Are Reits Rights For Department Stores?

Joel Groover / Shopping Centers Today

Thanks in part to some high-profile real estate moves at Dillard’s and JC Penney Co., speculation about the value locked up in department stores’ real estate is running high. And yet so is skepticism about the potential impact of these headline-grabbing “real estate plays.” In one scenario, top mall anchors give up control of their holdings by spinning them off into autonomous, publicly traded REITs that duke it out on the stock exchanges. In another—and one that draws fewer guffaws from the skeptics—retailers stay at the helm of their real estate even as they smartly monetize those assets by forming wholly-owned, or “captive,” REIT subsidiaries.

The latter of the two options offers certain advantages, but within the shopping center industry there is some confusion about the usual intent behind captive REITs, says ICSC’s Rudolph E. Milian, SCMD, SCSM, Senior Staff Vice President and Director of Professional Development Services. When landlords form large, publicly owned REITs, he explains, they do so in part to bypass hefty corporate taxes. This allows REITs to pay higher dividends to their shareholders who in turn pay income taxes on the dividends. But when retailers like JCPenney, Dillard’s, AutoZone or Walmart set up captive REITs, the goal is to take advantage of favorable income-tax treatment given to REITs by states and the federal government. “The retail parent company pays rent for each of the stores owned by the captive REIT to the REIT entity and deducts the rental expense as a business expense, thereby reducing its taxable income,” Milian says. “Another benefit is a dividends-paid deduction provision that gives the captive REIT the ability to avoid corporate-level tax on its earnings paid out to the captive REIT shareholders as dividends.”

Captive REITs are not uncommon among retailers. Penney, for example, holds the majority of its owned real estate in a captive REIT formed by the company in 1999, says Deborah Weinswig, an analyst with Citi Investment Research. And retailers can gain other advantages by forming REITs. Dillard’s, for one, aims to improve its overall liquidity and win more access to the markets for debt and preferred stock. Under the arrangement, Dillard’s will transfer properties to its wholly owned REIT subsidiary and then triple-net lease them back. Dillard’s shares jumped 18 percent following the Jan. 19 announcement. Likewise, Weinswig says, analysts and investors have been buzzing about the nearly 27 percent ownership stake—widely seen as a real estate play—taken in Penney by Vornado Realty Trust and Pershing Square Capital Management.

These moves have helped put a spotlight on the holdings, not only of Penney and Dillard’s, but also of land-owning anchors like Nordstrom, Kohl’s, Macy’s and Saks. Another factor is the rising valuation of REITs themselves. According to National Association of Real Estate Investment Trusts (NAREIT), REITs were up about 39 percent for the 12-month period that ended Jan. 31, outpacing a 22 percent gain for the S&P 500. They have also been raising a lot more money. Since early 2009, when Simon Property Group and other REITs began tapping equity and debt markets at impressive cost-to-capital rates, investor confidence in REITs has gradually returned, explains NAREIT’s Mike Grupe, executive VP of research and investor outreach. “REITs demonstrated that, in fact, they did have access to capital, both equity and debt, and this put to rest investor fears that REITs would be unable to refinance or repay their debts,” Grupe says.

But will these trends prompt top mall anchors to forfeit control of their real estate to publicly traded spin-off REITs—truly autonomous entities driven by new sets of shareholders? David E. Simon, Simon Property Group’s CEO, is among the skeptics. “There’s no market for a self-managed, one-tenant REIT in public markets,” he said during the company’s fourth-quarter earnings call. Likewise, Weinswig doubts Penney will spin off its REIT, both because Penney would lose control of its stores and because one-tenant REITs in cyclical industries tend to be unattractive investments.

Jim Sullivan, managing director of REIT research for Newport Beach, Calif.-based Green Street Advisors, questions whether anchors’ real estate is worth as much as some observers think it is. (One report put the value of Dillard’s real estate at about 80 percent of its market capitalization, with Penney’s at 63 percent.) If anchors’ real estate holdings could be subleased at the much-higher rates that prevail elsewhere in the mall, then, yes, they might be quite valuable, Sullivan says. However, this is rarely the case. “You cannot just willy-nilly take metrics that apply to one part of the mall and apply them to what should be a department store anchor,” the analyst said. Malls sometimes do buy out their anchors, landlords will not pay a premium to get control of these spaces, Sullivan adds. “The landlord will pay a price,” he said. “But that price is not going to be some wild, pie-in-the-sky number, like we have seen with some of these estimates as to the real estate value of some of the department stores.”

For Sullivan, the entire discussion is reminiscent of another vaunted “real estate play”: investor Edward S. Lampert’s $11 billion acquisition of Kmart in 2004. Some observers saw this as a move to flip Kmart’s real estate, but their high estimates as to the worth of those holdings now appear questionable, Sullivan says. “At the time when the Sears-Kmart transactions were being put together, it was thought that there was a very material upside,” he said. “I don’t think that has been achieved yet.”

Department stores’ real estate has always played a prominent role in the mall business. After all, some of America’s first big shopping centers were owned and built by the department stores themselves. Hudson’s, for example, built Northland Center in Southfield, Mich., in 1954. Two years later, Dayton Co. opened Southdale Center in Edina, Minn., the world’s first fully-enclosed, two-level shopping center. For its part, Sears took mall-development to a new level in the 1950s by founding Homart Development Co., which built Sears-anchored malls in the burgeoning postwar suburbs.

“After World War II, the big department stores—Macy’s, Hudson’s, Federated, May Company and so forth—all had what were, at the time, sophisticated methods of understanding who their customers were,” said Jim Bieri, a Detroit-based partner in X Team International, the global brokerage alliance. “These department stores were the ones that forced early mall development.”

While powerful retailers like Walmart, The Home Depot and Target still own their own real estate, this is because they have the credit and balance sheets to do it, Bieri says. “They haven’t needed the cash to go out and have investors in their real estate,” he said. By contrast, lagging chains like Dillard’s can make a good argument for spinning off their holdings into captive REITs. “In general, it makes a lot of sense for retailers to look at this,” said Chris Macke, a senior real estate analyst for CoStar. “There is significant demand for, and a limited amount of, institutional-grade property out there for sale. The timing is good.” Indeed, by unlocking the value of their real estate, struggling retailers could boost their competitiveness. Penney’s recent history illustrates the merits of such reinvestment, especially given the formidable threats posed by discounters like Walmart and Target, says Joseph Brady, Jones Lang LaSalle’s managing director for corporate retail solutions. “JCPenney was a brand that was down and out, not relevant,” he said. “But through store-within-a-store businesses, freestanding locations and a number of other moves, Penney has done a great job of repositioning itself … Smart companies are looking in the mirror and saying ‘do we want to be in the headlines like [bankrupt] Borders? Or do we want to innovate and reinvest in our company and evolve to meet or exceed our customers’ goals.’ ”

However, while some see REIT-formation as a way to help retailers focus on their core business by getting them out of real estate, others highlight the risk that REITs (particularly self-managed spin-offs) could undermine anchors’ retail operations. Jeff Green, president and CEO of Jeff Green Partners, the Phoenix, Ariz.-based real estate consultancy, cites the example of private-equity investors who run retailers into the ground. “When private-equity firms buy them, retail businesses become financial assets,” he says. “They are run financially, not with an eye toward the consumer. At the moment, this question permeates the entire industry: ‘Will retailers remain real retailers?’ ”

And landlords have their own concerns. Generally, their operating covenants and reciprocal  easement agreements with anchors sharply limit what, say, a spin-off REIT might do with a given store. But some of these clauses are weak, as in cases where the landlord had to make multiple concessions. And covenants do expire. “That means the department store anchor could exercise drastic changes in the usage of the anchor building it owns,” Milian said. “For example, a department store anchor in a weak center with an expired operating covenant could theoretically sell the building to be turned into a non-retail use that is inconsistent with the landlord’s goals.”

But landlords play such an integral role in operating the mall that Sullivan, for one, believes tenants are unlikely to go rogue. In fact, the analyst says, landlords may even be the ultimate beneficiaries of retailers’ real estate plays: “If there is big value-creation potential here, maybe people are putting the accent on the wrong syllable by focusing on the department stores and not the mall owners.”