Kmart, retailers have hidden value in land

Don Hogsett, August 2, 2004

New York — Its comps may be in freefall, but Kmart stock, which has already soared from $15 to more than $70 in just 12 months, could be worth even more — as much as $150 a share — not because the retailer is taking it in at the register, but because of the land it's sitting on.

Indeed, said a recent Deutsche Bank Securities report, Kmart is only one of a fistful of American retailers, most notably department stores, that are worth a lot more than their stock price suggests. And it has nothing to do with selling product.

They've become, like Kmart, a real estate play — in many cases worth more for their land than their merchandising skills. There may be a whole class of stores, said Deutsche Bank, "that should be considered land banks (or store banks) rather than viable retailers."

In fact, of the eight high-profile American retailers that Deutsche Bank singled out as being worth far more than their stock price — but only because of their real estate — most are chronic under-performers.

A case in point is ShopKo. Its stock is trading at $16 a share, but total up the value of ShopKo land and all of its other assets, and it could be worth almost three times as much, $47.77 a share, said Deutsche Bank.

And that's only the beginning, said the Deutsche Bank analysts. Retail space will "become more valuable given the scarcity of new mall space and the concentration of mall ownership."

Sitting on the mother lode, according to Deutsche Bank, are the nation's department store. "Once the grande dames of the retail world, department stores have seen their position erode with the rise of the freestanding discount stores and category killers. Consumers gravitated toward their offering of greater convenience and lower prices, and with that caused the dramatic growth of leaders such as Wal-Mart and Target. Now department stores are left to fight over a smaller percentage of consumer spending, and results have been mixed. At the same time, department stores are perhaps sitting on one of their best assets."

And it's not like department stores paid full value, Deutsche Bank goes on. "For years, the department stores got free land and generous build-out allowances from shopping-center developers. That has left them with very little real estate value on their balance sheets compared to its true market value."

The Deutsche Bank report cites two factors that contribute to the high value of department store real estate. "First is the value of the long-term leases at low rents. This is a remnant of the 1980s when mall owners needed the department stores to get a mall financed. The average term is approximately 10.3 years (before the favorable extension options) with rents in the low single digits."

Just how low is low? Home fashions suppliers paying for pricey Manhattan showroom space might want to take note. "The average rent for department stores is $5.15 per square foot, which is approximately half that of our total retail group at $10.07."

A second major factor contributes to the high value of department stores' land holdings. "The department stores own a high percentage of their stores, 42 percent versus 25 percent" for most other retailers.

But there's one big hitch, says Deutsche Bank — unlocking all that value. "Realization is the tough part."

Turning real estate into dollars can take a lot of time. "As the recent bankruptcies of Caldor, Bradlees, Ames and Service Merchandise demonstrated, realization takes time. The easy locations go fast, but then sites have to be converted to alternative uses. In the past five years, we've seen how movie theatres became fitness centers; Kids "R" Us became pet stores; old grocery stores become dollar stores, shoe stores, apparel stores, etc. This takes several years."

And that's if a retailer can sell, or even wants to. Sometimes a retailer can't, Deutsche Bank points out. May Department Stores "is trying to close its Lord & Taylor stores in the western United States, but can't because it has an operating covenant with the mall owners. It has to operate a Lord & Taylor or is in default. The mall owner has to approve the replacement. But the mall owner probably wants a competitor to May. May does not want to give the competitor certain locations. May has a strategic dilemma compounded by an operating clause."

And if a retailer wants to sell off some assets — likely buyers are its competitors. "The strategic dilemma is potentially huge," says Deutsche Bank. "If the retailer wants to maximize value, it would auction off the locations to the highest bidder, which could include competitors. Some companies are unwilling to do this. Thus, they are faced with the prospects of raising less proceeds."

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