Kmart-Sears deal no Blue Light Special for some in real estate

Kmart Holding Co.'s purchase of Sears, Roebuck and Co. might be bad news for institutional investors in some real estate funds and real estate investment trusts.

The reason: Edward S. Lampert, the power behind the deal, is expected to cut costs by closing Sears stores located in malls. And malls are the major component of institutional investors' exposure to retail real estate.

Mr. Lampert is the hedge fund mogul, chairman of Kmart and major stockholder in both companies who is expected to become chairman of the combined company, Sears Holdings Corp.

"Obviously, from a big-picture standpoint, the big winners (in the Kmart-Sears deal) are neighborhood shopping center owners, and it's a huge negative for mall owners," said Rohul Bhattacharjee, associate portfolio manager for Cohen & Steers Capital Management Inc., New York. Cohen & Steers is one of the few real estate investment managers to own large portions of most of the top mall REITs.

(Typically, a mall is a larger, enclosed property with multiple anchor tenants; a shopping center usually refers to a "neighborhood" center that includes one anchor tenant, often a grocery story, and miscellaneous small shops.)

Among the winners could be investors such as Heritage Property Investment Trust Inc., Boston, which counts Sears as one of its major tenants in its 160 neighborhood and community shopping centers. Heritage's majority investor is the $3 billion New England Teamsters & Trucking Industry Pension Fund, Boston.

But real estate insiders say it will be months before they know whether the combined Sears and Kmart, with 3,500 stores, will be a real estate bonanza or bust.

In the REIT area, 74% to 88% of the malls owned by CBL & Associates Properties Inc., Simon Property Group Inc. and Pennsylvania Real Estate Investment Trust have Sears as an anchor. One Penn REIT mall has both a Sears and Kmart store.

CBL, Glimcher Realty Trust, Penn REIT and Simon Property Group have the most malls with Sears stores located within a two-mile radius of an existing Kmart, which may mark them for closure, according to a Nov. 22 REIT report from Morgan Stanley Equity Research, New York.

Institutional real estate money managers with the largest percent of assets under management in retail are: Commonwealth Realty Advisors Inc., 94%; Prima Capital Advisors LLC, 40%; ING Clarion/Real Estate, 34%; ABN AMRO Asset Management Inc., 33%; and DRA Advisors LLC, 32%, according to Pensions & Investments' 2004 survey of the largest real estate managers.

On the REIT side, Cohen & Steers holds 5.61% of CBL. The $58.7 billion Ohio Public Employees' Retirement System, Columbus, owns 2.05% of CBL with 631,655 shares valued around $38 million.

No one is certain how many Sears stores will be closed, but some analysts are predicting as many as 1,000 within two years, as the retailer transitions from multilevel malls to standalone "big box" stores.

Earlier this year Kmart sold 78 stores to Sears and Home Depot USA Inc. for $965 million. This caused Deutsche Bank analysts to suggest that Kmart could become a "land bank" for the retail industry, in which it would gradually sell stores.

Potential strategies for the excess real estate of the combined companies include spinning off the properties into a REIT, entering into sale/leaseback contracts for core holdings or selling real estate interests to vulture real estate managers and operators. Each could lead to investing opportunities for real estate managers, REITs and institutional investors.

Two real estate managers already have their noses under the Sears/Kmart tent. Vornado Realty Trust, a Paramus, N.J.-based REIT and well-respected turnaround specialist, owns 4.6% of Sears; Third Avenue Management LLC, New York, owns about the same amount of Kmart. So far, neither manager is talking about strategies for the real estate owned by the struggling retailers.

However, not all investment managers expect a real estate bonanza from the merger.

"I think the real estate opportunity may be not quite as dramatic as people perceive it to be," said Mark Decker Sr., managing director of real estate investment banker Baird Capital Partners, Chicago. "The real issue is what control do they have over their real estate."

More information is needed to make that determination, said Mr. Decker, who heads Baird's real estate group.

"I'd want to know who really controls the real estate, what restrictions and covenants are in those leases, how much freedom do Sears and Kmart have to dispose of the property at will instead of getting approval from a third party," Mr. Decker said.

Morgan Stanley analysts anticipate the regional malls anchored by Sears to face the biggest challenges from the merger because Sears could use the free-standing Kmart stores to open the 60 Sears Grand stores it has planned for 2006.

Meanwhile, the number of hedge fund and real estate investors owning shares in both stores illustrates the recent overlap between the hedge fund and private equity investment universe and the real estate world, said Susan Stupin, managing director of Prescott Group LLC, a New York firm that manages real estate investments for endowments, foundations and high-net-worth individuals.

"There is more and more overlap," she said. For example, about a year ago, San Francisco buyout firm Texas Pacific Group joined with Goldman Sachs Group Inc., New York, and Bain Capital LLC, New York, to buy Burger King. Real estate investors fully expect that the TPG group will eventually focus on harvesting value from the underlying real estate.