Capitalizing on K-Mart

As published in the Florida Real Estate Journal March 1-15 , 2003

With K Mart announcing that it is closing more stores in Florida, it’s a good time to look at some important issues to consider when evaluating re-leasing or redevelopment strategies for the closed stores. Bankruptcy imposes a special process on the assets. There are some pitfalls to avoid and some strategies to employ in addressing the opportunities created by store closings.
    It’s important to understand the impact of the bankruptcy, which adds a layer of bureaucracy to the process.  When Kmart filed for bankruptcy protection, it had to file a reorganization plan with the Federal Court. This process gives Kmart the opportunity to renounce or sell leases that drag the company’s earnings down.  Once the plan identifies the stores that will be closed, or the leases that will be renounced, the trustee is able to market the leases that Kmart retains and the landlord must deal with any leased space that Kmart rejects.
    According to Jeff Schottenstein of Schottenstein Realty Co., a veteran of the lease liquidation business: “In the early days of the lease liquidation business, there were only a few players that would consider bidding on the individual leases or a package of leases on stores that the bankrupt firm plan to close. Today, a large number of firms have strategies that focus on the acquisition and subsequent liquidation of these types of leases.”
    This has caused the process to be much more competitive, driven down potential yields and made it difficult for an individual to get access to and control of specific leases early in the process. Schottenstein believes that in the case of Kmart, “The bulk buyers will liquidate the best properties and the best locations.”
    Schottenstein believes that “over the years, the bulk buyers and leasing community have become very sophisticated with their understanding of the reuse potential of the stores.” As an individual broker or developer, a good strategy would be to focus on the leases that the landlord still controls so you can strike a deal with him to represent the asset.
     Remember, the landlord will have gone through the easy solutions. You need to be creative. If your idea is different from the mainstream—and the strategy will generate a yield that is greater than traditional uses—you should be able to make an offer to the trustee or landlord that will be more attractive than the others.
     A logical use for the vacated Kmart stores would be other big box retailers. However, these retailers expanded aggressively during the 1990s and do not oak favorably on second-generation space that may not perfectly fit their needs. Even if you identify a retailer that is not in the market, you do not stand a good chance of getting that tenant interested unless the location you have control over is very compelling. This is why many of the liquidators or repositioning firms focus on non-traditional uses such as self-storage facilities, churches, call centers, theaters and schools. A pitfall of these users is that they may not complement the other tenants in a center and may actually increase the cap rate on the property.
     Other factors to consider when creating your repositioning strategy are the property’s surrounding neighborhood and the store’s position in the retail center. Is the vacant Kmart store located on the end-cap of a center? Is it freestanding?
     Francis L. Carter, senior partner at Ferrell Schultz Carter Zumpano and Fertel, observes: “If you want to purchase directly from the bankruptcy trustee, you need to be aware of another nuance of the bankruptcy processes—that the bankruptcy trustee or his agent will control the bidding.” You will not be able to purchase the asset directly from Kmart.  According to Carter, there are strategies that you can employ to protect your position. “You should make sure that the purchase and sale contract contains a clause allowing you to get a break-up fee or recover your due diligence costs if you are the initial or ‘stalking horse’ bidder,” he said.
     Carter also recommends that “minimum earnest money or ‘overbid’ requirements be used to protect buyers in their contracts.” If you are a broker, you need to realize that the bankruptcy code does not provide for you to collect a fee from the bankruptcy estate unless you have been previously appointed by court order to be the estate’s broker, so Carter recommends that a broker “makes sure he has a seller that is willing to pay his fee or that the broker is able to get a representation agreement with the bankruptcy estate.”
     Once you have identified the asset and have gotten it under control, you need to find the financing to close the deal. Remember, you will be purchasing as asset that has no cash flow. Financing the acquisition will be difficult. It will require significant amount of cash. This is another factor that limits the number of buyers and strengthens the trend that these stores will be controlled by any one of a number of deep-pocketed funds.
     According to Carter, “An effective bidding strategy should focus on land value, without a significant value being attributed to the building.” Schottenstein advises that the building may in fact have little or no value. In all likelihood, the building will need to be substantially modified.  A detailed budget and plan will need to be created and financing sources found. Local banks, “credit company lenders’ and opportunity funds are the sources most likely to provide the financing.
     The bankruptcy of Kmart will provide opportunities throughout the state. By carefully understanding the nuances of the process, identifying situations you can control, protecting yourself in the listing/offer phase, and generating creative ideas, a handsome return can be made.