It's the oldest adage in retailing: "How does one succeed in retail?" Location, location, location. In a retailer restructuring, an initial analysis of the quality (or lack of quality) of the debtor's store locations will typically provide interested parties a significant clue as to the ultimate outcome of the case. Despite amendments to §365 of the Bankruptcy Code designed to restrict the flexibility of a debtor retailer whose business is operated from leased locations, the primary advantage provided to bankrupt retailers is the ability to adjust its relationships with its landlords in a way that will make the debtor's restructuring plan more workable. In this article, we will explore some of the key indicia of quality in retail real estate and some of the techniques being utilized in and around chapter 11 to restructure or monetize real estate assets.

Quality: The Four-wall Analysis

When evaluating a retailer's real estate portfolio, the place to start is the four-wall analysis. This analysis first looks at the revenues generated at a particular location and the cost of the goods sold to generate that revenue, yielding a gross margin. From that calculation, the four-wall analysis then identifies the direct operating expenses associated with the location, usually on a 12-month rolling basis, together with such additional corporate expenses that may appropriately be allocated to the operation of the store. When those expenses are subtracted from the gross profit generated by that store, the analysis yields the direct-store contribution. Most retailers have a mix among stores that on a four-wall basis are positive contributors, break-even and non-contributors. Understanding the differences between store performances illuminates the metrics that will guide decisions around cash-flow strategy, asset deployment and returns on invested capital. Rational managers may determine that stores with negative contributions are nevertheless critical to the retailer's strategic plan because they provide critical mass and local market presence. Critical mass provides visibility and market share, and allows the retailer to leverage down the costs of things such as corporate overhead, advertising and, perhaps, purchases. The four-wall analysis provides a starting point in the analysis of the quality and value of a particular location that must then be layered on top of the retailer's restructuring plan in order to maximize the utility of this business tool.

Once the four-wall analysis has been undertaken, further analysis is required in order to understand what it is about a particular location that makes it a positive or negative contributor. There are many physical and financial factors that bear on the character and value of a retail location. Different retailers may place a premium on different aspects of a location's character depending on that retailer's concept and target market. In terms of physical characteristics, the big three are definitely "traffic," "visibility" and "access." Obviously, in order to succeed, a store needs customers. If the footsteps are already there, such as on a busy main street or well-situated mall, the retailer has the opportunity to turn those footsteps into sales. To do that, the retailer needs to be visible to the potential customer in order to convey its marketing message and bring that person into the store. Finally, barriers that might impede the decision to shop at the store must be eliminated. Parking, center-court locations and direct street access all contribute to customer access and enhance the value of a location.

Financial considerations are equally important. Here, the big three are "term," "rent" and "assignability." With respect to term, from the retailer's perspective, flexibility is the key. Flexibility comes in the form of options to extend the term or to shorten the term. In terms of rent, value is obtained when the rent and other charges associated with a lease are below market rents for comparable space. Assignability is really a two-fold analysis considered both in terms of legal limitations on assignment and practical ones. The modern trend in retail leasing is for the landlord to limit the tenant's ability to assign its interests under a lease to a third party. Practical limitations are imposed by the compatibility of the location's footprint with the footprint desired by potential assignees.

By undertaking a four-wall analysis and then digging deeper into the numbers to understand what it is about a store that makes it a positive or negative contributor, a retailer and its advisors can draw conclusions about the viability of its chain in general and of individual stores in particular. It can also help the retailer identify whether there exists (i) an opportunity to modify the way business is conducted at a store that can have a positive impact on the value of a store, (ii) the opportunity to modify lease terms in a way that will enhance the value of the store, and (iii) the opportunity to realize value from the assignment of the lease to a third party. Armed with this knowledge, the retailer can move ahead with transactions designed to create or enhance the value of its store locations.

The Creation or Enhancement of Leased Real Estate Value

As the foregoing discussion suggests, "value" is a relative term when used in connection with leased retail real estate. Hence, different cases will call for different solutions. The following discussion reflects some of the solutions currently under use or consideration by restructuring retailers.

Leveraging the Lease Portfolio. If a lease portfolio has value, it ought to be possible to use that value to secure advances from an asset-based lender. Outside of chapter 11, however, the opportunity to leverage leasehold interests is fairly marginal. The primary impediment is the difficulty in obtaining landlord consent to the assignment of the lease for security purposes and the cost and expense of filing and recording leasehold mortgages. These issues are somewhat mitigated when a financing order is granted under §364 of the Bankruptcy Code. Nevertheless, even in chapter 11 cases, most debtor-in-possession (DIP) lenders are unwilling to create a lending pool directly tied to leased real estate. They are more likely to take a security interest in the leased real estate as a backstop against a more aggressive advance rate tied to the retailer's inventory.

Renegotiating Lease Terms. The four-wall analysis may suggest that a marginal store or a store making a negative contribution could be made a positive contributor if relief could be obtained with respect to certain key terms of the lease. Examples of terms that might be subject to renegotiation might be base rent, financing for tenant improvements, or reconfiguration of the location into a more efficient space. Depending on the attractiveness of the store concept within its location, the number of locations leased by the retailer from the same landlord, or the comfort or lack of comfort that the landlord may have concerning its ability to re-let a store, the threat, express or implied, that a retail tenant may seek to reject or assign its interests under a lease may provide the tenant sufficient leverage to renegotiate the terms of its lease. Third-party firms exist that are willing to work with retailers and their landlords to facilitate these negotiations. Assuming a willingness on the part of the landlord to negotiate, the challenge for both parties is providing the landlord the comfort that the tenant will live up to its bargain.

Sale or Assignment of Leases. One person's liability may be another's asset. Even with the limitations imposed by §365(b)(3) of the Bankruptcy Code on the assignment of shopping-center leases, a retail debtor has the opportunity to profit from the sale of its leasehold interests. Most typically, leases will have value to a third party when they have below-market rents. Additionally, leases may have strategic value when they provide another retailer instant access to coveted locations or market share. This strategic value is most often going to be realized where the opportunity exists to bundle multiple locations in a contiguous geographic area. The importance of bundling transactions is likely to increase as struggling retailers increasingly "mortgage" substantially all of their leveragable assets, leaving only their real estate as a source of recovery for pre- and post-petition unsecured creditors in the event of a liquidation. There are many challenges facing a debtor trying to put together transactions of this sort. Marketing periods vary, and the analysis of whether it makes economic sense to carry a lease during that period is often rife with uncertainty. During the marketing period, the retailer must bear both the direct carrying costs associated with the lease and the indirect costs in terms of management distraction around an asset that is no longer core to the restructuring plan.

Designation Rights. In an effort to address the uncertainties, distractions and expenses associated with efforts to market leased properties, restructuring professionals have developed the concept of lease "designation rights." Although designation rights agreements take many forms, the basic thrust of such agreements is that the debtor conveys to a third party the right to act as the agent of the debtor's estate in connection with the decision to assume and assign or reject the debtor's leasehold interests. In return, the debtor typically receives an up-front payment, is relieved of the carrying costs associated with the leases subject to the designation rights agreement, and has the opportunity to receive additional consideration on the back end of the deal in the event that certain minimum revenue targets are achieved. Designation-rights deals bring immediate liquidity to the estate while eliminating management distraction around non-core assets during the lease marketing period.

Rejection Agreements. When all else fails, there may still be the opportunity to cut a lease rejection agreement with a landlord interested in reclaiming control over its space against a backdrop where there is the risk of continued delay or assignment to a third party. Although in some cases the debtor may be able to achieve a payment for its agreement to reject a lease, in most the rejection agreement will be based on the waiver of the landlord's claims against the estate.

Every store in a retail chain ties up assets, requires management time and attention and speaks to the public about who and what the retailer is all about. Too often, retail restructurings are handicapped by a commitment to locations that make a negative contribution and that do not further the strategic goals of the restructuring. This causes a diversion of precious financial, human and marketing capital and ultimately dooms many retail restructurings. The real estate solutions discussed here provide the tools to turn liabilities into assets and the opportunity to achieve a successful restructuring result.