The strong continue to get stronger and the weak continue to get weaker. If there is one overriding theme in the retail sector as we move to the far end of the 1990s, this is it. Examining the results of the recent, all-important holiday shopping season, we can see evidence of this. Wal-Mart, Home Depot, Staples and other "category killers" all racked up impressive sales increases. On the other hand, the northeast regional discounter Caldor's has announced its impending liquidation. Hills Department Stores has been acquired by its competitor, Ames, which is in the process of absorbing these new stores. Venerable regional names such as Boston Bed and Bath, Crowley's, Sun TV and Solo Serve all have thrown in the towel, acknowledging that they can no longer be successful in this ultra-competitive retail climate.

We are all witness to the signs of these changes. "Going Out of Business" and "Liquidation Sale" announcements have become commonplace. Literally billions of dollars of inventory is disposed of in the final swan songs of these businesses in order to satisfy creditors. However, the closure of a retail business results in more than the liquidation of inventory. An additional by-product of the disappearance of these weaker retailers is the redeployment of their real estate. Often the chains that succumb are mature businesses with good retail locations. Their leases were negotiated over time and may have rents that are below market. The redeployment of this retail real estate presents opportunities for creditors of the defunct businesses to recoup a portion of their investment, as well as for other retailers to acquire valuable locations at bargain prices.

Unlocking the Value

As retailers, landlords and insolvency professionals have focused more on the real estate side of retail restructurings and liquidations, many professionals now specialize in understanding and realizing on the value of retail leases. The value of a lease is largely a function of the perceived spread between the negotiated lease rate and the current "market" rate. In order to accurately calculate this spread, it is critical to understand the factors that affect "market value."

Unlike inventory, securities or most other types of assets, real estate is in no way a commodity. We all can easily understand the intrinsic value of a common consumer product such as toothpaste. We also can understand that the price of a stock or bond is based on the last amount someone else paid for the same security. However, it is fair to say that no two pieces of real estate are identical. It is also fair to say that different users will value the same piece of retail real estate differently. One may place a high premium on the size of the property's frontage, while another might put more value on the location. A third might really value the ability to lock in its cost structure (i.e., the rent and related occupancy charges) for the balance of the available term. As a result, the "market value" of a particular piece of real estate is a fluid concept, and pinning the actual value of a lease is as much an art as a science. Essentially, the market value is the amount that another user will pay to gain control of the property. The trick is to have resources that can identify who that user might be and to create a means to monetize that value.

There are three likely buyers for a lease—the existing landlord, another end user or a financial investor that will pay for the ability to capture the spread for its own benefit. There are advantages and disadvantages to dealing with all three.

The landlord often has the greatest incentive to buy back the lease. By recapturing the remaining term on a below-market lease, the landlord trades dollars today for the ability to control his own destiny and create an attractive package for an alternative tenant. He may have a neighboring tenant that is seeking to expand. He may have an opportunity to bring in a premier retailer to the center if he can only find the space. In any event, selling the lease back to the landlord represents the easiest and quickest way to create liquidity from the equity in a lease.

Marketing the lease to alternative tenants is a more difficult but potentially more rewarding means to unlocking the value of a lease. Successful, growing retailers will pay to acquire desirable locations at advantageous lease rates. By lowering their occupancy costs, retailers can achieve improvements in operating margins. The amount that may be spent to acquire the lease and renovate the space can be recaptured over time through depreciation. The keys are finding the right user who can pay the most for the property, and negotiating a deal that allocates value (in this case, the value created by the spread between the lease rate and the market rate) between the buyer and seller. However, in most cases there is a third party complicating the negotiation—the landlord.

Whether a case is in or out of bankruptcy, it is likely that the landlord will have something to say about a potential assignment. As we will discuss later, the landlord's rights are severely reduced in a bankruptcy proceeding where the court can disregard "anti-assignment" provisions, use restrictions and similar landlord-friendly lease terms that would have the effect of recapturing the value of a below-market lease in favor of the landlord. In an out-of-court restructuring, the lease usually provides the landlord with the right to consent to an assignment. Moreover, the buyer will frequently seek concessions from the landlord, such as the modification of a restrictive clause or other lease provision, or the financing of tenant improvements. The end result is a three-way negotiation requiring the available pool of value to be spread among the buyer, the seller and the landlord.

An alternative means to create liquidity from a valuable lease is to find a financial investor who will pay for the income stream that can be realized on the difference between the lease rate and the market rate over the remainder of the lease term. In this transaction, the buyer usually takes an assignment of the lease and then reassigns or sublets to the ultimate tenant. The financial buyer is basically purchasing a fixed income stream over the remaining lease term based on the credit of the ultimate tenant. The seller of the lease gets paid up-front, and the landlord gets a new, healthy tenant.

In or Out of Chapter 11?

One of the key considerations in deciding whether to undertake a retail restructuring or liquidation in or outside of chapter 11 is the real estate strategy. Out-of-court proceedings offer tremendous opportunities to cut costs and time, creating the prospect of an enhanced recovery for creditors. Operating outside of the scrutiny of the court and the multitude of professionals in a typical bankruptcy case allows greater flexibility in selling assets and dealing with the various parties to a lease assignment transaction.

An example of the success that can be obtained is the recent out-of-court liquidation of a Northeast regional 30-store hardware retailer. In this case, the debtor's parent company, a healthy operator of retail hardware stores in the Midwest, wanted to avoid the publicity and costs of a bankruptcy proceeding. The company's stores were typically located in older, urban strip centers, often in high-traffic, high-visibility areas. As a result of the healthy real estate market in the Northeast, many of the company's leases were substantially under-market. Unfortunately, many of these were older leases without much remaining term or unexercised option periods, severely limiting their value to alternative users. However, by taking advantage of each of the different transaction types described above, the value of the company's real estate leases was unlocked. Together with the proceeds generated from the liquidation of inventory and other assets, cash generated from the sale of the leases was used to fund a meaningful distribution to unsecured creditors. Some of the leases were turned back to landlords for combinations of cash payments, free rent throughout the liquidation period, and/or forgiveness of past-due amounts. In addition, a group of leases were packaged together and sold to a financial investor, who resold one to a well-known drug store chain and sublet the others to another hardware store operator, retaining the spread between the original lease rate and the new sublease rate for itself.

Because this case was conducted out of court, the landlords were party to most of the assignment and sublet negotiations. However, since the landlords were replacing the defunct company with a new, financially viable tenant willing to invest substantial amounts to renovate the properties, they were willing to grant their consent to the transaction as well as provide other accommodations, such as expanded use clauses, tenant estoppels and even extensions of lease terms. In one particularly interesting example, the landlord for one of the most valuable leases had a right to recapture the property (i.e., terminate the lease) upon receiving notice of the tenant's intention to assign the lease. As described below, such a provision would routinely be ruled unenforceable by a bankruptcy court. However, in an out-of-court process, the landlord had to be dealt with. The negotiated resolution: the landlord consented to the assignment in exchange for an increase in the rent over the remaining lease term, the new tenant accepted the higher rent because it was still below the perceived market rent, and the company reduced the agreed-upon sales price for the lease as a result of the change in the rent amount.

Notwithstanding this success story, selling, assigning and negotiating terminations of leases outside of a bankruptcy can be a difficult process. On the other hand, a bankruptcy court offers several significant advantages, including the power to reject unwanted leases,¹ the ability to assume and assign leases that expressly prohibit or require the landlord's consent to assignment or that create a financial penalty on assignment,² and the ability to override or modify a restrictive "use" clause if the enforcement of such a provision would be a detriment to the estate.³ In a case in which there may be substantial value in real estate leases, the use of these tools is a powerful reason to choose a bankruptcy forum over an out-of-court process.

In developing a real estate liquidation strategy, one thing to keep in mind (whether operating in or out of a bankruptcy court process) is effective management of the carrying costs of the real estate. Obviously, rent and other occupancy costs must be paid during the course of the liquidation of store inventories in order to keep the doors open throughout the liquidation sale. In addition, these costs must be currently paid in order to preserve the value of any lease that will be sold or assigned during the process. It is critical to mesh the timing of store closings with the effective date of rejection or termination of undesirable leases so as not to pay occupancy costs beyond the necessary period.⁴ Similarly, it is essential to understand the anticipated marketing period that will be required to find willing buyers for leases. The value that can be obtained through a successful sale of a lease must exceed the rent and other carrying costs that will be incurred while it is being marketed for sale. If possible, the company and its professionals should be marketing the leases during the period of the store liquidation sales to take advantage of the built-in occupancy period.

Based on all of these considerations, whether operating in or out of chapter 11, it makes sense for a retailer to seek the specialized expertise of a real estate disposition professional to lend assistance in understanding the value of the lease portfolio, and in creating and executing a successful real estate disposition strategy. Retailers often have in-house departments devoted to negotiating leases and dealing with the day-to-day real estate needs of a growing business. However, these groups may not be best qualified to determine "market" values and potential alternative users. Asset disposition specialists utilize resources to assist them in understanding the local real estate markets throughout the country, and bring with them relationships with landlords and other retailers that can be invaluable in maximizing the value of the leases.

Structuring the Deal

There are many different ways that asset disposition specialists can be compensated, and care should be taken to structure a deal that makes sense for both the company and the professional. The simplest structure is a fee-for-services arrangement, where the professional earns a commission based on the dollars generated from the sale of leases, savings generated in reducing lease reduction damage claims, or both. Under more complicated arrangements, the company may seek a guaranty from the asset disposition specialist on the minimum amount of the sale proceeds and/or the maximum amount of lease rejection claims with which the estate will be left. Probably the most beneficial deal structure is one where the asset disposition specialist guarantees a minimum lease value, allowing the estate to cover its downside risk, and then shares with the estate any upside that may be created above a negotiated threshold. This structure creates a true partnership between the estate and the service provider, where both parties have the incentive to achieve a greater result.

Conclusion

The equity built up in a retailer's lease portfolio can be a meaningful source of cash for the company and its creditors in a liquidation or downsizing. Understanding and capturing this value is critical to a successful outcome. However, in any such situation there is a need for speed. The lease is a declining asset; each month that goes by shortens the remaining lease term, making it less valuable to alternative users. In addition, costs of carrying the leases will quickly eat up potential value. Retailers, insolvency and restructuring professionals, and asset disposition specialists must create an effective strategy to quickly capitalize on this opportunity. Once a lease is terminated for failure to pay rent, not even a bankruptcy judge can compel the landlord to accept a new tenant.

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Footnotes

¹ Section 365(a) of the Bankruptcy Code, 11 U.S.C. §365(a). Return to article

² 11 U.S.C. §365(f)(1). Return to article

³ In In re U.L. Radio Corp., 19 B.R. 537, 544 (Bankr. S.D.N.Y. 1982), the court stated:

Section 365 expresses a clear congressional policy favoring assumption and assignment. Such a policy will insure that potential valuable assets will not be lost by a debtor who is reorganizing his affairs or liquidating assets for distribution to creditors. This policy parallels case law which disfavors forfeiture...to prevent an assignment of an unexpired lease by demanding strict enforcement of a use clause, and thereby contradict clear congressional policy, a landlord or lessor must show that actual and substantial detriment would be incurred by him if the deviation in use was permitted. Return to article

⁴ Under the Bankruptcy Code, the debtor is required to pay rent in accordance with the stated terms of the lease. 11 U.S.C. §365(d)(3). However, the bankruptcy court is frequently forced to grapple with the issue of whether the debtor is actually permitted to pay rent on a prorated rather than a monthly basis. The debtor will seek to pay rent only for the period it actually uses a leased location. On the other hand, the landlord may argue that by allowing the debtor to pay less than the full month's rent, the court is modifying the terms of the lease. This issue was recently preliminarily decided in favor of the landlords in the Eastern District of Massachusetts. See, e.g., In re Leejay Inc. (Jan. 28, 1999). However, there are numerous cases in other districts (including the District of Delaware, the Southern District of Ohio, the Southern District of New York and the Central District of California) where courts facing the same or substantially similar issues have determined that the debtor's obligation to pay rent is appropriately pro rated for the actual period of occupancy, notwithstanding what a literal reading of the lease would require. In reaching this conclusion, these courts reasoned that, as sitting courts of equity, they are duty-bound to balance the interests of similarly situated competing creditors against the interests of the landlords. Return to article