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With flagship deal, HBC opens the door to a REIT

Hudson's Bay Co.'s surprise sale-and-leaseback deal on its Toronto flagship store is a real estate story, plain and simple. Which is fine, because that's the story investors want to hear.

The Canadian retail giant's stock initially slumped more than 2 per cent on the news Monday morning that the company will sell its grand old downtown Toronto building and connected office tower to mall operator Cadillac Fairview Corp. Ltd. for $650-million, will lease the space back from the new owner, and will operate separate Hudson's Bay and Saks stores at this plum location. Perhaps investors are struggling to absorb this unexpected twist, as the company had given no hint that this was on the radar screen. Their focus has been jerked away from Hudson's Bay Co.'s recent acquisition of Saks Inc. and its planned expansion of the luxury retailer into Canada, and is now squarely on how the company will extract value from its large portfolio of retail real estate.

Unexpected or not, it's a large step toward removing a wedge between the company and the investment community. Hudson's Bay chief executive officer Richard Baker feels the market isn't recognizing the value of his company. The market isn't convinced Mr. Baker has done enough to unlock that value for shareholders. And real estate is at the heart of their impasse.

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Mr. Baker has been trying to position Hudson's Bay stores in that retail sweet spot between the low-end discounters such as Wal-Mart and Target, and the luxury chains such as Holt Renfrew and Nordstrom. It's a delicate path, offering a more upscale shopping experience to a value-conscious customer base. And it has seen a measure of success in areas such as same stores sales, which rose by 6.4 per cent in Canada in the (otherwise-disappointing) third quarter of 2013.

Yet the market hasn't much cared. The share price has languished while waiting for Mr. Baker to announce a spin-off of key real estate holdings into a real estate investment trust (REIT), an investment vehicle that would de-couple the rich real estate assets from the notoriously fickle retail business and release a torrent of essentially trapped value in the stock. The REIT has become the holy grail of Canada's retail sector over the past year. Loblaw Cos. did one. Canadian Tire Corp. Ltd. did one.

When Hudson's Bay announced its purchase of Saks – a retailer teeming with high-value properties – many investors saw a REIT as a mortal lock. When the company didn't unveil REIT plans with its quarterly financial report in December, investors punished it. The stock is down 22 per cent in the past two months.

Monday's sale-and-leaseback news, again, wasn't the REIT announcement the market has been waiting for. But it's a definitive step toward one. It creates a model for capitalizing on the real estate value of Hudson's Bay's other big company-owned landmark downtown stores (it owns similar buildings in the hearts of Vancouver, Calgary, Winnipeg, Ottawa and Montreal). It establishes a valuation on which a REIT spin-off can now be pegged. Mr. Baker made it clear that this is a prelude to creating a REIT.

The preoccupation for watchers of the stock now will be timing. Will the company need to get other ducks in a row – namely, other sale-and-leaseback deals – before it's ready to give the market the REIT it so dearly wants? How long might that take? What market conditions will Mr. Baker be looking for before he takes the leap?

The big questions surrounding the retail strategy – like, for example, whether it makes sense for the company to operate Saks and Hudson's Bay stores side by side, whether this muddles or enhances the brand message, whether the plan for downtown Toronto will be extended to other landmark locations across the country – will take a back seat. The market has been hungering for Hudson's Bay to show up at the retail real estate party; it just arrived.

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