By  on May 7, 2007

NEW YORK — Real estate can be a driving force in mergers and acquisitions, but it's becoming less of a factor in many retail M&A deals these days.

"While there are a few retailers who own some real estate, there are fewer and fewer chains now that actually do own any real estate," said Cheryl Carner, managing director for retail finance at CapitalSource.

Now, she said, many retailers are mall-based, and the stores they occupy are leased, not owned outright.

"There used to be transactions where you saw real estate play a role in the sale and leaseback deals, but those are the exception more than the rule," she said. The typical sale and leaseback deals now involve the sale of the company's headquarters, which are then leased back to the seller, she explained.

Adam Rifkin, senior vice president in the retail apparel group at Lehman Bros., who spoke last month here at the Emanuel Weintraub Associates panel on "M&A — Finding the Strategic Fit," said that real estate was only one of the many retail business attributes that private equity firms would focus on in M&A deals. However, he also noted that the current trend had included a number of considerations on the international front: sourcing and growth opportunities.

Still, real estate has played a significant role in retail mergers and acquisitions over the past several years, particularly those deals involving private equity, noted Jeffrey Bloomberg, a principal at Gordon Bros. Group.

"It started several years ago when Kmart sold a series of locations to Home Depot for an enormous number," Bloomberg said.

In June 2004, Kmart Holding Corp. signed an agreement to sell up to 24 stores to the Home Depot Inc. for a maximum purchase price of $365 million. In August, the two revised their agreement to provide for the sale of no fewer than 13 stores for $173 million in cash and up to 19 stores for $288.5 million. In the interim, in July of the same year, Sears, Roebuck & Co. acquired 54 Kmart locations in a deal worth $620 million that also includes leasehold interests in seven stores from Wal-Mart. Kmart later acquired Sears, Roebuck& Co.Bloomberg thought the sale of the Kmart stores to Home Depot was a good deal since in some hard-to-develop areas, the strategic value of a market is its clusters. "Some areas may take five years for a retailer to get into to build out a cluster [involving a] full penetration of stores. Meanwhile, until that happens, the retailer has to deal with the inefficiencies of the back office. If a group of stores can be acquired at once or over a space of six months, that'll give the retailer a full penetration of that market. That's what Kohl's did with some former Bradlee's and Caldor stores. One huge advantage is the benefit of efficiencies, such as in advertising," Bloomberg said.

Bloomberg also sees real estate as a means to finance a transaction. "Shopko had a very strong real estate component. So did Mervyn's and Lord & Taylor. Those are the ones where [a portion of] the purchase price is backstopped by the real estate. The real estate becomes the finance vehicle because the rents can be changed and a mortgage obtained at a lower rate," he said.

During the beginning of the current leveraged buyout boom, deals focused on real estate value. For example, Toys "R" Us owned sites in what many real estate and retail executives considered great locations. The expected sale of those locations allowed private equity buyers to leverage up the deal, knowing that the debt incurred could be paid down fairly quickly through the sale of the real estate.

An investment group consisting of affiliates of Kohlberg Kravis Roberts & Co., Bain Capital Partners and Vornado Realty Trust, in March 2005 said it was buying Toys "R" Us for $6.6 billion, plus the assumption of debt. The deal closed in July 2005.

But while real estate played a role in some past deals, will it continue to be important in future retail mergers and acquisitions? Bloomberg said it would depend on the chain involved, but the key factor still would be the number of real estate properties owned. It's also a matter of strategy, which Bloomberg pointed out is dependent on the timing of a retailer's entry into a marketplace.

Harold J. Bordwin, president of Keen Consultants, believes that where possible, real estate will likely continue to play some role in retail transactions."I think smart buyers have always looked at real estate and its value. If you look at the LBO market of the 1980s, real estate was an important component. The deals that Kimco or Vornado have done with retailers were largely real estate driven. Real estate provides a cushion and it says that the business is backed by some real hard assets," Bordwin said.

Mark Montagna, analyst at C.L. King & Associates, believes that there will still be some instances when a real estate asset can drive a particular transaction. One retailer that he's eyeing now is Gottschalks, which he said had some real estate that was "undervalued." And if a chain has most of its stores in the malls, the so-called real estate value lies in any leases that are undermarket, the analyst said.

Still, Montagna offered one caveat for anyone thinking that the past trend will continue into the future: "There are a decreasing number of retailers now who still own their own stores."

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