The idea that J.C. Penney could benefit from spinning its real estate holdings into a stand-alone REIT has gotten a lot of media attention this week, but REIT analysts say it’s a dead-end.
While this is certainly not the first time that someone has floated around the idea of turning stores into REITs—hedge fund investor Bill Ackman proposed the strategy to Target in 2008 and department store Dillard’s attempted a similar spin-off in 2011—there are fundamental challenges to spearheading a REIT IPO concurrently with operating an ongoing retail concern, according to Rich Moore, a REIT analyst with RBC Capital Markets.
If the retailer in question has no plans to vacate most of the stores, one of the major issues for potential REIT investors would be buying shares of a real estate company that relies on a single tenant for all of its revenue. Typically, REIT shareholders don’t want to see a single tenant account for more than 10 percent of a REIT’s space, Moore points out.
“A captive REIT with a 100 percent of the revenue coming from one tenant is not going to appeal to anyone,” he says. “The conversations I’ve had with some of these retailers [who thought about filing for REIT status], they think they are going to be like apartment REITs, with a 40x cap. They are shocked to find out it’s going to be more like a 10x cap.”
Even if the retailer manages to strike agreements to sublease some of its stores or sections of its stores to other chains, the rent revenue would most likely not be enough to justify a spin-off, according to Howard Davidowitz, chairman of Davidowitz & Associates Inc., a New York City-based retail consulting and investment banking firm. He notes that in mid-20th century, many U.S. department store chains, including K-Mart, would lease out various departments to third-party sellers. But the practice disappeared from the retail industry after these chains realized they were not making enough money and needed the gross margins dollars.
And the strategy would be less viable for J.C. Penney at this point because its lenders likely view its real estate holdings as collateral and would not want to let a struggling retailer spin off its most valuable assets, Davidowitz adds. What’s more, a REIT conversion might take months or years to accomplish and J.C. Penney doesn’t have the time or money to undertake it.
“How will they get from step A to step B and not go into bankruptcy?” Davidowitz asks. “Can you imagine going to the banks and telling them they are going to take new losses? If you are J.C. Penney, you can’t get there.”
Value still exists
That’s not to say that a retailer’s real estate holdings don’t offer other options for cash generation if the stores are owned outright or come with below-market rents.
Cedrik Lachance, managing director with Green Street Advisors, a Newport Beach, Calif.-based consulting firm, points to the deal Sears Holdings Corp. struck with General Growth Properties last year, when it sold 11 anchor pads to the regional mall REIT for $270 million. The deal included both owned and leased stores.
“I think the most likely course of action is to sell boxes directly to landlords,” Lachance says. “The value of these boxes is now entirely dependent on what else can go into [them] and that value is far, far great in class-A malls than in class-B malls. And it’s questionable in how many class-C malls you can replace J.C. Penney with a value-accretive proposition.”
Both Davidowitz and Moore view this strategy as the most profitable and logical one as well.
“Selling real estate is actually a better solution because you’ve got a lot of landlords who’d like to buy it,” Moore says.
The idea of spinning J.C. Penney stores into a REIT, on the other hand, was created by someone “who knows nothing about real estate.”