Illustration: Macy's store

A Whole Foods market on the lower level of Macy’s Herald Square flagship? An Equinox gym near the eighth floor activewear department? It’s all within the realm of possibility as Macy’s attempts to put its real estate to work.

Macy’s Inc. chairman and chief executive officer Terry J. Lundgren told investors listening to the retailer’s third-quarter earnings call in mid-November that the company is moving quickly to try to maximize the value of its trophy real estate assets, including flagships in New York’s Herald Square, San Francisco, Chicago and Minneapolis. Lundgren said the company will consider joint ventures or other tie-ups to redevelop portions of its key stores in a way that maintains a robust Macy’s presence while bringing alternative uses to the buildings. The appeal of Macy’s real estate is obvious. The Herald Square flagship alone has been valued at between $3 billion and $4 billion.

The strategic moves come as Macy’s and other multiline retailers have been facing stiff headwinds. And Macy’s has been under scrutiny by

activist investor Starboard Value, which has advocated for the retailer to unlock its real estate value through a Real Estate Investment Trust.

Macy’s has taken some small steps toward finding the highest and best use for its real estate. The retailer in August said its Brooklyn flagship will be redeveloped through a deal with Tishman Speyer, leading to a $250 million gain in the fourth quarter this year.

Macy’s subsequently expanded its relationship with Tishman Speyer, which will advise and support the retaler’s senior management team in identifying and advancing potential store redevelopment projects nationwide.

“We are very early in this process,” a Macy’s spokesman said on Tuesday. “You can count on the fact that we and our advisers will consider all potential alternatives. There’s nothing to comment on — or speculate about — at this point.”

Macy’s has said its real estate strategy consists of a mix of owned and leased stores in order to maximize profitability and operational flexibility. “We continuously evaluate all our locations and their retail and alternative use values,” the company said. “For example, we recently sold or exited locations, or are exiting locations, including in Cupertino, Calif., and in downtown Pittsburgh, to make way for redevelopment projects. We recognize the potential attractiveness of real estate investment trusts and similar alternative real estate ownership structures in today’s marketplace. We are currently evaluating those structures including analyzing the various economic, tax, operational and other issues associated with them.”

Macy’s ultimately rejected forming a REIT for its properties, saying that a REIT doesn’t offer enough upside potential for value creation.

Retailers are investing in real estate or look- ing at ways to get the most from their portfolios. Nordstrom, which is opening a 285,000-square- foot flagship at the base of 225 West 57th Street, reportedly paid $300 million to own its portion of what will be the world’s tallest residential tower.

Hudson’s Bay Co. closed on a joint venture with Simon Property Group in July to capitalize on undervalued real estate. Richard Baker, governor and executive chairman of Hudson’s Bay Co., said at the time that the Simon deal will unlock the value of HBC’s real estate portfolio and provide funds to strengthen the company’s balance sheet and cut debt. Baker said the deal also creates the possibility of a REIT in the U.S.

In an effort to unlock the value of its real estate, Sears Holdings Corp. spun off 235 Sears and Kmart properties into Seritage Growth Partners, a REIT that began trading publicly in July. Sears also has 50 percent interests in ventures with Simon, General Growth Properties and Macerich.

Macy’s has said it will test its Backstage off- price retail concept within 10 existing Macy’s stores, creating a hybrid store-within-a-store.

“Backstage could definitely be a possibility,” said Bridget Weishaar, senior apparel analyst at Morningstar. “It would draw more foot traffic and hopefully a younger consumer. Macy’s would have to weigh whether the cost structure makes sense. Off-price operating margins usually don’t make sense in more expensive real estate.”

Weishaar said Macy’s could attract more customers with a noncompetitive business such as Whole Foods. “You wonder whether Macy’s couldn’t run their stores like shopping malls, with a spa or a SoulCycle or a gym.”

That’s the thinking behind the retailer’s test license of 300-square-foot Best Buy departments in 10 doors, staffed by Best Buy employees and featuring Samsung smartphones, tablets and smartwatches, as well as audio devices.

Licensed arrangements are nothing new to Macy’s. The retailer already operates licensed Sun- glass Hut, Finish Line and Lids shops in its stores.

Joanne Podell, vice chairman of Cushman & Wakefield, suggested taking that idea one step further. “The ground floor of Macy’s is worth a fortune,” Podell said. “A lot of the departments there are licensed. Macy’s doesn’t make the kind of margins it should on the products. It may be better to condominiumize or net-lease some space, say to, Ralph Lauren. Saks is doing the same thing.”

Podell said vendors would jump at “a chance to own a piece of the most famous flagship in the world. Macy’s can be selective. It’s a way to create a cash event and improve their business. A vendor with an ownership stake in the property may be more invested in the store — no pun intended — and do a better a job.”

Macy’s could even finance the sale of the retail condominium square footage. “By taking control of the financing, Macy’s is able to create cash,” Podell said.

Spinning Macy’s real estate off into a REIT might inspire shareholders and help stimulate sluggish sales. But Jared Epstein, vice president and principal of Aurora Capital Associates, cautioned against “giving up long-term control of Macy’s greatest revenue-producing stores if the company believes that the large format department stores will remain key to its future.”

Epstein said Macy’s should structure sale and leasebacks at high valuations. “To maintain some control over their destiny, they sell the leaseback to themselves,” he said. “They would need to have incredibly tenant-friendly long-term leases featuring low rent, minimal increases and no resets. Macy’s could lease a property for the next 99 years. Not capitalizing on this opportunity in the current climate would be a mistake.”

Macy’s might also be able to create some independent retail spaces on 34th Street in Herald Square for compatible retailers since the rents in the area are $750 per square foot to $1,000 per square foot on the good blocks.

“The only way to sell real estate is with long-term leases that are very favorable to Macy’s, which depresses the value of the real estate,” Epstein said.

Under a different scenario, Macy’s may decide it doesn’t need all the space in a flagship and could give up “half of the upper floors and a small portion of the ground floor so that there can be a commercial condominium where the retailer keeps the base of the building and sells condos above,” Epstein said.

Building a residential condominium or a hotel above a flagship doesn’t seem to be an option in the case of Macy’s Herald Square, where 151 West 34th Street, the retailer’s address, has a floor area ratio, or FAR, of 1.3 million feet, per the New York City zoning board. The store has more than 2 million square feet of retail space, indicating that it’s significantly overbuilt, Epstein said.

“Does Macy’s Herald need to be more than 2 million square feet?” said Stephan Stephanou, a principal at Crown Acquisitions. “Is there some value in the property? Macy’s could move employees to office buildings nearby and create interesting spaces, even in the shell of the existing building, or it could give Apple or Microsoft a chunk of space that would drive mutual traffic and generate a boatload of rent, more than is being generating from retail sales.

“There’s an incredible appetite for residential condos,” Stephanou said. “They could do condos or a hotel or a combination thereof. That would be a fabulous opportunity for Macy’s in San Francisco and State Street in Chicago.”

“The way you get money out of your real estate is to give it up and lease it to someone else,” said Jeffrey C. Paisner, partner at Ripco Real Estate. “I could see renovating, remerchandising or advertising the big flagships. They can cut deals with mall operators and downsize or give up entire stores if they’re not performing. They could extract money from the real estate by utilizing some of it for other purposes. Macy’s could edit the stores and remodel. But if Macy’s exited 30,000 square feet of space on three levels at the Herald Square flagship, they’d get about $14 million in rent. Is that going to move the dial for them?”

Walter Loeb, president of Loeb Associates Inc., said it’s difficult to put a value on Macy’s real estate because the properties have “unusual value as department stores and nothing else.”

“In extremely favorable locations, Macy’s makes the location more valuable,” he said. “It’s not a redevelopment but an evaluation of the property as it is.”

HBC paid 2.4 billion euros, or $2.7 billion, to buy Kaufhof’s and plans to sell 40 percent or more of Kaufhof’s properties to the Simon joint venture. The Kaufhof’s deal and another deal with RioCan raised HBC’s market capitalization to 5 billion Canadian dollars or $3.84 billion, from 3 billion Canadian dollars or $2.3 billion.

“Any transaction with Macy’s is very difficult,” Loeb said. Let’s say they sell real estate to someone. That person is hoping some other guy comes along and gives them more money. You can’t improve on Herald Square and San Francisco. Macy’s did a superb job on those stores.

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