The realization that corporate occupiers of commercial real estate should look at the value that their occupancy creates, and manage real estate more as a strategic asset than simply a cost of doing business, is long overdue.
Until recently, most companies have viewed their occupancy of properties, whether retail, office or industrial, as a necessary operating expense, and taken a tactical and operational view. The significant investor demand for yield has driven billions of dollars into the business of being Landlord to the corporate occupiers, as evidenced by the growth of groups like Blackstone and the myriad of net lease REITs that have sprung up in the last decade. Most recently, a number of large footprint corporate entities have begun to look at ways to unlock the value that their properties and their occupancy create.
In this light, the Starboard Value open recommendation to Macy’s presented on January 11, 2016 puts a spotlight on the overall enterprise value of corporate owned real estate, and almost as importantly, the value that can be created by the commitment to occupancy by a rated credit company, on what would presumably be a long term lease. Unfortunately, in part due to new Lease Accounting Guidelines, the strategy of rolling Macy’s owned assets into a joint venture, leveraging them with debt and outside equity, and committing to long term leaseback has the potential to negatively impact the profitability of the operating business as a going concern on a permanent basis. Although the presentation does not mention it explicitly, the recommended deal structure resembles the REIT spinoff strategy which has recently come under scrutiny by the IRS.
The Starboard recommendation has the effect of Macy’s taking out a Home Equity Loan, and committing 33% of their earnings to service the debt, only worse. Even though the initial plan returns about 40% of the cash paid back to Macy’s, the impact on the business’s P&L and Balance Sheet is significant. Under the new FASB lease standard, the net present value of the lease commitment will be placed on the Balance Sheet as both a Right of Use Asset and corresponding Liability. Depending on how the lease is structured, it is likely that there will be an extended period (+/- 10 years) of negative equity created since the asset and liability do not amortize at the same rate.
There are a few other considerations of the recommended structure that should be weighed before Macy’s pursues this course:
1. The valuation of the properties using the income approach significantly inflates the value for most of the assets above their value vacant (locations other than Iconic). This has the effect of creating much higher Loan to Value (LTV) ratios, which can create issues, particularly if Macy’s needs to vacate a particular store.
2. The long term Leaseback creates an escalating operating expense spread compared to owned property accounting where Macy’s has a much lower depreciation expense due to the age and basis of the owned properties.
3. As the retail business continues to adjust to the impact of e-commerce, the cost of vacating leased properties (particularly with 10+ years remaining) is significantly more costly than vacating and selling owned properties.
4. It appears that the interest expense shown in the presentation is part of “interest only” financing, which is generally at a floating rate or for a term shorter than the leaseback period. In either case, in an escalating interest rate climate, the interest expense can be expected to increase, further diluting the cash return.
There is a way for Macy’s to unlock the value of the owned real estate without jeopardizing the long term profitability of the operating entity. In creating a wholly owned real estate subsidiary, and using a combination of preferred stock, debt and internal leases with the operating units, the company can raise capital, maintain ownership accounting treatment, and have complete autonomy and control over closing or selling individual assets. For more information, please read White Paper on New Financial Statement Treatment of Leases Calls for Fresh Corporate Property Strategies, and the accompanying comparison between ILPS and a REIT spinoff.