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A skeptic's take on retail real estate's 'hidden value'

We can debate the outlook for Canadian housing. But there's no question retail real estate is hot.

Sears Canada Inc. could get more than $200-million for up to three leases it's selling in hot Ontario shopping spots. Seemingly every other Canadian retailer is considering spinning off its real estate into a separate trust, if it hasn't already done so.

It all suggests there's real value not just in a retailer's operations, but also in the brick and mortar used to move the merchandise. In fact, that is a thesis long held by value investors who look to retailers' cheap shares and see hidden worth.

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And it's a thesis I've long been skeptical of, particularly as it relates to the United States' more troubled names.

In recent years, the real estate play is about the only reason to have bought the shares of Sears Holdings Inc., which controls Sears Canada. Sears Holdings owns the Sears and Kmart nameplates, both of which have lost crowds of customers to retailers like Target and Wal-Mart.

Interestingly, the idea that there is huge amounts of hidden value in retailers' real estate seems to pick up speed as more retailers become troubled. JCPenney, which made a hash out its turnaround plan under former CEO Ron Johnson, is the latest example. In an article earlier this year in the U.S. investing newspaper Barron's, the author said he had spoken to investors in the company's bonds whose estimates of the value of JCPenney's real estate ranged "anywhere from $1.6-billion [U.S.] to $3-billion," with one estimate that included the company's leases coming in at $8-billion.

One problem with assessing the accuracy of these estimates is that companies don't list the value of their real estate at market value on their balance sheets; instead, it's at a historical cost that may bear no relationship to how much the company can sell it for now. Leases, generally considered liabilities, aren't on the balance sheet at all. But sometimes, as Sears Canada illustrates, the leases can turn into assets when landlords think they can get more money by kicking the retailer out early and finding a new tenant.

What concerns me, however, is the sheer amount of real estate operated by U.S. retailers who are troubled, shrinking or merging. Kmart has over 100 million square feet of retail space; Sears has another 100 million, I estimate from its disclosures. JCPenney says it has 116 million.

Office Depot and OfficeMax, which intend to merge, seem to have about 40 million square feet of space between them; even before the deal was announced, each had a store-closure and reduction plan. I figure Office Depot planned to axe about 5 million square feet all by itself, based on disclosures.

Best Buy, also engaging in space-cutting, has about 40 million square feet all by itself; bookseller Barnes & Noble has about 18 million.

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The sum space for those retailers is more than 400 million square feet of space. By comparison, Hudson's Bay Co. operates just 25 million square feet across all of its North American concepts (including Lord & Taylor and Home Outfitters.)

Will all of this space become vacant? Certainly not. Will enough of it go empty so has to cause a problem in the U.S. retail real estate market?

I spent some time talking to people who say no.

Robert McMillan, an equity analyst for S&P CapitalIQ who covers REITs, calls the idea of a massive overhang "ridiculous," since bankruptcy levels and forecasted store closures are at low levels. Even if chains close locations, he says, landlords have plenty of options, from bringing in health clubs to tapping hot, new growing concepts like H&M, Forever 21, Zara or Uniqlo. (DDR, a retail-oriented REIT with significant exposure to the office retailers, says it welcomes the chance to replace them, since existing leases average roughly 30 per cent below what the REIT could be charging today.)

Moody's analyst Merrie Frankel says she asks the same questions I do of the landlords, and the response is "we have other tenants lining up to take this space." Her colleague Charles O'Shea, who has remained positive on prospects for brick-and-mortar retail in general, thinks retailers may not create widespread vacancies. Instead, they can "redeploy" existing space for distribution as they make successful transitions to online retailing.

Did the optimists win me over? I'm probably dissuaded from the idea that there's a coming retail real-estate apocalypse. But companies like Uniqlo, which has just seven U.S. stores, don't seem like the answer to what could be tens of millions of square feet of vacant space. Nor do they seem to provide the support needed for the most troubled retailers' shares.

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