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Discount Chains Gobbling Up All the Store Realty in Sight; JCP, Sears Retreat

Just as the emerging popularity of fast fashion has been changing the rules of retail, the increasing prominence of bargain-oriented chains has been forcing major retailers to take notice and retool their strategies.

A perfect confluence of multiple factors set the stage for discount chains to replace traditional big-ticket retailers as the shopping destination of choice for American consumers. First, a rebounding commercial realty market has sent prices soaring, favoring those retailers in good enough fiscal shape to afford expansion. Vacancy rates in U.S. shopping centers dropped to 8.6% at the close of 2013, compared to 9.5% in December 2012. According to Cassidy Turley, a commercial real estate services firm based in Washington, D.C., that means a whopping 38 million square feet of retail space has become available and it’s largely getting occupied by bargain chains.

TJX Cos, parent company of T.J. Maxx and Marshalls, spent $759 million for property expansion for the nine months that ended November 2. The company expects to invest another $950 million in 2014 on new realty, adding to its already massive reserve of 3,200 stores. Dollar General plans to add hundreds of stores in 2014 on top of its 11,000. Likewise, Costco Wholesale Corp., Nordstrom Rack and Ross Stores all have aggressive plans to occupy considerably more space in the next year.

In comparison, J.C. Penney only plans to spend $300 million on new space, while shuttering many of its existing locations. The mega-retailer, which operates approximately 1,100 stores across the U.S., recently announced its intent to close thirty-three stores and lay off 2,000 employees.

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Sears’ turnaround strategy actually seems premised upon a massive retreat from its vast physical holdings, preferring to sell off its best performing stores than add new ones. Over the last eighteen months, Sears has sold almost a dozen stores in the U.S. and Canada, some of them admittedly among their best money makers. Some industry experts have speculated that Eddie Lampert was originally attracted to Sears precisely because of the value of its real estate. One of Sears’ investors, Baker Street Capital, issued a report recently that the retailer’s 350 remaining locations were collectively worth $7.3 billion. Consider that Sears’ total market capitalization is approximately $600 million.

Sears has even taken to leasing its existing space to third-party vendors, like Western Athletic Clubs Inc., which rented a colossal 69,000 square feet in Cupertino, California. In 2012, Sears allocated a grand total of $378 million to store improvements, a paltry sum in comparison with competitors like Kohl’s Corp., which spent $785 million and Macy’s, which parted with $942 million.

Similarly, former industry leaders Staples Inc. and RadioShack Corp., one familiar fixtures in strip malls all across the U.S., plan to collectively close 1,325 stores in concession to straitened financial circumstances and shriveling sales. “I see a lot of companies interested in the space that Staples would be exiting,” said Peter Dixon, manager of Fidelity Select Retailing Portfolio.

Many experts have also noticed the consumer hunger for discounts affecting the kinds of shopping centers currently slated for construction. Outperforming a sluggish full-price shopping retail sector, discount outlet development has been experiencing powerful growth. With 220 retail outlets operating in the U.S. and plans for nearly another fifty to undergo construction, the industry is poised to grow by a brisk 25 percent.

Many retailers find outlet development irresistible since it typically flourishes in both strong and weak economic circumstances. According to Lisa Wagner, a partner in EWB Development LLC, outlet centers are more resilient than their full-priced counterparts. “A strong outlet center will always outperform a strong regional mall. Some of these outlet centers are performing double what typical malls do,” said Wagner. “If you look at certain brands, their outlet business is exponentially huge compared to their full-price stores.”

Steven B. Tanger, president and chief executive officer of Tanger Factory Outlets, sees the allure of the outlet center as recession-proof. “The value proposition is embedded in the lifestyle of today’s consumer, and outlets are the natural destination of choice for branded apparel,” he observed. “The old adage is true: in good times, people love a bargain and, in tough times like these, people need a bargain.”

And the enthusiasm for retail outlet development isn’t confined to the U.S. European companies have been aggressively expanding, with an eye to construction in China. Scott Malkin, chairman of Value Retail and cochairman of Value Retail China, sees outlets as the last best hope for European growth today. “Europe’s possibly only growth industry today and maybe for some period is outlets,” said Malkin. “We are up in terms of spend and visitation, and the quality of our consumer is strengthening.”

“In China, you are going to have a wave of outlet center construction because there is very little of the product in existence,” Malkin continued. Brands have been growing at full price and and haven’t been pushed to be more efficient in terms of correctly disposing of their surplus. That’s all coming now.”

Garrick Brown, director of research at Cassidy Turley, said, “We’re seeing a seismic shift in retail shopping centers. The challenges of the weak economy are being replaced by the challenges of e-commerce.”

According to a new report issued by the Cowen Group, a retail analysis firm, the anemic sales performance and mounting debt of retailers like Sears and JCP will require a sizable retreat from their realty holdings. The study, entitled “There Are Always Winners and Losers in U.S. Retailers,” said:

“The continuing market share losses by Sears, Kmart and JC Penney present a stark contrast between steady growth in retail sales and operating metrics for retailers and their landlords. Moreover, the financial pressure on both SHLD and JCP appears to be intensifying. Sell-side consensus estimates assume the two companies will generate a combined negative $1.1B in EBITDA in 2013. As the market share losses have accelerated and credit metrics have become stretched, SHLD and JCP have been able to use declining risk premiums and record low yields in the high yield credit markets to refinance existing debt and extend maturities. The companies carry a combined $8.3B in net debt, with CCC- ratings across senior unsecured credit. Given that the two retailers lease or own an approximate 350MM sq. ft. in their 3,624 N. American stores (including Sears Canada), we believe that we are at the onset of a significant shift in retail real estate deployment.”

The receding ground for JCP and Sears, however, creates real estate opportunities for thriving discount chains like TJ Maxx and Ross. As one sector of the market languishes, another, in turn, blooms.

“This shift portends a host of opportunities and risks for Retail REITs and Retailers. In this report, we focus our analysis on the Mall and Strip center REIT sectors as well as the segments of our Retail coverage that we expect to be most impacted by the shift, which include Off Price retailers TJX, Ross Stores and Burlington.”