From a small northwestern observatory…

Yeah, I grew up in one of those households.  Mom would pack me in the car and drive 40 miles to the nearest Sears to be at the door when they opened at 9am.  Christmas shopping always involved The Catalog (THE Catalog).  Except for a car, a house, and a dog, if Sears didn’t sell it, we probably didn’t own it.

As of this writing, it appears that they may — or may not — emerge as a shell of their former self.  Many (most?  all?) of the stores will close.  Every retail pundit in the universe is trying to explain why the business went into bankruptcy.  I have my own ideas, but that’s not the issue here.

One of the more interesting stories, though, is how badly Sears has apparently managed its real estate holdings in the last few years of its life.  There are a lot of claims on the assets out there (one argument is that Sears’ expensive defined benefit retirement program is taking it under).  Intriguingly, however, Sears owns a very valuable asset which, in bankruptcy, it will simply throw away.  That asset is a nationwide network of below-market leases on very valuable real estate.  The current Board Chair, Eddie Lampert, is making a $1.8 Billion bid for this real estate, although there is some question as to whether the court will accept his bid.  In fact, many of the landlords are clamoring to evict Sears and turn the assets over to more profitable tenants.

Imagine you own a shopping mall, and you can rent 140,000 square feet of Sears space (the average size of a Sears store) for $15 per square foot.  Instead, however, Sears currently rents that space for $5 per foot, due to a favorable lease they negotiated when the mall was first built.  Imagine that Sears still has 20 years remaining on said lease.  At a 7% rate of return, the difference is almost $15 million in present value.  In real estate terms, that’s called a Leasehold Estate.  Multiply that by hundreds of stores, and… well… you get the picture.

Leasehold Estates may or may not be transferrable, but often can be subleased.  Indeed, Sears in its hey-day made quite a bit of money sub-leasing portions of the store to third-party merchants (many big retailers still operate this way).  When Woolworth’s realized that they were not long for this world, rather than head down the bankruptcy path, they carefully managed their long-term leasehold assets.  Indeed, some analysts argued that Woolworths was worth more as a real estate holding company than as a retailer.  In Sears case, that may have been a possibility at one time, but sadly that ship has sailed.

I’m currently writing a book chapter on the importance of differentiating between the business value and the real estate value in the analysis of a closely held enterprise.  The melt-down of Sears is a shining example of the failure to do just that.