Revisiting Retail Real Estate

One of the areas I've avoided investing in for the past few years is retail based real estate. I wrote about this issue some time ago. (Physical Retail's Long Shadow- September 6, 2016.) Like most observers, I assigned the decline of physical retail to the onslaught of online merchants. But this assessment was premature, as it actually covered the smaller part of the problem. Problems are being made for mall operators, not by them, by the unrestrained recklessness of private equity loading these companies with unsustainable debt loads. Many of you have seen news articles pointing this out.

But I really didn't appreciate how much, until I started looking at the numbers for companies that had either gone bankrupt, or defaulted on their debt obligations.

Toys R Us: 1758 units, $5.23B in debt, owned by KKR, Bain

Gymboree: 650 units, $1.37B in debt, owned by Bain

Bon Ton: 260 units, $1.0B in debt, (Self Inflicted)

Claire's Stores: 3088 units, $2.17B in debt, owned by Apollo

The Limited: 250 units, $3.60B in debt (estimated), originally bought out by Sun Capital

*Nine West: 277 units, plus broad distribution to various retailers, $1.5B in debt, owned by Sycamore Partners

There's more to list, but given the roster of failed chain operations, it seems few actually failed due to changing consumer tastes (i.e., Radio Shack) or competition from Amazon. For some of these firms, the basic math of dividing the number of store units by the total debt load the firm carried revealed an impossible task: treated as if they were free standing units, how in the world were they supposed to have serviced debt loads of what amounted to millions of dollars per store, given the margins they were forced to reckon with? The owner of a bodega would know better, yet the Ivy League trained Masters of the Universe seemed to have difficulty quantifying the sustainability of these operations. (Actually, it's not due to a lack of understanding of a P&L statement- looting the operation is what it's about, while the bondholders are left holding the bag.)

More of concern is the human cost that is being ignored. Toys R Us created 32,000 newly jobless. Payless ShoeSource, which is fighting to survive, had 25,000 employees before shrinking its footprint. At it's peak, Claire's Stores had 18,000 employees. J. Crew nearly went under, which would have taken out 9500 jobs, but not before its bondholders were practically wiped out. And here we are, with hundreds of reporters circling a Carrier factory in the middle of nowhere, and singing dirges to steel plants mothballed 30 years ago. We blame everyone but ourselves for our workforce problems, all of them foreigners, of course, but the ones who actually create them are feted as geniuses and philanthropists, their words of wisdom sought after and heeded on business media.

The stores that aren't leveraged to the neck, like Ross Stores, Dollar Tree and JC Penney, will survive. These organizations have been accustomed to change for decades. They've been through wars and depressions. They've seen "category killers" like Toys R Us and Bed Bath and Beyond try to cannibalize the department store model. They'll survive the inroads online merchants will make, too. And with a tighter footprint, and less stretched resources, could come out stronger for it. So far, to the surprise of many debt analysts, the commercial mortgage backed securities (CMBS) market has held up well, at least in the aggregate.

In any case, spotting pricing from 18 months ago, the grey line is the S&P 500, and the colored lines represent the stock performance of a few mall operators, including GGP, (Blue) which was recently bought out by Brookfield at the prevailing stock price, to the disappointment of existing shareholders. Simon Property Group (SPG, yellow line) Tanger, (SKT, orange) and Washington Prime (WPG, aqua) all show underperformance relative to the market.

These firms are actually well managed by people who know their business, unlike the leveraged buy out and hedge fund operators who know nothing about what it takes to be a merchant. They've got a harder path to follow, but no one should count these firms out. Especially since they hold a great deal of very valuable real estate in highly desirable locations. I wouldn't own them. But I wouldn't sell them short either.

*Nine West Holdings was added after the original publication of this article. It was once the Jones Apparel Group.