The Real Deal New York

Risky retail plan finds footing

Zara and Swatch new store deals boon for investors at 666 Fifth's retail condo, but it's been a white-knuckled ride
By Adam Pincus | April 01, 2011 10:00PM

A rendering of the retail condo at 666 Fifth Avenue, where Zara, Hollister, Swatch and Uniqlo have all taken space

The notion of a $1 billion retail blockfront on Fifth Avenue seems like a pipe dream from the boom times. But it may yet happen.

The record-setting purchase last month of a slice of the retail space at 666 Fifth Avenue by the parent company of Spanish clothing store Zara looks to be the tonic needed to get the once-wobbly investment by the Carlyle Group, Crown Acquisitions and Kushner Companies into the black. But it has been a turbulent road for the investment trio.

In 2008, buoyed by a top-of-the-market lease from Abercrombie & Fitch, they paid $525 million for an 89,000-square-foot retail condo at the base of the 41-story office tower, located between 52nd and 53rd streets.

Then the market tanked, and the investors couldn’t find another prime retailer for almost two years — leaving them on the hook for more in expenses than they were taking in.

This month The Real Deal takes a behind-the-scenes look at just how much the downturn hurt the investment group in the two years they were unable to find a blockbuster tenant (click here or scroll down to see accompanying chart). “[We went through] dark days in 2008, when a lot of retailers were coming to try and pick our bones,” one owner said. “They said, ‘We’ll give you 10 million bucks a year.’ We said, ‘No, we’ll wait another six months.'”

It seems their patience to better that $10 million low mark paid off.

Late last month, Swiss watchmaker Swatch inked an $80 million, 15-year lease for the last 2,000 square feet in the retail portion owned by the investment group, prompting the New York Post to herald the sale and leasing effort as “one of the most remarkable retail repositionings in the city’s history.”

That deal came just weeks after Inditex, the parent company of Spanish fast-fashion chain Zara, agreed to pay $324 million for the prime 39,000-square-foot retail space formerly occupied by the NBA’s retail store. Inditex bought the property as a condo — taking nearly half of the trio’s stake, but only about a third of the prized ground-floor space. At $8,300 per square foot, it was the highest price ever paid for any commercial property larger than 10,000 square feet in New York, Real Capital Analytics data shows.

Yet even with those two deals making headlines, about $250 million in expenses indicate the goalpost for the investment group to profit was farther than it appeared to the New York City real estate community.

And while it seems the retail portion of 666 Fifth is in the clear, the office portion upstairs is still in financial straits. Jared Kushner, CEO of Kushner Companies, was actively negotiating with lenders last month to get a reduction in interest payments in exchange for his company putting more cash in the building, the Wall Street Journal reported.

The question of just how profitable the original retail condo purchase ends up being for each member of the investment trio is not just a parlor game for nosy brokers. How valuable the retail condo is ultimately perceived to be is critical for determining values at other retail sites on this high-profile stretch of Fifth Avenue.

Mounting expenses

Just a year after the Kushner Companies’ January 2007 purchase of 666 Fifth for $1.8 billion — then the most ever paid for an office building — it was in contract to sell the retail condo. The thought was that the building’s retail space, which was generating about $15 million in rent a year, could be making $50 million off the space. Assuming a 5 percent capitalization rate, that would make the retail alone worth $1 billion.

The deal was structured with Kushner remaining the majority owner with a 51 percent stake of the condo. The balance is held by Carlyle, a global money-management firm based in Washington, D.C., which is the controlling partner and put in the most capital, and Crown, the retail firm led in this deal by Haim Chera that put in only a small fraction of the cash but stands to profit once the property is sold. Kushner and Chera declined to comment for this article. Carlyle, meanwhile, called the condo a “superb investment.”

Even before the sale of the retail condo closed, the trio of investors immediately went on the hunt to replace the low-paying, in-place tenants of Brooks Brothers, NBA and Hickey Freeman, who were paying about $600 to $700 per foot on the ground floor, where a new tenant would pay about triple that.

In January 2008, Kushner finalized the terms of a $47 million buyout of the Brooks Brothers lease — which had six years and an option remaining — over lunches at Cipriani in Grand Central Terminal with the retailer’s CEO, Claudio Del Vecchio.

Then, before finalizing the condo purchase, the investors locked in Abercrombie & Fitch. The apparel company, represented by retail broker Laura Pomerantz, a principal of PBS Real Estate, signed up to pay $15 million per year for 20,000 square feet in the 53rd Street corner space occupied by Brooks Brothers.

With lease in hand, the investors attracted the interest of SL Green Realty, the aggressive real estate investment trust, which provided a $135 million mezzanine loan. The REIT charged a hefty 15 percent interest rate, or about $20 million per year.

“SL Green thought [it] was getting the keys,” said one real estate insider. Barclays provided another $325 million first mortgage, costing about $16 million per year.

That left the investors to cover the equity portion of about $65 million on the $525 million price tag. But additional costs quickly began to mount. The group poured in more cash for tenants’ buyout interest, commissions and other expenses, totaling just over $250 million, according to an analysis by The Real Deal.

In January 2009, Brooks Brothers moved out. In June, the owners shelled out $12 million to remove another tenant, the men’s clothing store Hickey Freeman. And that same month, they announced that Abercrombie would relinquish its corner space, and instead take the slightly larger mid-block 21,700-square-foot space, paying the same rent. But there was a catch. The critical ground-floor space was 1,200 square feet smaller, and it was off the corner. A corner carries a 15 percent premium, insiders say.

To induce Abercrombie to move, the landlord paid them about $20 million, sources said. Some insiders say that fee was later repaid in additional rent over the next year, but others dispute that. (Hollister, a division of Abercrombie, opened in November 2010.)

But all the while, the trio, represented by Cushman & Wakefield’s Bradley Mendelson, was talking to Japanese retailer Uniqlo, Top Shop, Forever 21 and Victoria’s Secret about the corner spot occupied by Brooks Brothers, anxious to sign a deal, sources said. Even discount clothing retailer Daffy’s was looking at the property, court documents show.

Then they got the big break. In April 2010, Uniqlo inked a $300 million, 15-year deal for 89,000 square feet, taking all of Brooks Brothers’ corner spot, plus 60,000 square feet of office space on the third floor. (After about a year of free rent, Uniqlo cut its first rent check in March.) It’s paying roughly $17 million a year, with about $13.7 million going to the condo owners, and the balance going to the office portion of the building.

On and off the market

Once Uniqlo was locked in, the investment trio did not waste any time putting the Hollister and Uniqlo portion of the retail condo on the market, sensing that with the large leases in place, it would be attractive to a potential buyer.

They listed it with Eastdil Secured in April 2010, expecting to get $600 million to $700 million. But the property languished on the market.

Some critics said the condo offering was ironically being hurt by the Abercrombie lease. The problem was counterintuitive. Because the investment trio scored such a high price for the lease at the top of the market, they made it too difficult for a new owner to further increase the value of the space. In addition, large tax increases for the entire condo that are paid by the current tenants will eventually rise to $8 million a year, a cost a new owner will have to consider when the leases expire.

But last month, Inditex, represented by Savills, closed on its purchase of the NBA space. At the same time, the ownership trio officially pulled the Hollister/Uniqlo condo off the market, and instead refinanced it, paying off the Barclays and SL Green loans and taking out a $300 million first mortgage from Morgan Stanley.

“The sigh of relief that was brought on by locking in a profit and creating so much value in a difficult market was causing everyone to be euphoric [at the closing],” one insider said.

That sale was seen as a coup for the owners, who were represented by Eastdil’s Doug Harmon, leading some retail brokers to question why Inditex agreed to the deal. Indeed, insiders speculate the retailer will have to sell about $50 million a year at the location to justify its cost, and could face its own annual tax bill of $2.5 million.

Finding profit in the deal

For a private transaction like this, it’s difficult to uncover how the cash was laid out, and thus, to learn who stands to profit the most.

Generally the entities that provide the cash are paid back first, and receive a percentage return on that capital, before the final profits are divided up. An entity like Crown in such a deal, which provided very little money, sees its share of the profits in the so-called promote. That gives them a share of profits after the investors have made a certain return on their capital, often 10 percent to 15 percent.

Sources close to the owners say all but $14 million in equity is out of the deal, but an analysis by The Real Deal indicates that nearly $75 million still remains. Regardless, the investors only have $300 million from their Morgan Stanley mortgage left in debt. Plus, there’s an ongoing positive cash flow (after interest payments) of about $15 million per year coming from tenants. So, any sale of the rest of the condo priced above the remaining equity and debt is pure profit.

Christopher Ullman, a spokesperson for Carlyle, said the investment is “one we’d be happy to own forever.”

“Most of the equity has now been returned to our investors and the remaining is receiving high current cash returns,” he said.

But the real money is in the sale of the condo. Few doubt the remaining slice will sell for less than $600 million (though there are some skeptics). The net operating income, set at $30 million in the 2010 offering plan, would give the condo a price of $600 million, using a cap rate of 5 percent.

But some insiders say the net income is actually $35 million, which would generate a price of $700 million with that same 5 percent cap rate. The bump in income, one source explained, came from an increase in the property taxes at the building that counterintuitively put more money into ownership’s hands.

Jeff Fishman, an investment sales broker at Robert K. Futterman & Associates, who was not involved in the condo deal, said the value of the property was driven by its location and its long-term leases, including Abercrombie’s. “If it is perceived above market, then that will cause a higher cap rate, but notwithstanding that, you are talking about a condo on the top three-block stretch of Fifth Avenue. You are not going to see a cap rate approaching 6 percent in that kind of market,” he said.

The remaining condo portion is off the market for now, as the owners enjoy their newly profitable venture. “We have $35 million of [net operating income]. There is no chance in hell that it will sell for less than $700 million,” an owner source said.

Add that to the $324 million that Inditex paid, and there’s your billion.

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