The turbulent U.S. economy has transformed retailing into a dangerous game. Gone or wounded are such hallowed names as Montgomery Ward, Service Merchandise and Kmart. Their empty stores are being recycled by a new group of ascendant merchants such as Target and Costco and Home Depot.

Still, there's an estimated 500 million sq. ft. of excess retail space nationwide, most of it second-generation space, according to Howard Makler, chairman and COO of Excess Space Disposition Inc. in Huntington Beach, Calif.

The glut is the result of not only retail bankruptcies, but also an ongoing pruning process among retail chains. For example, Toys “R” Us and Albertson's grocery chain, have regularly disposed of 10% to 20% of their worst-performing stores in order to boost earnings.

In the middle of the disposition cycle is a tight coterie of retail space disposition specialists, firms that have become experts at finding new tenants for dark spaces — a business that is both lucrative and risky.

Liquidation and workout specialists such as Kimco Realty Corp., Keen Consultants LLC and Hilco Real Estate LLC are assuming high-profile roles in determining the fate of leases suddenly deemed unaffordable by bankrupt retailers. They've also become crucial negotiators within the combustible mix of creditors' committees, retail boardrooms, landlords and mall lenders.

Disposition work, in fact, has become so complex that only a few firms are willing to take on the biggest assignments. When a retailer announces its intent to sell hundreds of 80,000 sq. ft. big-box leases to shore up its finances, it consults a short list of a half-dozen or so firms with the resources to do the job.

But even in a tough economy, experts say, the pool of healthy retailers in growth-and-acquisition mode makes disposition work easier. Therese Byrne, a former Wall Street analyst who publishes the New York-based investment newsletter Retail Maxim, surveys more than 380,000 store sites each year. She found that in 2002 there were 10,630 store closings around the nation. At the same time, however, 18,500 new stores were opened, many of them in the closed spaces. (See chart, page 28.)

Byrne predicts that new openings will climb this year, exceeding 19,000. “Retail is constantly evolving as consumers' buying habits change,” she explains. In the 1990s, names such as Caldor and Edison Bros. disappeared altogether, while others, such as Filene's Basement, were downsizing. “But there is always opportunity for fresh retail,” she says. “New companies and new ideas are ready to replace the old.”

Over the past 16 months, Troy, Mich.-based Kmart has closed 600 stores and terminated 57,000 employees. Many of those workers have found new jobs, and much of the real estate has been recycled. In Chicago, for example, a Kmart on the city's southwest side is about to be taken over by Target, another in Geneva is now occupied by sporting goods chain Gander Mountain, and a supermarket chain will take over a location in Plainfield.

Earlier this year, the retailer put 317 of the locations up for sale. New Hyde Park, N.Y.-based Kimco Realty Corp. entered into an exclusive joint venture to find buyers for the real estate. Kimco isn't commenting, but the company is likely to succeed in landing fresh tenants for most of the stores. There's a reason for that. “Most of the Kmarts are good locations. That makes them prime candidates for reuse,” says Michael Bell, president of Chicago-based real estate brokerage Pentad Realty Inc.

Capitalizing on Opportunity

The cycle of disposition and replacement has transformed entrepreneurs such as Hersh Klaff, president and CEO of Chicago-based Klaff Realty LP, into real estate moguls. More than a year ago, Klaff and his partners bought designation rights — essentially options on real estate leases usually caught up in bankruptcy proceedings — on 220 liquidating Service Merchandise stores.

On 25% of those properties, Klaff failed at redevelopment efforts and handed the leases back to the company. But for the other 75%, the firm found new tenants, most growing chains such as T.J. Maxx and Bed Bath & Beyond, or sold the leases back to landlords with ready tenants.

Klaff also has taken positions on dozens of Kmarts over the years. One 2-story store in Chicago was split into a Kohl's and Burlington Coat Factory. Another 85,000 sq. ft. store in Naperville was split into a Marshalls and Linens 'N Things. More recently, a 50,000 sq. ft. Service Merchandise in Smyrna, Ga., was sold to a Lexus dealership for $8.5 million.

Privately held Klaff won't reveal its profits on such deals, but the CEO acknowledges that returns on individual properties can be good. “You can hit some home runs in this business. It's a high-risk game, but if you know what you're doing, it can be very rewarding,” Klaff says.

How rewarding? Nobody seems to know exactly outside the disposition firms themselves. Their profits are wrapped up in whatever they can sell a lease for in excess of the price they paid. Experts estimate that if Kimco pays $50 million for a bankrupt retail real estate portfolio, for example, it intends to sell the locations for a total of $60 or $70 million, or 20% to 40% higher than what it paid for the portfolio.

The Role of the Middleman

Klaff and his rivals are quick to point out that the designation-rights process generally benefits all parties. Its tight deadlines give creditors an expedited means of disposing of leases on an entire portfolio of stores, for example.

But those creditors aren't necessarily getting top dollar. The buyer of the rights is typically a middleman acquiring leases or fee-owned properties in bulk at wholesale and then reselling them at retail. These middlemen are believed to earn big money, although outside observers seldom can determine just how lucrative the business is, since negotiations are usually shrouded in secrecy.

The money is by all accounts well-earned. Fifteen years ago, landlords were often entrepreneurs willing to compromise in negotiations. Today, the landlord is likely to be a large institution with fixed expectations of lease terms and yields.

“It used to be that we could get a landlord to pay cash to take back a lease from a tenant in bankruptcy,” says Harold Bordwin, president and owner of Keen Consultants in Great Neck, N.Y., which does disposition and restructuring work. “That's much less common now. The landlord expects you to do the work of going out and finding a replacement.”

There also is the matter of scale. When Detroit-based Highland Superstores was liquidating more than a decade ago, a 20,000 sq. ft. shell was enough to fit the superstore label. Today many of the spaces being left behind by companies like Jacobson's, Albertson's and Toys “R” Us routinely run 50,000 sq. ft. and more.

The stakes for these huge boxes coming onto the market are high, because there are only a handful of other retail users that will use that size space, says Mitchell Kahn, president of Hilco Real Estate LLC in Northbrook, Ill., one of the largest liquidation specialists. “Once you exhaust that supply, you don't have a lot of options,” he explains. “You may have to explore subdividing the space, or even turning it into an industrial building or residential apartments. The bigger the space, the greater the challenge of disposition.”

Creative Solutions

You do it by thinking outside the box. Paul Godles, senior vice president at Excess Space, cites the case of a 110,000 sq. ft. Kmart that closed in Lubbock, Texas, in 2001. Without a replacement retail tenant in sight, Excess Space looked in the office sector and found Cingular Wireless, which was willing to set up a call center on the site. The landlord eventually agreed to a new long-term lease with Cingular, the municipality granted a zoning amendment and Kmart was happily off the hook for the remaining term on its lease. “The landlord's willingness to negotiate a new lease was key to the deal,” Godles says.

What are landlords thinking when presented with a space about to go dark? Rick Scardino, president of Affinity Commercial Real Estate Inc. in Schaumburg, Ill., who has worked on many dispositions, says that lessors walk a tightrope in difficult times.

“If I have a tenant who is about to go bankrupt with a $2 million obligation left on its lease, do I, as the landlord, accept a $300,000 check to settle the obligation, or do I take the risk of the company going bankrupt and possibly handing the lease back to me for nothing?” Scardino says. “If a landlord works closely together with his tenant he's more likely to make the right decision in such cases.”

The smartest landlords anticipate trouble before it happens. Robert Michaels, president and COO of General Growth Properties Inc. in Chicago, the nation's second largest mall owner, says that the company had eight Montgomery Ward stores in its centers before the chain decided to close more than two years ago.

General Growth bought most of the leases back from the Ward creditors committee and remarketed them to Wal-Mart and Target — a neat trick, considering the 2-story formats were alien to the discount chains' regular prototypes. “We could see the Ward's bankruptcy coming before it actually happened and we started to remarket those spaces ourselves,” Michaels says. “So we had tenants ready to go. We came out ahead because our replacement retailers have generated more traffic and sales to our malls. And most of the economic deals we negotiated with the new tenants were better than what we had with Ward's.”

Disposition work often involves attempts to subdivide space, which is rarely easy. Utilities must be split, new entrances carved out, signage moved and expensive fireproof walls erected. The bill for such work mounts quickly. It doesn't help that the biggest boxes, Kmart stores in particular, have narrow fronts and deep back-end space. Layouts like that are hard to break up.

But the right ingenuity can surmount such obstacles. Michaels of General Growth, for instance, is in the process of carving up a 180,000 sq. ft. vacant J.C. Penney store in the company-owned Ala Moana Center in Honolulu. Spread over four levels, it will soon become home to some 30 separate replacement retailers. The complicated redevelopment project is both a testament to the tidy inventory of small tenants standing in line for space in prime malls and to the superior economics in renting to smaller tenants.

Michaels won't say, but observers believe the mall owner will double its rent for the 180,000 sq. ft. by chopping it up into bite-sized parcels. Big boxes like Penney are valuable to shopping centers, but they are also notorious for the cheap rents they negotiate.

David Ward, president of Baltimore-based brokerage firm H&R Retail Inc., has watched as Target recently took over old two-level Montgomery Ward spaces in nearby centers such as the Springfield Mall in Springfield, Va. Target decided which locations it would take in a matter of weeks when the properties were offered. That leads to some tough choices for creditors' committees, Ward says.

“You may have Home Depot willing to pay $100 million for 50 stores and maybe Kohl's is willing to pay $50 million for just 20 stores,” Ward explains. “Kohl's will pay more per unit, but Home Depot may well win the bidding because in disposition work the guy willing to take the most stores with the biggest overall price often is the one chosen,” Ward explains. “Speed is crucial in the bankruptcy process.”

Location is also an important factor in disposing of space quickly. When Richard Walter, president and CEO of Faris Lee Investments Inc. in Irvine, Calif., , recently acquired a center in Southern California that had a vacant Kmart and Vons grocery store (the latter a healthy chain), he wasn't concerned. “Each was paying about $4.80 net per sq. ft. on an annual basis for space that was worth closer to $12 a foot. So we didn't see the vacancy as a liability. There is plenty of upside as we go looking for replacement tenants,” Walter says.

On the other hand, Faris Lee sold a center in Yorba Linda after its Ralphs grocery anchor (part of another solid retail chain) closed. The company continued to pay $600,000 a year in rent for its 45,000 sq. ft. space and tried to find sublease tenants, finally settling for an ice skating rink. The lesson: Yorba Linda was viewed as a weak trading area — a liability in any disposition effort.

In 2002, Faris Lee brokered the sale of excess retail space valued at $32 million and expects that total to reach $60 million this year.

In suburban Chicago, CB Richard Ellis Inc. broker Lynne Brackett is offering a dozen Shell Oil gas station sites for sale. Most of the sites are less than an acre, but are carrying asking prices upwards of $500,000. “Shell has changed its prototype and these locations are no longer needed,” explains Brackett, who had two dozen offers in the first two weeks the sites were on the market.

Brackett finds assurance in the continual ebb-and-flow of local retail. “Banks, drug stores and sandwich shops are all hungry for well-located corners in the suburbs. We won't have any trouble selling these sites for our client,” Brackett says.

More Pain in Store?

On the sale side, prices on retail assets being disposed of have startled some observers. Richard Lubin, vice president at Zifkin Realty & Development LLC in Chicago, reports that a privately owned, unanchored 20,000 sq. ft. shopping center in Arlington Heights was recently put up for sale with the expectation it would be sold at a capitalization rate of 9% or more.

Zifkin found itself in a crowded field of 10 bidders, with the winner eventually purchasing the center at a cap rate of 8%. “This is becoming typical around here,” Lubin says. “Retail assets are being bid up even as the fundamentals in the marketplace deteriorate.”

Investors willing to pay top dollar in such transactions should beware. Analysts warn that the retail marketplace could sink over the next couple of years.

According to Byrne, who investigates the credit of 250 major retail companies, the financial outlook for 30% of those companies was troubled in 1996. Today, some 70% of the firms she covers are on her watch list, reflecting uncertainties in the aftermath of the war, the economy and poor consumer confidence. “Landlords should be concerned,” Byrne says. “We may see more store closings ahead.”

H. Lee Murphy is a Chicago-based writer.

How Bankrupt Retailers Shed Excess Space

  1. Troubled retailer files bankruptcy.

  2. Management identifies poorest performing stores to be jettisoned.

  3. Management gains permission of creditors' committee and bankruptcy judge to sell leases.

  4. A portfolio of properties to be disposed of is offered for auction.

  5. Winning bidder markets the properties to other retailers.

  6. The highest bids are taken back to management and creditors' committee. Deals, some subleases and some new leases, are struck among the buyer, seller and landlord.

  7. Unmarketable sites are handed back to the retailer, who then typically hands them over to the landlord. Under bankruptcy law, the lease liability is ended.

  8. After shedding weak real estate, retailer prepares to exit bankruptcy.