Gone but not forgotten

It is one of the pundits' pet themes: the demise of British retailer Woolworths -- founded 99 years ago in Liverpool by American variety store pioneer Franklin Winfield Woolworth and then embellished with that very British "s" that transforms Samuel Smith's firm into Smiths Group plc and Barclay & Co. Ltd. into Barclays plc -- has come to symbolize the dangers and evils of sale-and-leaseback deals. That shouldn't come as a surprise. The immediate cause of Woolies' slide into bankruptcy administration was its inability to pay the rent on its stores. Even if the underlying reason was a business model gone bad, the opportunity to point an accusatory finger at greedy executives and property barons was too good be missed.

In the background was Woolworths Group plc's 2001 demerger from Kingfisher plc. The transaction included a sale-and-leaseback deal for 182 of the retailer's 800-plus stores, raising £614 million ($903 million) for Kingfisher but committing Woolworths to 25-year leases with a minimum annual increase in rent of 2.5%. Sure, customers weren't as interested in the chain's mixture of candies, children's clothes, stationery, kitchen appliances and pop music videos as they once had been. Much of that could now be had just as cheaply in more brightly lit, modern supermarkets during the family's weekly shop. But Woolworths was too boxed in by its rental payments to invest in adjustment to the new retail environment.

There are other cautionary tales. Sheltered accommodation group Southern Cross Healthcare Group plc, formerly owned by private equity firm Blackstone Group LP and, before that, West Private Equity, had learned to finance growth by selling and leasing back its newly acquired homes. That model worked well while the property markets were sizzling. But the company ran into trouble earlier this year, when it failed to sell new assets to meet debt repayment deadlines. Eventually, it secured a refinancing with its banking syndicate, surprising the markets and revitalizing the business. But it was a close shave.

Perhaps most dramatic of all is the case of Debenhams plc, a department store taken private in 2003 by CVC Capital Partners Ltd., Texas Pacific Group and Merrill Lynch Global Private Equity, provided great returns to the private equity owners but refloated two years later with a debt burden 9 times what it had been before the buyout and, crucially, minus 23 freehold properties that it now paid rent to occupy. Critics at the time said Debenhams was selling the family silver. In October, it halved its dividend after year-end profits fell 16%, to £110.1 million, though of course it's a tough market for all retailers.

It is tempting to draw the obvious conclusion. J Sainsbury plc, Britain's No 3. supermarket chain, got it right last year, when it saw off two multibillion-pound offers and steadfastly refused to allow any funding structure that would finance itself from the sale of its property portfolio. No doubt, with the property market in turmoil, both Sainsbury's own board and its potential buyers are now breathing easier as a result.

But let's not get too carried away. For most companies, property deals made sense. Until the disappearance of securitization and asset-based finance and the onset of the credit crunch, it was cheaper to borrow against property than to raise a corporate loan. Supermarkets like Sainsbury have also preferred to have control over their property because it allows for more flexible expansion and rebuilding. But selling, rather than mortgaging, can provide immediate cash without building up debt. Tesco plc, Sainsbury and others have sold mature properties on a case-by-case basis and may now be tempted to reduce their land banks because of changes in the regulatory environment. Many of the most successful retailers have traditionally rented their outlets and have not seen themselves as property companies at all.

As Woolworths' problems have shown and as its new CEO Steve Johnson well understands, rents must be set at a sustainable level. And sustainability has to leave considerable headroom to allow for a severe downturn in revenue and demand. In Britain, at least, where 25-year commercial leases are common and rates are fixed for five years at a time, rent is as much a fixed cost as debt -- and often tougher to redeem. Companies tied to burdensome leases, like those that are overleveraged by private equity owners, will be those that now struggle to survive.