Toys R Us Bankruptcy Provides a Different Way of Investing in Real Estate

Investors have a lot of ways to make money in real estate.

The simplest is buying a property, collecting rent for a while and hopefully selling it later for a gain.

But when big-box retailers such as Toys R Us file for bankruptcy protection, other paths for real estate investment emerge.

Last year, Petaluma, California-based furniture chain Scandinavian Designs bought a lease to use the ground under a Toys R Us store in Dothan, Alabama, for $150,000. The deal effectively gave it ownership of the building, which It then subleased to a thrift store in July.

Tallahassee, Florida-based NAI Talcor confirmed that America’s Thrift Stores, which has 20 locations in the Southeast, would be filling the space.

Buying the ground lease allowed the furniture retailer to gain control of the property for 33 years without ever owning the real estate. That’s the term left on the lease, according Raider Hill Advisors, the New York firm handling the disposition of hundreds Toys R Us properties.

With a ground lease, a tenant typically builds the structure on top of the dirt. The lease usually comes with an initial number of years, sometimes as long as 20 years, with options to renew for several years at a time.

Often, these ground leases are also net leases in which the tenant pays most if not all of the property’s expenses: insurance, taxes and maintenance. The owner simply collects a rent check.

If the tenant decides against renewing, the owner of the ground then gets the building.

Ground leases are popular among fast food chains. An investor can own Burger King real estate without owning the business.

But buying and selling leases isn’t often an investment option.

“You don’t see many come up for sale” unless there’s a bankruptcy or mass store closings, said Barry Wolfe, a senior director with Marcus Millichap’s national retail group.

When Toys R Us filed for bankruptcy protection last year, it put nearly 800 Toys R Us and Babies R Us leased or owned properties on the market. The company has been selling off leases and properties over the past year.

Toys R Us is hardly alone. Payless ShoeSource and Shopko have been selling off property and leases as well. Dressbarn announced recently that it’s closing all stores, a move that put 674 leases on the market.

When the leases appear for sale, determining their value becomes a big question. Creating value in a property is pretty straightforward: buy land, build something and rent it out.

“Creating value in a ground lease is more labor intensive and challenging,” said Bill Read, executive vice president with Birmingham, Alabama-based Retail Specialists. “It’s not for everybody.”

Typically, the value is based on rent that would be paid over the years left on the lease. Then it’s a matter of looking at the lease’s rental rate compared to the going market rate.

Real estate brokers said the buyers of those leases tend to either have their eye on using the property for expansion or they think they can sublet the property for more. “They make money on the spread,” Wolfe said.

If the rent is close to the market rate, Read said buying wouldn’t be worth it. A lot of the Toys R Us leases, however, tend to be far below market, brokers said, particularly those at older locations.

Read, who has been tracking Toy R Us properties over the past year, said, based on his research, Toys R Us has sold about $61 million in ground leases alone.

Most of the buyers have been furniture stores and discount retailers seeking to get below-market rents on great locations they couldn’t justify financially otherwise.

Scandinavian Designs has been one of the most active buyers. According to bankruptcy court records, it has bought 17 leases at various sums. The highest it paid is $1.9 million for a lease in San Rafael, California, about a mile from its existing store in the city.

In some cases, the furniture retailer is taking the space itself. In Sioux Falls, South Dakota, earlier this year it opened a location in a former Toys R Us store that has a ground lease. According to court records, Scandinavian Designs paid $200,000 for that lease.

The retailer is also opening a store in Phoenix in a location that is on a ground lease it bought for $350,000. Another store set to open in the Phoenix area is going into one of the 15 properties Scandinavian Designs bought outright.

Scandinavian Designs didn’t respond to a request for comment on plans for other leases and properties it owns. But Meridian Commercial, a real estate firm based in San Rafael that has represented the retailer’s founding family in the past, has listings on some of its properties.

For example, the firm has listed one in Waldorf, Maryland, that the retailer won with a $300,000 bid for the ground lease, beating discount retailer Big Lots, according to court documents.

While a lot of leases have been sold, there’s still more to go. Based on the store closings of big-box chains, it could be a while before all of the Toys R Us stores completely disappear.

“There are still empty hhgregg stores around,” Read said, referring to an electronics and appliance chain that closed all 220 stores two years ago after filing for bankruptcy protection.