Few investor tremors expected over Sears bankruptcy

Updated with correction

Now that Sears Holdings Corp. has filed for Chapter 11 bankruptcy protection, real estate investors diversified and tilted toward core properties should see less downside risk.

Questions intensified over the retail legend's prospects in March 2017, when Sears warned that it may not be able to continue as a going concern. That gave institutional investors enough time to gauge the potential impact of a bankruptcy filing, which came Oct. 15.

The bottom line: While the pain to mall owners will be real and long lasting, investors with core portfolios that hold high-quality retail properties in good locations should be fine because those properties are more likely to withstand a Sears or Kmart store closure, industry sources said.

Many institutional investors still have a large portion of their real estate portfolios — 40% to 60% — in core, according to consultant Meketa Investment Group Inc. But investors in some real estate investment trusts could feel pain should more vacant stores clog the market, potentially triggering co-tenancy clauses that would give other tenants a chance to terminate their leases without penalty.

In all, REITs and institutional real estate managers owned about 30% of retail real estate in the U.S. as of Sept. 30, 2017, according to estimates by LaSalle Investment Management Inc., Chicago.

That's where having a high-quality property will help. Owners of top-shelf malls will find it easier to redevelop the property and re-lease it for higher rent, said Benjamin Lentz, Baltimore-based managing director and director of research for LaSalle's securities business

Meketa began fielding calls from clients 18 months ago asking about the impact of a Sears bankruptcy and bankruptcies of other large retailers on real estate portfolios, said Christy Gahr, Westwood, Mass.-based principal.

"The headlines are scary," Ms. Gahr said. "It's easy to think that it would have a material impact on the real estate program."

As a result of a study Meketa conducted following those calls, the consultant concluded that core real estate managers tended to have exposure to the retail sector ranging from 20% to 30%, she said. The NCREIF NFI-ODCE index is approximately 20% retail; the NCREIF Property index is 23% retail.

Closed-end value-add real estate funds had 6.3% in retail as of Sept. 30, 2017, according to NCREIF Fund Index-Closed-End Value-Add.

Little exposure

Meketa's study, which focused on U.S. diversified real estate funds, found that less than 1% of many funds (measured by rent and gross leaseable area) was exposed to companies with major 2017 store closures or anticipated 2018 store closures, she said.

The result is that although retail has been the worst-performing sector in the NCREIF Property index, with a 0.56% return for the quarter and 3.9% for the year ended Sept. 30, most investors with diversified portfolios and the majority of their investment in core properties should feel less pain from Sears' bankruptcy.

Officials at the New Mexico Educational Retirement Board, Santa Fe, do not expect Sears' bankruptcy to have a big impact on its real estate portfolio. The $13 billion pension fund no longer invests in REITs and has no exposure to Sears in its equity portfolios, said Bob Jacksha, chief investment officer, in an email.

"Our only exposure is an active mandate with Brookfield (Asset Management) that is less than 2% of total assets," Mr. Jacksha wrote. "Thus, any Sears exposure they have will be pretty minor in the overall scheme."

Other investors have larger exposure to retail. Some 30% of the California Public Employees' Retirement System's real estate assets are in retail, and the $351 billion Sacramento fund is in the midst of a review of its retail portfolio, according to a September report to the board. CalPERS declined comment on the review.

Currently, Sears owns or leases about 400 mall-based stores. The firm's restructuring plan in bankruptcy includes closing 142 locations — 77 Sears stores, which are almost entirely at malls, and 65 Kmarts that are predominately stand-alone locations — by the end of 2018, an Oct. 16 report from Green Street Advisors LLC, Newport Beach, Calif., noted. Last year, Sears closed 358 stores.

And although for now Sears is in reorganization — with company executives hoping the company will emerge as a going concern — Sears has not provided guidance around how many stores the company will have when it emerges from bankruptcy, the Green Street report noted.

Overall, about 30% of Sears and Kmart stores are in Class A space, about 50% are in Class B, or midquality retail, and 20% are in Class C, the lowest quality retail, said Brad Hutensky, Hartford, Conn.-based CEO of retail real estate money manager Hutensky Capital Partners LLC and a trustee at the Urban Land Institute, a real estate trade organization.

"So much depends on the location, the size of the market, the property owner's skill and the owner's access to capital, Mr. Hutensky said.

Hutensky Capital has no Sears or Kmart stores in its portfolio because it only owns open-air shopping centers in large markets.

Improving properties

Some of the largest real estate managers say they have been taking steps to improve the outlook of properties where Sears is a tenant.

John Ragland, managing director and U.S. retail sector co-head at TH Real Estate, a subsidiary of Nuveen, said the firm has equity investments in 89 retail properties in the U.S., including 17 B-plus, A-minus and A-plus rated malls — all owned in joint ventures with REITs such as Brookfield Properties Retail Group or Simon Property Group Inc. Within the U.S. mall portfolio, TH Real Estate had nine former Sears stores locations, including five that TH Real Estate purchased and three that it sold to Seritage Growth Properties, a REIT Sears spun out to hold some of its properties. It has one Sears-owned store in a successful mall, he said.

William Walzer, New York-based partner in the commercial real estate group at a law firm Davidoff Hutcher & Citron LLP, said that at the end of 2017 Sears had $3 billion worth of real estate. In 2015, SEARS "cherry picked" part of its real estate holdings and created the REIT for $2.7 billion, he said. The portfolio included 235 Sears and Kmart stores as well as Sears' half interests in joint ventures with mall REITs such as Simon Property Group, General Growth Properties Inc. and The Macerich Co.

Seritage has been redeveloping properties where Sears has closed stores, and Seritage investors are doing "very well," he said. But "the remaining store locations are not so great," he said.

Shopping centers in smaller cities are competing with Amazon and other online retailers more than centers in larger cities, Mr. Walzer said.

"They are already in trouble and will be hurt if there is a gaping hole" where a Sears or Kmart used to be, he said.

Closing stores could have a domino effect in troubled or lower-quality shopping centers. "Because (Sears) is a national brand with so many locations all over the country, it accelerates a trend of middle-tier shopping centers closing and being repurposed," he said.

Many real estate managers have been studying their options, including talking to potential new tenants, because Kmart and Sears are mostly paying below-market rents and have been generating very few sales, Mr. Hutensky said.

For high-quality retail in densely populated locations, a Sears or Kmart closing could give the real estate manager the opportunity to put multiple tenants in the same area for higher rent, he said.

"If the property is in a major market and is a high-quality asset ... it could be a way to increase returns," he said. "It could be a wonderful windfall."

A Kmart or Sears closure could also be a positive for managers with properties in less desirable locations if the mall can be redeveloped into another use such a medical office that potentially offer higher returns, Mr. Hutensky said.

"I think there will definitely be the have and have-not (Sears) locations" with small malls in tertiary markets an example of a "have-not" mall as well as "have and have-not retailers," he said.