What does a company do when it’s dug itself into considerable debt, yet still plans to somehow squeeze profits out for shareholders. One strategy is to spin off its more valuable real estate holdings into a REIT (real estate investment trust) that would cut its corporate tax and capitalize on demand for these investments.
The company in question in Sears and it’s considering a move to release nearly half (up to 300) of its 712 company-owned stores to form a REIT to raise some cash in anticipation of another quarter of significant losses.
It’s no secret that Sears has been struggling for years. Recently, the company warned that store sales were flat and the net loss could be north of $600 million. This, in addition to some $6.4 billion in losses over the last three years.
Sears isn’t the only one trying to boost cash on the books and save on taxes by forming a REIT. It’s been a growing trend among companies that aren’t in the real estate business that includes a private prison operator, casino owner, data centers, cell phone tower operators and most recently the telecommunications company Windstream.
The IRS regulations for forming a REIT are pretty involved but the upshot –and the attractive part for a company– is that the act of spinning off and forming the REIT is tax free. Then, as long as they earn most (75%) of their income from rent or sale of the real property and distributes 90% of the earnings to shareholders as dividends, it’s exempt from corporate tax.
Though some consider companies that spinoff REITs responsible for eroding the corporate tax base they also point out that its less controversial than an inversion such as the one explored by Burger King when the chain announced it would relocate its corporate HQ to Canada (and avoid the high price of U.S. taxes).
Sears has long recognized the potential value of its land holdings. In the aftermath of the recession, the company quietly set up a real estate portfolio under the name SHC Realty in 2010. The aim was to list closed stores for purchase or lease as well as in-store space in operating locations and land adjacent stores or in parking lots.
On the news of the spin off, the flagging company’s stock rose 31% to $42.81, its highest closing price since April, then fell again to $36.92 as of November 12.
There are no guarantees that a potential REIT would do more than save Sears some tax dollars. In fact, Barron’s reported that such a spinoff assumes that investors are focused on earnings-based valuation metrics and aren’t looking at leverage. That doesn’t always translate to sustainable returns and compares it to holding a big mortgage that doesn’t reflect the true market value of the home. Barron’s Vito Racanelli warned that a REIT spinoff of a retailer that has consistently negative cash flow “is a stretch.”
TheStreet’s Ratings team concurs. Advising investors to sell Sears’ stock, they say, “The company’s weaknesses can be seen in multiple areas, such as its deteriorating net income, generally high debt management risk, disappointing return on equity, poor profit margins and weak operating cash flow.”