Opinions Divided On Dillard’s REIT

Dillard’s created a REIT in 2011 as a wholly owned subsidiary but hasn’t said much about the move or what properties are in it.

Even though Dillard’s stock price hit an all-time high of $123.80 on Aug. 8, an activist investor believes the value could go much higher if the Little Rock retailer changed the way it handles its real estate.

Marcato Capital Management LP of San Francisco, which owns 4.9 percent of Dillard’s Inc. stock, said in a news release last month that it wants the company to create a stand-alone real estate investment trust for its assets.

But some REIT and retail experts wonder if spinning off a REIT would be a good move.

“It’s a financial sleight of hand as far as I’m concerned,” said Kenneth Leonard, principal of Leonard Associates of Chicago, which specializes in retailing and shopping center real estate. “It doesn’t do anything … except maybe fool the stockholders into thinking that there’s more collateral value to that stock and to that company than there is in the real world.”

Marcato Capital disagrees.

“We believe that Dillard’s could unlock tremendous value were it to pursue such a transaction,” Mick McGuire, managing partner of Marcato, said in the news release. “We believe executing on this plan would value the companies at a combined $193 per share, representing a 75 percent increase from current prices.”

Both Dillard’s and Marcato declined to comment.

Howard Davidowitz, chairman of Davidowitz & Associates Inc., a national retail consulting and investment banking firm in New York, said a number of retailers — including Dillard’s — have looked at forming a REIT as their own stand-alone companies but haven’t followed through.

After all the transferring of funds, the numbers typically don’t work in the company’s favor, Davidowitz said.

“I understand there could be a benefit to shareholders. Instead of just having shares in Dillard’s, you would have shares of Dillard’s and the REIT,” Davidowitz said.

One problem arises, though, when the operating company has to pay rent to the REIT, something it didn’t have to do as a property owner. And the rent has to be market rate because regulators examine the transactions closely to root out fraudulent transactions, Davidowitz said.

“Well, you get it on one hand and lose it on another,” he said. “That’s why this hasn’t been done.”

Some experts, however, could support the move to a REIT. While Dillard’s earnings per share would probably fall if the REIT was a stand-alone company, the REIT would make up the difference, said Dan French, a professor who teaches about REITs at the Jeffrey E. Smith Institute of Real Estate at the University of Missouri.

“It still might be a win-win situation,” he said.

He said if Dillard’s runs the numbers and comes up with the $193-per-share figure for both companies, “to me, it would be good for Dillard’s shareholders to have” it.

The Existing Dillard’s REIT

A REIT is not new to Dillard’s. In 2011, it created a REIT as a wholly owned subsidiary.

In a January 2011 filing with the U.S. Securities & Exchange Commission, Dillard’s said the move would “enhance its ability to access debt or preferred stock and thereby enhance its liquidity.”

But the retailer has offered few details about it. In its latest annual report, the company said that in 2011 “certain properties” were transferred to this subsidiary, but it didn’t list which ones.

Dillard’s operates 278 Dillard’s locations and 20 clearance centers across 29 states plus an Internet fulfillment center. It owns about 90 percent of its SF. For the fiscal year that ended Feb. 1, Dillard’s valued its property and equipment at $2.13 billion, down from $2.29 billion the previous year.

But the Dillard’s wholly owned REIT doesn’t satisfy Marcato Capital.

It ran some of Dillard’s real estate numbers and projected that if Dillard’s spun off its property into a stand-alone REIT, the REIT would generate about $456 million in rent, according to a presentation that was attached to Marcato’s news release.

The REIT, then, would be required to pay out at least 90 percent of its profit back to the shareholders, which is what makes REITs attractive, said French, the Missouri professor. And there could be a tax savings too, he said.

“Any income to the REIT, as long as it’s passed onto the shareholders of the dividend, is not taxed at the corporate level,” French said. “So that’s where the extra value comes from. In other words, you’re taking … tax revenue from the federal government and moving it to shareholders.”

However, shareholders then will have to pay taxes on the dividends, and REIT dividends are taxed as ordinary income rather than enjoying the lower tax rates of most dividends.

Marcato Capital said in its news release that in recent months other major companies have announced plans to explore operating a REIT and Dillard’s should too.

“We encourage Dillard’s board and management to actively explore this opportunity to the extent it is not presently doing so,” McGuire said in the statement.

Davidowitz said REITs are attractive to investors because REIT stocks have been climbing over the past five years. The S&P United States REIT index had a five-year return of 13.21 percent, according to S&P Dow Jones Indices LLC.

Dillard’s stock price jumped nearly 9 percent to close at $121.04 on Nov. 20, the day Marcato made its announcement urging Dillard’s to make the REIT move. The stock has cooled slightly since then and was trading at around $116 a share on Wednesday.

Dillard’s didn’t make a statement about Marcato’s proposal. But on Nov. 21, the day after the news release, Dillard’s announced that its board had approved the repurchase of up to $500 million of outstanding Class A stock.

Determining Rent

Davidowitz said it could be difficult to determine what the market rate rent would be for department stores in malls.

“Clearly, they’re worth less than they were,” he said. “What we have in America is 400 really great malls … that are worth a huge fortune.”

He said generally those are the upscale malls anchored by stores such as Neiman Marcus, Nordstrom or Saks Fifth Avenue

The midlevel malls, which are the ones anchored by retailers such as J.C. Penney Co., are struggling, he said, because middle-class shoppers are having a tough time in the economy.

Leonard also agreed that determining the value of a department store in a mall can be tricky. Under the terms of a mall’s reciprocal easement agreement, which covers department stores in malls, typically only another department store can go into a site for a department store in a mall, he said.

So if Dillard’s, or any other department store, wants to close a store in a mall, it would have to sell the location to another department store, which would be difficult, he said. “There are no department stores that will even take it off their hands for free.”

He said the department store that wants to exit the mall would most likely have to pay the new tenant millions of dollars as a subsidy because of the mall’s restrictions on what businesses can go into the mall. “So what’s the real value of that?” Leonard asked.

Davidowitz said if the investment community is pushing for the REIT, it won’t happen.

“It has to come from the company,” he said.

And that is probably especially true for Dillard’s, where the founding family gets to select eight of the 12 directors.