REITs: A Smart Move for Retailers?
A red-hot real estate market and sky-high property values have some retailers, including Macy’s and more recently, McDonalds, feeling the pressure to cash in on the value of their real estate assets. How? By spinning off store properties and/or land assets into a REIT and entering into a lease-back deal.
In some cases, extracting value from real estate can generate a boost in share prices. In the case of Macy’s, the July announcement of hedge fund Starboard Value’s concept to sell the veteran retailer’s real estate assets to a newly formed REIT sparked an immediate 4% bump in shares. The move has also panned out well for Hudson’s Bay Co., which has experienced a 25% boost to its shares since announcing its joint venture with mall operator Simon Properties in February.
Critics, however, argue that leasing the property back from the buyer effectively saddles the retailer with ongoing rent payments that increase costs over the long-term, and that such costs might not be worth the short-term gain.
So far, two primary funding pathways have emerged among retailers choosing to take this approach. The company can sell some or all of its real estate assets to a third party, rake in the proceeds and then lease back the property under a long-term rental agreement. Alternatively, the company can spin off its real estate assets – via either transfer or sale – into a newly formed REIT, relinquishing control of the property over to the REIT and leasing the property back for continued use.
As the retail industry weathers ongoing disruption due to the rise of e-commerce and the growing spending power of the Millennial consumer, separating a company’s real estate assets from its operating business has steadily been gaining more traction as a strategic move to capitalize on a booming real estate market. Taking a closer look, what potential benefits can retailers enjoy by taking this approach?
A Burst of Liquidity
In the short-term, spinning off real estate can be an effective tool to add value in several ways. Perhaps most importantly, creating a REIT can generate an immediate influx in cash, which could then be used to pay down debt and cut down associated interest rates, invest in store or infrastructure upgrades or expand. Of course, the influx of cash comes at a cost: a long term commitment to pay rent.
Renting store space can be more practical than owning for high-performing retailers, or even retailers experiencing a mild slump while still remaining profitable, since funds aren’t tied up in a long-term asset. Investing the funds instead in the primary operating business can generate a higher ROI. For some retailers, particularly those in a growth phase, freeing up these funds can justify the potential drawback of entering into a lease agreement with the buyer and committing to increased costs over the long-term.
Lower Asset Management Costs
One very tactical benefit of REIT spin-off deals is the shift in property management responsibility from the retailer onto the buyer – in this case, the REIT or third-party buyer. This is advantageous for retailers in a number of ways, namely by reducing costs associated with maintenance and capital projects. It also reduces day-to-day expenses, like payroll for property management personnel or the cost of third-party property management.
Happy Investors
It’s important to note that the investment community’s push to take advantage of the current real estate market has been a driving force behind the rise in popularity of lease-back deals. REITs can trade at higher multiples than public retail companies, and REIT earnings are taxed less heavily as long as profits are distributed to investors as dividends. If a store’s retail operation is profitable, spinning off real estate assets could generate a windfall that can then be passed along to investors, as well.
Retailers should remain especially mindful of investor satisfaction, particularly in the current climate of change in the consumer business industry. If investors were to underestimate the value of the business’ real estate holdings, its valuation could be artificially lowered, so spinning all or part of the real estate off into a REIT can increase valuation and boost shares, adding value from an investment perspective.
It’s worth noting, however, that while spinning off real estate assets can produce some benefits, doing so won’t singlehandedly salvage a troubled business. If a retailer’s value proposition isn’t resonating with its target consumers, a short-term windfall might be a short-term fix rather than an effective value add in the long-term. Historically, retailers direct more of their attention to store operations and top-line metrics (sales and revenue) than on pursuing new strategies to add value for investors. But in today’s business landscape, retailers could benefit from taking new approaches to unlock value as their industry weathers ongoing disruption.