Seritage Growth Properties

I made an investment in Seritage Growth Properties (SRG) at a prices averaging $39.84 per share as the earnings of the company are poised to increase substantially over the coming years. Further, being a REIT, such earnings will be distributed to owners.

SRG was formed as a spin-off (effected via a rights offering) from Sears Holdings (SHLD) in July 2015. As a part of the transaction, SRG purchased 235 properties from SHLD and leased 224 of them back to SHLD at rents approximating $4 per square foot under a Master Lease. The remaining 11 have non-SHLD tenants. Further, SRG purchased from SHLD its 50% interests in three JVs (GGP-JV, MAC-JV, SPG-JV) for $430 mm. These JVs represent 31 properties and are managed by General Growth Properties, Macerich, and Simon Properties Group respectively. The total purchase price paid by SRG was $2.7 billion.

The 235 wholly owned properties are divided into Type I, Type II, and Type III properties. The Master Lease allows for SRG to “recapture” (i.e. move Sears out) up to 100% of the space in Type I properties, 50% of the space in Type II properties, and 100% of any Sears Auto Centers. SRG can then re-develop and lease them to new tenants at higher rent. This is the expected source of increased earnings.

The JV Master Lease is similar to the SRG Master Lease and allows the JVs to re-capture up to 50% of the space in the stores and all of the space in the auto centers.

Current lease income:

Under the Master Lease, SHLD will pay annual rent of about $140 million as of the time of separation and further reduced as spaces are re-captured. Additionally, third party tenants that had already signed and begun their leases at separation were paying an additional $16 million, giving a total of $156 million in initial cash rent. Against this are expenses of approximately $20 million for G&A and $58 million for interest, giving a net cash inflow of $78 million before considering the JVs.

Opportunity to increase rents:

The properties currently occupied by SHLD are either freestanding locations or mall anchors. The redevelopment of each property will take a different form. But the increase in earnings generated from re-tenanting should follow the formula: new rent less old rent and development costs. Development costs will most likely be borrowed and, hence, the development expense will show up as interest expense and principal repayments. The leases are similar to triple-net leases and while G&A will go up, large increases won’t be needed.

Third party in-place rent averaged about $11-12 per square foot at inception. It’s impossible at this point to know what the average per square foot rent on re-tenanting will be as that depends on the type of tenant, size of the space, etc. However, it’s easy to see that the spread can be quite substantially simply because $4 per square foot paid by SHLD is too low. Surveys by CBRE and 10-Ks of other REITs routinely show anchor rents in Class A malls of $12-25 and even in Class B malls of $9-12 per square foot. In fact, the leases signed with the three JVs referenced above have an average rent of $8-10 per square foot and the JVs expect to redevelop the space to revise the rent further upward. Also, free-standing spaces (e.g. Thousand Oaks, CA) and mall spaces (e.g. King of Prussia Mall, PA) are being divided to house multiple tenants which allows for higher rent per square foot as smaller spaces garner higher per square foot rent.

With the advent of online shopping, retail space has come under pressure as corroborated by Macy’s and other retailers shutting down stores to reduce their physical footprint. However, it doesn’t appear to be as bad as the news might suggest. Retailers appear to need some physical presence combined with a substantial online presence. This is demonstrated by online-only retailers such as Warby Parker, Bonobos, and even Amazon opening up physical stores as physical presence remains a need for brand building, accepting returns, facilitating quick deliveries for online orders, and trying out new products. However, the space needed for these purposes has increased demand for the best properties and away from the mediocre properties, which has been reflected in the results shown by Class A mall owners v/s Class B & C owners. Class A rents continue to move up, further helped by a lack of development of new malls since the Great Recession, and the physically impossibility of building new retail space in some densely populated high traffic areas (for e.g. Santa Monica, Beverly Hills, etc.). What this means for our analysis is that we should bifurcate and analyze “good” and “okay” properties separately. A lot of the good space is located in Type I properties, though Type II also has many good properties.

There is approximately 3.9 million square feet of Type I space. In the recent quarter filed by the company, new leases were signed predominantly in Type I space (Braintree, MA, Memphis, TN Honolulu, HI) and a one auto center (San Antonio, TX) in a Type II property. The rent achieved on the leases signed for this space were approximately $30 compared to $6 that the company was getting from SHLD, i.e. a “lease spread” of $24. Prior to the separation, leases were also signed for the anchor pad at King of Prussia mall, which was re-tenanted with Dick’s Sporting Goods and Primark achieving a rent of $25 per square foot. The fact that the company chose to start redeveloping the Type I and auto centers first supports our thesis that these contain more “spread” than the others. If the 3.9 million of Type I space garners a rent of $25 (i.e. $21 lease spread), the top line growth from this source alone could be $82 million.

Further, auto-centers are particularly attractive as they can be redeveloped for use by small retailers, fast-food chains, and such other companies. The Sears Auto Centers are located in highly trafficked areas of the shopping centers/mall, with easy street access which also makes it attractive to chains operating drive through outlets. In retail, jewelers and fast-food/cast-casual (whether inline or free-standing) pay some of the highest per square foot rents as they have high per-square foot sales compared to, say, apparel retailers. Current leases for auto-centers have been executed with Jared’s Jeweler, Outback Steakhouse, Chipotle, Smash burger, Applebees, REI, etc. The auto-center in Carson, CA was signed up at leases averaging $45 per square foot. It’s not known separately what rent SHLD pays for the auto centers, but if the payment is comparable to other spaces around $4, this equates to a spread of $41 for the Carson location. Auto centers like the one in King of Prussia mall will provide higher rents but some others may provide lower rents. Even if average rents of $40 (i.e. spread of $36) were achieved on 3.6 million of auto-center space, total top line contribution would be $130 million.

Development potential also resides in Type II properties. Type II properties are a mix of malls with some great properties (such as Westfield UTC, San Diego), many mediocre properties, and some terrible properties. How much SRG will earn from these properties is unclear as some of them may have to be sold, and others could be re-tenanted and the rent would depend on the type of redevelopment and tenant. The space is a mix of mall and free-standing space. If one were to conservatively estimate that if even 70% of the 50% “re-capturable” square footage of 13.8 million square feet (50% times 36.6 million total less 3.9 million Type I, 1.5 million Type III, and 3.6 million auto center) could be re-tenanted at $12 per square foot (which would be in line with Class B space and below SRG’s disclosed leases), additional top line rent would be $80 million.

At the time of the separation, the company had noted that the rental income would increase $15 mm each year for the first two years following the separation due to re-tenanting for SNO leases as of that time. The company appears well on its way to achieving this, based on recent disclosures.
Living in Los Angeles, I have had the opportunity to visit some of the Southern California properties owned by SRG to check them out and I’m satisfied that the redevelopment plans as envisioned by the company are reasonable.

Cost of redevelopment:

Retail redevelopment costs can range anywhere from $100 per square-foot for smaller projects to $300 per square-foot for a complete rebuild and even up to $1000 per square foot in areas where construction is more difficult and expensive. Generally it tends to be $100 to $250 per square foot, though construction costs have gone up recently. For SRG’s completed and announced projects, the costs have run around $150 per square foot for the high-density areas. They could be lesser in other areas, particularly with larger free-standing stores. Assuming a cost of $150 per square foot for the auto centers and Type I properties and $100 per square foot for the Type II properties, for the 21.3 mm square feet of space noted above, this would equate to a total cost of $2.1 billion, though this outlay won’t be required all at once. Currently SRG has $250 million of liquidity, which should suffice for the near term development projects without needing equity issuances. As projects are delivered and cash flow increases, a portion of the projects could be funded internally and pre-leased projects could be funded with development loans. Though it’s difficult to say how much equity issuance will be needed in the future, the controlling shareholders and management own enough stock that they could be expected to be parsimonious in this regard.

Equity Accounted JVs:

The three JVs taken together control about 5.4 mm square feet of space, of which 5.1 mm is leased to SHLD. The JV malls are of high quality, evidenced by high average sales per square foot for these properties in their in-line stores. The JV partners manage the operations of the JV and are owed a management fee approximating 4% of rental revenues. The SHLD rent, at inception, was set at $42.3 mm per year or $8.2 per square foot and could be re-tenanted at $12 to $25 per square foot. As an example, the King of Prussia Mall which does greater than $700 per square foot in sales was re-tenanted with a Primark and Dick’s Sporting Goods yielding a rent of $25 per square foot. There are several malls in the JVs that achieve a comparable or higher level of sales per square foot and, thus, could obtain similar rental levels. Using $25 per square foot (same as our Type I property assumption), the lease spread would be $17 per square foot, giving a top line addition of $43.4 mm. Thus total JV rental revenue (net of reimbursable property operating expenses) is calculated as $42.3 million + Current Third Party Rent (not known precisely but probably approximates $4mm) + $43.4 million = $89.7 million.

Against this are expenses of 4% for management fee, or $3.6 million, and any redevelopment costs. At $150 per square foot at 2.55 million square feet, the cost is about $382.5 million. Currently the JVs do not have any debt at all and, thus, could certainly support a portion of this amount as development gets going. Interest at 5.25% on $382.5 million of debt equals $20 million, giving total income of about $66 million. Half of this, or $33 million, would be attributable to SRG.

Valuation:

Adding it all together, a fully-developed SRG may look something like below. Note that exact development of events is unknown but reasonable assumptions show significant preponderance of value over price. The company may take a different route which may realize more value, but I believe the below serves as at least the lower bound for valuation.

Additionally, two sources of value are potentially present but are not included in calculated value:

Outside of the current GLA, SRG owns very significant land and outparcels which can be redeveloped for non-retail use, including mixed-use properties. The company has noted this possibility in its prospectus and entitlement for one project is underway, though this will be much further down the road than some of the retail re-tenanting opportunities. The total acreage owned (including the GLA noted above) is approximately 3000 acres. Excluding such GLA, the acreage would equal about 2100 acres, though some of this is used for parking, etc. and may not be available for redevelopment. Some (but certainly not all) of this acreage is located in very desirable areas. Evidence was provided by the sale of a 5.3 acre Sears property (not sold by SRG but by another owner) in Hollywood for $43.5 million, or $8.2 million per acre. Large land holdings like the 34 acres in Braintree, MA could be worth significant amount, but exactly how much is difficult to say as a lot depends on zoning, financing environment, timing of sale, etc. It’s not easy to move large real estate lots quickly. No value is being ascribed to this in our valuation, but perhaps there’s potential, particularly in acreage around free-standing stores. Such value could range from ‘a little’ to ‘a lot’.

SHLD has the option to “put” to SRG any stores that have rents higher than EBITDAR, subject to the limitation that rent under the master lease may not be reduced by more than 20% in any given year. As of the separation date, 59 stores qualified for the put. While a large number of stores coming in at once is certainly a risk, this may also allow SRG to obtain more real estate than could otherwise be obtained under the 50% re-capture provision of Type II stores. Thus, more space could be re-tenanted at a higher rent, if and when appropriate.

Additionally, I have not shown rent escalation above which would add some (but not a lot) annual income.

Risks:

SHLD bankruptcy: SHLD has been performing poorly for some time. However, near term maturities have been handled and a bankruptcy doesn’t look plausible in 2016 and perhaps even 2017, though it cannot be completely ruled out. SHLD has further assets to divest to keep the retail operation afloat for longer as has been done in the last few years.

Bankruptcy of SHLD and a rejection of the Master Lease would certainly have a very adverse near-term effect on SRG as it relies on SHLD for a majority of its income. However, being a unitary lease, SHLD is unlikely to reject it under Chapter 11 as it would need the leased properties to re-organize as a retailer. The below-market rent of the leases is in fact a benefit to SHLD which it may find worth keeping in a reorganization. A re-organization may even benefit SRG in the long run as more properties become available quickly without having to pay the amounts due on providing re-capture notices.

While a SHLD bankruptcy or the exercise of the property put by SHLD would subject SRG to some trouble in the short run, third party leases are being signed at a rapid rate and it’s probably that within the next few years, third party rent income should be enough to pay the operating expenses of SRG.

Fraudulent Conveyance: If SHLD were to file bankruptcy, the court may deem the SRG separation a fraudulent conveyance (similar to the Tronox/Kerr-McGee/Anadarko litigation) and have the transaction reversed. In this case, theoretically, the shareholders would get value equaling $29.58 per share. Practically speaking, SHLD will likely not pay this amount to buy SRG back. Rather, SRG would owe some monetary value to SHLD’s bankruptcy estate. Given a purchase price of $39.84, the potential loss under this scenario can be approximated as $10.26.

Competing space available: Recently several retailers, including Macy’s, have announced store closures and their troubles may flood the market with more retail space which competes with SRG pushing down leasing rates.

Please note:

Under NO circumstances should any content or communication here be construed as investment advice or a recommendation to buy or sell any security, whether expressed or implied. Factual statements are believed to be truthful and reliable, but are not warranted against errors or omissions. PLEASE do your own due diligence prior to investing.