to sit there.”

Deutsche Bank Securities recently studied nine department store chains, including Neiman Marcus, Nordstrom, Saks and Sears, and came up with an average rent of $5.15 per square foot. (Retailers outside the department store sector paid twice that.) The average Kmart lease has about 17 years left, with rent at $2 per square foot and little or no outstanding debt, the study says.

Tempting leaseholds are also part of the attraction to Toys ‘R’ Us, says Anthony E. Mansour Jr., president of the Culver City, Calif.-based Clover Co., which represents national tenants throughout Southern California. “We’re seeing it out there, where retailers either sublease their leasehold interests or sell them outright,” he said.

Today’s low cap and interest rates make strategies like sale-leasebacks, in which retailers sell their real estate and then lease it back from the buyer, increasingly viable, says John M. Crossman, a senior vice president and director of investment services in Trammell Crow’s Orlando office.

Such strategic moves can help cash-strapped retailers stay in the game by raising reinvestment capital that can be used to, say, launch re-branding initiatives or to revamp stores, Crossman says.

Fundamentally, however, successful retailers make their hay not by selling real estate, but by selling products. “For most retailers, disposing of their unprofitable stores is an exercise in mitigating liability, not in reaping a profit,” Makler said. “There are some, like Kmart, that are in a unique position, but by and large that is not the norm.”

Besides, “no retailer should aspire to have its real estate worth more than its operating business,” said Kmart/Sears impresario Edward Lampert, who will be chairman of the new Sears Holdings, on a conference call to announce that merger.

And that points to the limits of Wall Street’s fascination with retailers as lucrative land banks: It is essentially an endgame.