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What developers and owners should know about the Kmart bankruptcy: A Q&A with shopping center attorney Gary Glick

With Kmart’s announcement today that it will close 284 stores as part of its Chapter 11 bankruptcy reorganization, Shopping Center World talked with Gary Glick, a partner at Los Angeles-based Cox, Castle & Nicholson LLP who frequently deals with shopping center developers and owners.

Glick urges developers and owners to become aware of their rights under the bankruptcy code in order to avoid making bad decisions about how to handle leases rejected by Kmart.

Some of the basics: Section 365 of the code allows a debtor-in-possession such as Kmart to assume or reject a lease. A landlord’s claim for prospective damages from a rejected lease is limited to one year’s rent or 15% of three years’ rent — and that claim is unsecured.

Glick says it’s important to note, however, that thanks to lobbying efforts by ICSC in the wake of the 1990s recession, the onus is now on the bankrupt retailer to decide -- in 60 days -- how it will handle its leases. The timetable had been totally up to judges, who sometimes left developers and owners in limbo for months. Glick also notes that many Kmart leases give the retailer the unrestricted right to assign the lease without the landlord’s consent, a potential pitfall.

SCW: Could you talk a little bit about some of the risks or challenges that developers and owners face as a result of the Kmart bankruptcy?

GG: If you’ve got Kmart in your shopping center, obviously you’ve got a significant risk at the moment. In some cases, Kmart will stay. In others, Kmart will leave. Or, in a kind of middle approach, Kmart might look to assign or sublet their premises. Some of that depends on whether they own or lease that site.

Now, if they own that site, you really don’t have a lot of control, because typically in those circumstances Kmart can close their store and in many cases the landlord will not have any remedies. There may be some circumstances where the developer may have negotiated a purchase right if Kmart goes dark within their shopping center even though Kmart owns their own property. But I think those are going to be few and far between.

The more typical approach is going to be that Kmart is going to potentially close their doors and then you're kind of stuck hoping that they go ahead and lease their premises to somebody that will be synergistic with the rest of your shopping center, or that they sell their parcel and somebody comes in that’s going to be synergistic with your shopping center, or potentially that you go and buy it.

SCW: What’s the feasibility of Kmart subletting to a Wal-Mart or a Target?

GG: Sure. I think that it’s very interesting because when these types of things happen there is a mad dash among the competitors to look at all the locations that might become available and to potentially pick them off.

There are only so many retailers that will typically look at a 125,000-sq.-ft. building or a building somewhat similar in size to that. These include Costco, Sam’s Club, Wal-Mart, Target and potentially Kohl’s. You also have some supermarkets that may be willing to retrofit the building, take half of it, and potentially try to lease the other half. So there are definitely a lot of retailers out there with keen interest.

Now the other situation is one in which you’ve got Kmart in your shopping center and Kmart is leasing that space. Typically in a bankruptcy the tenant debtor has 60 days to assume or reject all of their leases. That’s the norm.

It’s possible that a bankruptcy judge will give a debtor greater time to do that but the law is pretty strict because of the shopping center industry having lobbied for that type of provision, that they’ve got to make that election fairly quickly. So these landlords are faced with the possibility that if Kmart rejects their lease, it’s not the equivalent of a termination but it’s very similar.

What it basically means is that you get back the space. You’ve got a claim against Kmart. But your claim is limited by the bankruptcy code. By and large it’s limited to one year’s rent and is an unsecured claim, and you wait in line with all the other unsecured creditors and you’re probably going to get a small fraction of the money that is owed to you. You’re only entitled to one year’s rent which may in many cases be much less than what you need to retrofit the building and go out and re-lease it.

SCW: You’ve got your space back but it’s not exactly a good situation.

GG: No, not exactly the best situation to be in. Now, the alternative is that Kmart views the location as being valuable or the lease as being below market. So Kmart wants to realize that value. In that circumstance, what they’re going to be looking to do is to assume the lease. Now, if they’re going to operate from that location they’re going to assume the lease and they’re going to continue to pay rent.

They don’t have to operate unless there’s an operating covenant under their lease which is usually not the case, and in order to assume the lease they have to provide the creditor-landlord with reasonable assurances of performance. They also have to make up all of the prior defaults, so that would be something they would have to satisfy and they may also take the position that they want to assume and then immediately assign or sublet. And they can do that, but again they have to provide the landlord with reasonable assurances that they can continue to make the rental payments.

Plus, they have to come current, and then hopefully from Kmart’s standpoint they go out and they find a replacement. Now, from a shopping center developer’s standpoint, that can be scary because you don’t know who they’re going to put in there.

SCW: Seems like that scenario would apply to a fair number of Kmart stores.

GG: Exactly. So you could end up with a use that you’re not particularly happy with, although under the bankruptcy code they do need to meet certain minimal criteria. They do need to again provide adequate assurances that the rent is going to get paid. They cannot violate things like radius restrictions, exclusivity provisions, other types of provisions. And they generally need to assign or sublet to somebody who is going to use it for a use that is reasonably compatible with the tenant mix of the shopping center. Those things are provided by the bankruptcy code and they’re all things that the shopping center industry lobbied for over the last ten years or so.

The biggest thing is that with all this space coming on the market it does create a real negative impact on a lot of people because a lot of people have centers with Kmart in them. But at the same time it creates great opportunity for other developers who are creative and can make use of that space or for other retailers that can solidify their market share within certain areas.

SCW: I think Wal-Mart announced that it plans to expand by 50 million sq. ft. in 2002 alone. Granted, a lot of that expansion is supercenter conversion.

GG: They might not be large enough in most cases for a supercenter unless it’s a SuperKmart. But the demographics for these Kmart locations probably work better for Wal-Mart than for most. Typically in the industry people have not viewed the Kmart locations as being the best real estate locations around. They’ve got some good ones but by and large they haven’t done as good a job as Target or Kohl’s or Wal-Mart, so they definitely have a lot of secondary and tertiary locations.

Nonetheless, I don’t think it’s so negative for the real estate industry per se. Needless to say it’s always good I think to have competition, and the more competition you have the better things are. Kmart may get healthier as a result of this and in the long run they may prove to be better competition for Wal-Mart and Target. So that’s a potential positive.

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