In the last issue I wrote about retail and made the point that retailers should stop being about “retail” and be about “brands” that are “exclusively” sold in their stores. 

To refresh, my point was that “retail” is merely a place – a location – where someone with branded (or unbranded) goods sells their wares to the public.
 
Retail is therefore a classic “middleman”.  And what does the internet do to “middlemen?”  It destroys them – or at least eviscerates their profit margins.
 
Retailers are trying everything possible to save themselves, which is admirable; however, I suspect most efforts will fail.  For example, the flavor of the month is for retailers to try to make the “experience” wonderful for their visiting customers.  Sorry – I just don’t see this.  Even if it is just so much fun to visit the new Widget Store, how many times are you going to go there for the “experience?”  Maybe twice and then it is just shopping and then you will care only about getting the brand you want at the lowest price.
 
However, I have another thought that may be a powerful one.  It may sound like just a twist of the dial in thinking, but sometimes rethinking the nature of the business you are in can be the catalyst for all sorts of unplanned upside.
 
Consider a major asset of what classic retailers have going for them?  They have locations!  And these locations are typically near people, i.e. customers.
 
Yes, the value of a “location” is in flux due to the technological disruption of the real estate world; however, location is still a critical factor and likely will be for some time to come.
 
So, pretend you are a classic “retailer.”  What should you do?
 
I would suggest you re-think your business and change your understanding of the “purpose of your business” from “retailing” to, instead, being “a distributor of branded goods!”
 
And I would add to that concept – if possible – a distributor of branded goods that are “exclusively” found in your store. 
 
Now this may sound like just semantics, but I think it is a lot more than that.  If you look at some of the most successful businesses, they succeed because of their distribution network. 
 
Indeed, this is part of Amazon’s magic.  Based on my thorough research – one click on Google – it appears that Amazon has about 100 “fulfillment centers” nationwide.  Sears/Kmart has I think about 1500 stores.  And many troubled retailers have networks with even more locations.
 
If (some) retailers rethink the purpose of their stores as essentially “fulfillment centers”, they may have a dramatic advantage – even over the likes of Amazon.  At this point I don’t see retailers thinking this way.  Meanwhile, Amazon keeps on increasing its fulfillment centers because Amazon is really in a lot of ways at heart just a distributor.  If no one wakes up to this it will soon be “game over” with Amazon winning.  But it really doesn’t have to be this way.
 
This re-thought business model – where a retailer’s many existing locations are essentially distribution outlets/fulfillment locations for branded goods – works neatly with:

  • The internet – i.e. the magic of having locations near people plus availability on the web.

  • The brands themselves – how many brands would make an exclusive deal with a retailer that has, say, 2000 stores near its customers nationwide?

  • Saving a fortune by not spending a ton of money on enhancing the shopping “experience”.  Instead of the experience, which costs a fortune and is incredibly hard to do in multiple locations – consider the much lower employee training time and cost for a fufillment location – all you do is put the stuff on a shelf in a “fulfillment” center and let the customer take it.

  • Saving a fortune with fewer employers.

  • Saving time and trouble with less focus on customer service and all the other accoutrements of classic “retail”. 

  • Indeed thinking this way, might just be a major relief to retailers struggling with all these problems how to make their stores “better” to compete with a third party in a world that may not care about that in the first place….

As you peel away the onion, I am sure there are a lot of other ideas that flow from this that I haven't thought of.

To sum up:  If you are a classic retailer, consider changing the essence and purpose of your business to be “Distributor of [Exclusive] Branded Goods”.         

Hearkening back to my Power Niche theme – if properly effectuated, this mode of thinking would take a retailer from a weak position to a Power Niche position.

Distressed Real Estate – Coming Soon?  Or is it here?   We have been seeing an uptick in distressed real estate matters of late.  It is too soon to tell if this is a trend, but if it is D&S is well-positioned to assist our clients.  We have a lengthy history representing clients in distressed real estate matters and prior to the financial crisis, we assembled a team of 60+ lawyers from our real estate, bankruptcy and litigation practice groups in order to form our Distressed Real Estate Practice Group.  At the time, it was one of the largest real estate workout/litigation groups in New York City.  The goal of the practice was to protect clients during the financial crisis while also helping them to capitalize on opportunities created by the shifting market.  Since that time, we have added our finance and tax practice groups to the mix, which has further bolstered our capabilities in this area.  Whether our clients are being victimized in a tough situation and need a strong and creative defense – or our clients are seeking to capitalize on a distressed opportunity and need skilled and creative advice – our Distressed Real Estate Practice Group is here to help.

Tax Reform Threatening Your Interest Deduction? Don’t Panic!

Tax reform proposals in Congress include denying the interest deduction, which has been a feature of the tax law for more than 100 years. Losing the deduction will boost the cost of financing commercial real estate, which has people worrying about the effect on real estate values.

Journalists know that bad news sells best: “If it bleeds, it leads.” But in this case, the fearmongering is unjustified.

The loss of the interest deduction would be far outweighed by other benefits in these same proposals. The most extraordinary benefit is the ability to deduct the entire cost of a building in the year it is bought. Think about it. Back in 1981, when Congress shortened the depreciation period to 15 years, it set off a real estate boom. Imagine what will happen if the entire cost can be written off at once. To be sure, Congress did not tamper with the interest deduction back then. But the interest deduction was far more important then, with interest rates in the double digits. At today’s low rates, the tax deduction matters less.

It is clear that the first-year write-off is a bigger deal than the interest deduction, because the economists working for Congress estimate that the first-year write off will cost the government $1.1 trillion over ten years, but the lost interest deduction will bring in less than half that in additional revenue. 

Moreover, tax lawyers and accountants are really good at thinking up ways to magnify the benefits of the first-year write-off:

  • Parties with tax losses can sell real estate to someone else who can use the write-off, and lease it back at a favorable rental rate that reflects the tax benefit.

  • Buildings subject to a long-term triple-net lease with a good credit can become “currency” to be traded among taxpayers, each of whom can buy enough each year to zero out their tax bill.

  • Taxpayers could buy buildings from schools and hospitals (who, being tax exempt, will incur no tax on the sale), and lease them back.

  • An exchange of properties can be structured to be tax-free under current law, but a taxable exchange could be even better, since each party will get capital gains on the sale but can write off the entire value of the new property against ordinary income.

There are also ways to mitigate the burden of losing the interest deduction:

  • On a purchase money mortgage, the parties can reduce the interest rate and increase the purchase price, thereby creating additional deductions out of thin air.

  • Positions in financial derivatives can be a substitute for borrowing; these can generate losses that are not treated as interest.

  • A partnership can replace borrowings with preferred equity that pays deductible “guaranteed payments” or provides a preferred return that draws away taxable income from the other partners.

  • Since the limitation only applies to interest deductions in excess of interest income, other transactions can be designed to characterize payments as interest income, particularly if the other party is not a US taxpaying entity and is therefore not sensitive to the loss of interest deductions.

All of this sounds too good to be true, and it no doubt is. The techniques listed above are well known in the tax community, and were even described by some eminent practitioners at a recent bar meeting in Washington that was attended by senior IRS and Treasury officials. Congress will have to do something to curb these techniques, since they would otherwise have the effect of nearly making paying taxes optional. But it is impossible to stamp out tax planning completely, and any restrictions will spawn more sophisticated tax avoidance techniques.

In the end, none of us knows what, if anything, Congress will do. In theory, they could kill the interest deduction without offering the first-year write-off, which really would be a disaster for real estate. But the political winds in Washington are blowing in the exact opposite direction: the Administration’s current preference is to keep the interest deduction while also providing the first-year write-off.

Moreover, any tax reform will have to be signed by the President. Whatever one thinks of his politics, one cannot deny that he has a well developed sense of self-interest: a final tax reform package is therefore unlikely to hurt the real estate sector. Real estate is a volatile asset class, and many things can affect real estate values; but tax reform should be low on anyone’s list of concerns.