Strange Real Estate Developments
On Friday we had the news that Sears Canada has agreed to vacate the premises of three of its large stores and return them to the landlord in return for $170 million.
This immediately strikes me as odd. Normally a tenant is making rent payments to a landlord. Here, we have a landlord paying the tenant $57 million per store to vacate.
I understand that Sears may have had a below-market lease and I assume it must have had many years to run. But that is a staggering amount of money.
In a somewhat similar situation we had the story earlier this year that Zellers was going to collect $1,825 million in return for giving up its leases on up to 220 locations. That’s is $8.3 million per location. Given that Zellers appeared to be a struggling department store and that (from my observation) many of those locations were not that large and not that prime, that seemed like a lot of money.
I am a bit too stubborn to accept at face value that these transactions make sense for the payers of this money.
I am not smart enough or knowledgeable enough about lease rates involved to understand immediately how these transactions make sense.
I’d like to do some analysis and thinking about this and the implications for both the retail stores that have long-term leases and the owners of the properties. I understand that as interest rates have declined the value of retail properties rises since a given flow of rent will support payments on a larger mortgage. I also understand that if lease rates have increased then the value of property rises. But it seems there is a sharing of these benefits depending on the lease.
If a retailer has a 50-year fixed price lease then I suppose that essentially all of the increase in value really “belongs” to the retailer, even though another company owns the property. Conversely if a store only has a one-year lease then the owner captures the full increase in value. Perhaps most situations are somewhere in between.
Given this information, perhaps we have to be cautious when a REIT states that its buildings have gone up in value. It may be that the tenant and not the REIT will capture that increase in value.
It’s interesting to consider that with Target paying Zellers so much money just to acquire leases, it may not exactly have cost advantages when it comes into Canada.
With these huge dollars at play, it may be necessary to understand the leasing arrangements for retailers. I know Dollarama leases all of its locations. I have not looked in detail to see if it has advantageous long-term leases.
Consider Canadian Tire. It owns 70% of the Canadian Tire store buildings (not sure about the land). From a balance sheet perspective there is certainly hidden value there. Canadian Tire does not mark its buildings to market whereas a REIT does. Canadian Tire may have vast opportunities to sell its properties to REITs. It could get a huge one-time gain. But then it would face high rent costs that would lower future profits. Selling and leasing back its stores might make sense if interest rates subsequently rise which would lower the value of the buildings and leases.
Financial statements may not clearly disclose the details of leases. If the information is there it may be relatively hidden.