Is the planned acquisition of Toys 'R' Us a real estate or retail play -- or both?

Bain Capital, Kohlberg, Kravis, Roberts & Co. (KKR) and Vornado Realty Trust last week created a 23rd-hour partnership to buy Toys 'R' Us for $8.8 billion, including $1.8 billion in company debt. It beat out one team comprised of Cerberus Capital Management LP, Goldman Sachs Group Inc. and Kimco Realty Corp. and another made up of Apollo Advisors LP and Permira Advisors Ltd.

The consensus among analysts is that the deal is a little bit retail, a little bit real estate. Despite recent comments by Vornado Chief Executive Steve Roth that it was primarily interested in Toys 'R' Us for its real estate, most agree that the realty trust will remain a largely passive investor while Bain, which owns KB Toy Stores, and KKR try to rebuild the tarnished toy empire.

However, Vornado is expected to take an active part in determining which of Toys 'R' Us stores should be unloaded first. While some of Toy's 'R' Us real estate is expected to come to market following this deal, a full real estate play is not expected before management tries to turn the toy retailer's fortunes around. Currently, Toys 'R' Us owns 314 of its 685 domestic locations, some of which is very valuable real estate.

"The involvement of Bain suggests that the transaction will be predicated on operations as well as realizing value in Toys property interests," stated Lehman Brothers analyst David Harris in a recent investor note.

Vornado has a track record of maximizing the real estate of troubled retailers. In the mid 1990s, it invested in Alexander's, which eventually went out of business. Vornado spun off the retailer's real estate assets into a new REIT. The value of Toys 'R' Us real estate has been estimated at between $4 billion and $8 billion.

Vornado, which at one time was rumored to be interested in outbidding Kmart for Sears, gave its blessing to that merger after allying itself with KKR and Bain for Toys 'R' Us. Vornado has a 4.3 percent interest in Sears and stands to gain from both deals.

With the Toys 'R' Us purchase, the partnership gains a healthy international division and the baby apparel subsidy Babies 'R' Us. Babies 'R' Us is running strong with net sales up 10.6 percent last year. Facing little competition overseas, the international division's net sales rose 17 percent in 2004.

However, the investment partners have a hard task ahead of them if they want Toys 'R' Us to regain market share. The domestic toy division has struggled with U.S. sales at Toys 'R' Us falling more than 4 percent last year. Market share has eroded in recent years due to lower prices at Wal-Mart and Target. These chains together control one-third of the $20 billion domestic toy market.

One way to turn around the troubled toy retailer is to lower costs by improving efficiency. Already $225 million in savings have been earmarked for the company by consolidating several distribution centers and eliminating the company's headquarters. Several out-of-the-box approaches have been floated around inside the venture's management, such as allowing birthday parties to be held at Toys 'R' Us locations to build brand loyalty.

Possible synergies exist between Toys 'R' Us and KB, which also has been hurt by price cutting at Wal-Mart and filed for bankruptcy last year.

Whatever approach management decides to take, it appears the commitment is there -- for at least a little while. Generally, analysts expect this attitude among KKR and Bain to last for three to five years before the partnership looks for an exit strategy.

If the retailer is unsalvageable, there is always the value of the real estate.

"Toys 'R' Us has some of the best locations in the country," says Britt Beemer, President of America's Research Group in Charleston. "They are in the pads of every major mall in America."

For now, it appears that some Toys 'R' Us stores will be converted into Babies 'R' Us. How many and which stores will be changed over remains to be seen as the three partners work out details of their deal. One possibility is that the joint venture will make conversion in markets that have no Babies 'R' Us stores and where Wal-Mart penetration is greatest.

While the future of the company's domestic toy business is unclear, Bain and KKR have the experience to know when to call it quits. And if that time does comes, Vornado should be able to unload the real estate for its maximum value.

KKR is the majority shareholder in Retail Traffic's parent company Primedia. --David Koch