When the news of Kmart Holding Corp.'s plan to buy Sears, Roebuck and Co. broke in mid-November, the headlines were all about how the discount and department-store giants were banding together to better withstand the onslaught of Wal-Mart Stores Inc. But there's another story in the $11 billion deal, and it's all about real estate.

The force behind the deal, investor Edward Lampert, made it clear that his plan for Sears revolves around maintaining its basic merchandising formula, but taking it to the places where target customers now are found: outside conventional malls. Lampert told analysts that “several hundred” Kmart locations will be converted to free-standing Sears stores. The goal, Lampert noted, is to snag the consumers out on the strip who are heading for the big-box stores

Lampert's remarks indicated real estate's centrality — especially off-mall development — to the deal strategy. “Sears' experience, services and products are every bit as good as their competition,” he said after the deal was announced. “The problem is that they aren't where their customers are.” The Kmart-Sears partnerships will solve that problem by bringing “Sears experience and products where the Best Buys, Targets and Home Depots are.” In general, that means Kmart-like pads. “Put Sears in a Kmart box and it should do very, very well,” he said.

Access to Kmart's real estate portfolio will give Sears an opportunity to aggressively grow its “Sears Grand” concept, a new off-mall department store/grocery format that resembles Target and Wal-Mart supercenters. The fourth Sears Grand recently opened in Rancho Cucamonga, Calif., and Sears has said it plans to add eight to 10 more by the end of 2005.

But industry sources question whether Lampert — who owns about 50 percent of Kmart and 14 percent of Sears through his hedge fund, ESL Investments Inc. — might really be looking to make his returns entirely off real estate, rather than retail. “I think that this was a pure real estate play and that both companies will be out of the business after the holding company divests itself of the best real estate,” said one industry executive surveyed by Retail Traffic and sister publication National Real Estate Investor.

Lampert, who will be chairman of the new company, Sears Holdings, prodded Kmart to shed more than 600 stores, slashing costs and building up $3 billion in cash. That helped drive Kmart shares to $101.22 pre-merger, up from 74 cents before its January 2002 bankruptcy. Deutsche Bank REIT analyst Louis Taylor estimates that Kmart's real estate is worth up to $152.95 per share and Sears' portfolio is worth up to $55.38 per share (about $5 more than its pre-merger value).

Another indication of real estate's importance was the news just a week earlier that Vornado Realty Trust had built a 4.3 percent stake in Sears over three months. That announcement — which the REIT divulged in an earnings report — sent Sears stock up 25 percent. Analysts speculated that Vornado was making a play for Sears' real estate (and perhaps planning a takeover bid). The merger announcement ended such talk, but sent Sears stock still higher. In two weeks Vornado made $114 million. Company officials have refused to comment on the merger. Lampert says he had no contact with Vornado when putting the deal together.

Reducing Risk

How the new company handles its portfolio could be a huge factor in retail real estate markets in the coming year. However, in announcing the deal, Lampert emphasized that the retail strategy was the No. 1 priority. After the merger, the company will have 2,350 full-line stores and 1,100 specialty stores and an estimated $60.8 billion in annual revenues. The two chains will continue to operate independently, but will share each other's brands — including Martha Stewart, Diehard, Craftsman, Sesame Street, Kenmore and Joe Boxer.

At the very least, the underlying value of the real estate reduces Lampert's risk. Should the turnaround plan fail, he could push for a breakup and recoup his investment on real estate value alone. Liquidation, however, would only be a last ditch strategy, says Taylor. “That won't happen,” he says. “It would flood the market and not maximize value.”

To gauge the impact of the deal on the retail real estate industry, Retail Traffic and NREI conducted an online poll of readers. Three-fourths of the almost 300 respondents agreed that the deal will likely trigger more department store consolidation. Also, 81.5 percent agreed that it was a direct response to Wal-Mart, other big boxes or both. The biggest losers could be JCPenney and regional malls, readers said. Will the new deal help or harm real estate values? The answer is unclear: 35.7 percent said the deal would have no impact, 30.6 percent said it would increase values and 18.7 percent said it would decrease values. (For full results, please log on to www.retailtraffic.com or www.nrei.online.com.)

Some analysts see it as a plus for the owners and developers. “I think it's going to give landlords the opportunity to turn unproductive space to more productive space and help the overall performance of centers,” says Taylor. “To me the sea change here is the fact that someone is going to finally look at these stores and look at what is the value as a retail location, what's the value as operating business and what's the value as an alternative retail use?”

The biggest impact may be on mall owners and REITs as Lampert accelerates Sears' new off-mall strategy. While executives said they plan to maintain Sears' presence in malls, it's clear they see growth opportunities elsewhere — in the development or redevelopment of standalone pads and power-center properties. This process was already under way before the deal. In June, Sears bought ownership or leasehold interest in 50 stores that Kmart was vacating for $575.9 million. (Sears has also bought excess space from Wal-Mart.)

Many observers expect the merger to trigger more deals. Dillard's and Saks both control real estate portfolios worth more than their retail businesses. In another segment, Staples, Office Depot and Office Max are ripe for consolidation.

Opinion remains divided on what Vornado's role will be. As a straight investment, the REIT has already achieved huge returns. But it also stands to gain if Lampert winds up selling real estate assets. Vornado would have an inside track on getting its choice of both chains' real estate. The company has been down this road before, buying into now defunct chains such as Two Guys and Alexander's. Earlier this year it lost out on a bid for Target Corp.'s Mervyn's chain.

Whatever the result of the Kmart deal, it is fraught with meaning for the retail industry. Will it be a new beginning for Sears, which has been a fixture in the industry since the 1860s? Or will it be the final chapter?