Seritage Growth Properties Stock (SRG) is a Retail REIT focused on creating substantial value through the redevelopment of single-tenant buildings into first-class, multi-tenant shopping centers at meaningfully higher rents.
The crux of Seritage’s strategy is to convert its legacy Sears leases ($5 PSF) into market-rate leases ($20 PSF) over time as Sears winds down its operations.
Is Seritage Growth Properties Stock Undervalued?
Yes, it is because:
(i) It is unconventional in the sense they are feeding their development through temporary asset sales from the large land banks
(ii)They are in the midst of a transition from retail to residential and other mixed uses which becomes difficult to value as traditional metrics don’t apply
(iii) Average population density around SRG’s properties is 650,000 within 10 miles with an average household income of $90,000
(iv) Retail is transforming and not dying as shoppers continue to prefer to check the size before they buy
(v) SRG is in the sweet spot of development where they can choose to develop communities that meet future demand and lease them to tenants that have survived a pandemic and have a sustainable future. Moreover, its premier real estate will eventually become 40% of the overall portfolio.
The value creation, as well as risks, revolve around SRG’s ability to redevelop, lease, and optimize its portfolio as fast as possible while managing debt.
As of Q3 2020, SRG had 94% of its tenants open and paid 86% of its nine months’ rent. It has been mildly concerning to know that Seritage had its CFO and CEO left the company at such a crucial time.
However, at today’s price of $14 per share, Mr. Market seems to put no weightage on its well-located properties and management’s execution capacity.
Thus, Seritage Growth Properties seems like an asymmetric bet that can reward patient investors over the long term as its shares could conceivably be worth more than $57 per share even after considering 20% equity dilution over the next decade.
My price target of $28-30 per share implies a capital appreciation of 100% in 24-36 months
What is SRG
Seritage was spun off from Sears to diversify its real estate in 2015. Sears was paid $2.7 billion for 40m sqft via a rights issue.
SRG recaptures the space from Sears, deploys capital fixing the space up and modernizing it, then releases it at a market rate which is generally multiples higher than what Sears was paying.
The company’s primary objective is to grow its net operating income by developing old sears boxes into residential, retail, and mixed-use spaces.
As of today, SRG holds 199 retail and mixed-use properties with a 30m sqft gross leasable area that has further densification opportunities up to 37m sqft.
Currently, only 36% i.e., 10m sqft of the total assets are leased that provide $97m in annual rents and $68m of signed leases are scheduled to open in the next 12-18 months.
Figure 2 shows the details of SRG’s leasing portfolio.
Since its inception, Seritage Growth Properties has made a lot of progress; it has recaptured 9m sqft of real estate from Sears and has gone from being ~84% exposed to Sears to be only 3% by Q3 2020.
They have been redeveloping and leasing approximately 2m sqft every year with exception of 2020 due to Covid19.
During the past 5 years, SRG sold 10m sqft to fund its redevelopment.
The real estate portfolio consists of 6.5 m sqft is premier and large-scale retail that can be further densified into residential, office, and other mixed uses.
These assets can be expanded up to 6500 residential units and over 5 m square feet of mixed-use space as shown in figure 3.
Their suburban retail assets include 136 properties of 21.2m sqft that can be redeveloped into first-class, multi-tenant retail centers or repurposed for alternate, non-retail uses.
The Seritage Growth Properties Stock continues to sell its 2.8 m square feet of smaller market assets if they don’t have any potential redevelopment opportunities.
SRG’s mixed bag of tenants includes Dicks sporting goods, Dave and busters, Round one entertainment, Burlington stores, Cinemark, etc. 95% of the in-place tenants were fully open as of October 2020 and 86% of nine months FY2020 rent was collected with 14% being deferred on mutually agreed terms.
Financially, DSG is doing okay, At home is fine with people wanting to renovate their homes, Burlington stores and Ross is burning cash but have deep pockets.
Fitness and Entertainment Temporarily Hit – Covid19 has made it difficult for fitness and entertainment centers like Dave and busters, round one entertainment, and Cinemark but I think this is temporary.
Moreover, fitness and entertainment real estate are destination centers and don’t compete with amazon which will provide steady cashflow after the pandemic is over.
Why is it so cheap?
The opportunity exists because when the market looks at SRG, it sees:
Solvency Concerns. SRG is undoubtedly in a cash crunch. They have $120m in cash and annual in place rent that pays $97m a year as of October 2020.
They have a debt of $1.6 billion at 7% interest that is due in 2023. They also have preferred shares of $70 m where they must pay $5m a year in dividends.
Current operating expenses and G&A range about $110-120m. The current annual rent does not cover annual expenses.
Temporarily depressed metrics – SRG is likely to earn $35m of NOI and Negative FFO this year.
The market seems to extrapolate this current poor economics into the future and gives no value to its underlying real estate which has development potential.
Poor retail outlook and struggling tenants. There have been 14,000 store closures in the US as of September 2020 that can go as high as 25,000 by end of the year.
Covid19 has worsened already dampening retail prospects.
While SRG has a diverse tenant base with some that have deep pockets such as Nordstrom, Burlington stores, dicks sporting goods, many of its entertainment and fitness tenants are affected by the pandemic that include AMC, 24-hour fitness, bed bath and beyond, etc.
Capital required for the development. SRG has 20m sqft of space that needs additional capital of $2.7-3 billion to be redeveloped depending on how much property SRG has to sell.
SRG will have to either dilute equity or take additional debt to fund this CAPEX until its operating cash flows grow to meaningful levels
Litigation – Fraudulent Funds transfer. Sear’s lenders filed a legal complaint against Eddie Lampert – SRG’s major shareholder for fraudulent funds transfer of sears real estate assets. They claim that its real estate was worth $650m more than what sears was paid.
What is the market missing?
Upon deeper inspection, Seritage Growth Properties Stock is undervalued because:
Asset sales supporting development. Short sellers are unable to accept the fact that a company like SRG can be sustained via a large number of one-time asset sales to a more stabilized income profile.
SRG has an enormous inventory of quality land assets that they can and they are selling to develop the rest of the pool to produce clean, regular NOI online.
This is not the first time; Alexandria real estate had previously carried the same transition.
In the midst of transition. The reason for the wide disconnect between SRG’s valuation as compared to mall REIT’s is because SRG is in the midst of massive transition and cannot be easily valued along the same lines as other REITs.
The company needs to shut off income-generating assets for a 12-18-month period, invest capital to turn them into higher-yielding assets.
SNO Leases and Location. They have about 4m sqft of signed but not opened leases than can start paying rents up to $70m in the next 12-18 months and materially increase SRG’s base rents.
These properties are at city centers where the average population density around is 650,000 within 10 miles with an average household income above $90,000.
Retail isn’t going away. While store closures have been accelerated, they are transitioning into experiences rather than just shopping.
Even with the e-commerce boom, physical stores have been important as many shoppers enjoy the retail experience and still prefer to check the size, fit, and appearance of certain products at a physical location.
Online shopping cannot replace this experience.
SRG is in the sweet spot. SRG can develop the needs of future communities, lease them to tenants that will have survived a pandemic, and shall have a sustainable future.
Its Large and premier real estate itself will eventually increase to become 40-50% of the overall portfolio.
Short term cash needs are being met. SRG sold $272m of assets to cover spillover cash burn of $25m for nine months of FY 2020.
They also funded their redevelopment of $245m during this time. Moreover, they have amended their loan terms to defer the interest in case cash levels deplete below certain levels.
What it might be Worth?
Seritage Growth Properties Stock has a limited downside due to the value of its properties its liquidation value seems to be more than its current market cap of $800m.
Asset Sales: SRG generated $800m from the sale of 10m sqft in the last 5 years. Even during a pandemic for nine months of FY2020, $167m of gross proceeds were generated from the sale of 1m sqft at a CAP rate of 5.9% that was leased for an annual base rent of $15m.
These income-generating properties are worth 10-11 times their annual base rent.
SRG has 10m sqft that could produce $165m of annual base rent which can be worth $1.65b.
Additionally, the remaining 20m sqft of real estate can be densified into 27m sqft and is worth at least $80-$100 per sqft which sums up to about $1.6-2.0b. 50% of this will be premier and large-scale retail, residential and mixed-use real estate in densely populated areas.
From my estimate, the total portfolio shall be worth $3-3.5 billion including JV interest.
Relative property comps – Deep diving further, SRG’s 171 out of 199 wholly-owned properties were individually compared using relative property transactions that were closed within the last 12 months.
These properties were approximately worth $3 billion. Properties with JV interest are worth even more on a per square feet basis as they are in prime locations.
Thus combined, these shall be worth 3.5 billion in the pre-pandemic scenario at least. (Refer to Appendix 1 – SRG Property Relative comps)
Pandemic and relative valuation. It shall be noted that SRG’s equity value will vary with the valuation of the properties it holds.
In distress, valuation can drop as much as 20-25% which can bring equity value around $800m – $1 billion after considering for debt as shown in figure 5 below.
The Upside and How will it get there?
Current potential – Seritage Growth Properties Stock has 10m sqft that provides $97m of in-place rent and has $68m of signed leases. With operating expenses of 65%, the company shall generate $35m of NOI this year.
FFO will be negative as SRG has $40m of G&A expenses and $117m of interest expenses including $5m of preferred share dividends.
Overall debt is $1670m which is due at end of 2023.
New Development. SRG has kick-started development on its all 6.5m premier and large land parcels and shall at least develop a total of 17m sqft over the next 10 years.
The total capital required for this development shall be around $2.7-2.9 billion (17m X $155 PSF).
|SRG Portfolio (m sqft)||2015||2020||EST2030|
|Premier and Large Scale||6.5||5|
Seritage Growth Properties Stock’s real estate portfolio is transforming from 100% retail to mixed-use and residential with added densification. The market will realize the stability of SRG’s cashflows once residential developments start paying rents.
Capital Management. The 2.7 billion capital will be generated from asset sales, debt, and funds from operations. SRG can sell 10m sqft for approximately $800-$900m.
$300-$400m of FFO shall be generated over the next 10 years. The remaining $1.6b will have to be served by additional debt. Thus, the total debt will increase from $1.6b to $3.2b.
Arguably, SRG’s newly developed properties will be much higher quality than existing properties where they can obtain asset level mortgage financing for properties at a much lower interest rate (3-4%) than its companywide cost of capital of 7%.
For reference, Washington prime group was able to obtain similar asset level mortgage financing for properties at a rate of around 3.75% or so against a companywide cost of capital closer to 7.5%
Net operating income and FFO. Seritage Growth Properties Stock aims to generate 11-12% unlevered returns on incremental invested capital.
The rental economics work out as they invest about $150-$160 PSF to develop the properties that can be leased on average for $18-20 PSF. Once developed and stabilized, 27m sqft shall provide $540m of the annual base rent.
NOI should be in the range of $360-$430m, assuming a 75-80% NOI margin (average of last 3 years pre-pandemic).
Keep in mind, these are triple net leases where the tenant pays for all the maintenance expenses. With $40-$50m of G&A and $130-180m of interest payments, SRG should generate an FFO of $250-300m once fully developed and stabilized
The upside. NOI of $360-$430m shall bring enterprise value close to $7 billion at a CAP rate of 6%.
Equity shall be worth $3.5-3.7 billion or $50-$57 per share after subtracting debt of $3.3 billion and assuming equity dilution from 55m shares to 67 shares over the next 10 years. (Refer to Appendix 2 – Valuation)
Margin of Safety – There is a risk of SRG not being able to get additional debt more than $400m after 2023 due to high DEBT/EBITDA ratio.
In that case, SRG will have $1200m invested (from $800m asset sales + $400m debt) which shall generate additional rent of $140-$150m once stabilized.
The total annual base rent will go up to $300-310m. NOI margin shall increase up to 70%-80% to generate 210-$250m of NOI. Keep in mind that these are triple net leases where the tenant pays for all the expenses, SRG is currently paying for since they are unoccupied.
Thus, most of the rent shall come directly down to the bottom line.
With a 7% interest of $140m on 2000m, FFO shall be $70-110m at least. Moreover, SRG can refinance this debt at lower interest say 4% once these properties become more cashflow stable and reduce annual interest to 80m to bring FFO up to $170m.
At a conservative estimate of a 6% CAP rate, $200-$230m NOI should make equity be worth $3.5 billion.
Here’s the trump card – SRG will be still left with 10m sqft of undeveloped properties that shall be worth at least $800m at today’s price of $80 PSF. Let’s assume $600m for an additional margin of safety.
Total equity becomes 4.2 billion and with a debt of $2 billion, Seritage Growth Properties Stock can be worth $2.2 billion or $35 – 40 per share depending on near-term equity dilution.
Thus, the current market cap of $800m has a 50-70% margin of safety depending on dilution.
Retail is transforming into ‘New Retail’
Transition to experiences – Millennials value themselves by their experiences as in where they are, who they are with, and what they are doing.
Retail is moving into providing experiences rather than just selling products.
A good shopping experience gives the same dopamine shot that one gets when they have intercourse, see ‘like’ notification on their Facebook post, or gamble.
Online shopping has not and will not be able to take away this experience in the long run. Many shoppers enjoy the retail experience and still prefer to check the size, fit, and appearance of certain products at a physical location.
Physical Store is still important – While e-commerce is a vital channel for meeting the needs of many shoppers, retailers have found that online sales fall in areas where they close a physical store.
Curbside pickup is another variant of the hybrid online/physical store model that has surged in popularity during the pandemic
Recycle – Retailers that do not adapt to this transition will continue to close down and get replaced with the ones that provide an engaging experience for their customers.
Recycling of retail space allows big opportunity to redevelop these properties that meet future demand and densify them with mixed-use such as residential and medical offices.
Additionally, retail outlets are converting into industrial fulfillment centers. Chances of tenants staying are favorable once these centers are automated.
SRG in the sweet spot – Company has 20 M sqft that can be further densified and redeveloped to meet the demand of future, experience-oriented retail.
Residential and mixed-use densification provide SRG the flexibility to get maximum return on their investment.
Does Management Have Integrity, Intelligence, and Energy?
Leasing and Development – Seritage Growth Properties Stock’s management has been focused on its goal to maximize shareholder value via recapture and redevelopment. Below are some of the major milestones that highlight management’s execution capacity.
- Leasing Volume. SRG leased 9.6m sqft over the last 5 years which includes in place as well as SNO leases.
- Leasing spreads have been 4 times base rents with an average rent of $18.46 PSF.
- Redevelopment. SRG has developed 100 projects of size 9m sqft with total capital of $1600m during the last 5 years.
CEO and CFO Departure – Management has been an important key to execute SRG’s vision into reality and with the latest news of CEO and CFO departure, it shall take more time than originally anticipated, for management to execute successfully on its goals.
While there is no proof, it is being said that CFO and CEO decided to depart as benefits to stay dried up.
Management shall find an internal candidate to take up this role by next quarter.
Eddie Lampert – Eddie is chairman and major shareholder (40%) of SRG personally as well as via his investment fund ESL.
He had bought Sears in 2005 with hopes of reviving the historical retail chain.
However, he could not execute on this vision over the next decade leading up to the extraction of different assets outside of Sears before Sears filed for bankruptcy.
Eddie through his personal assets as well as his fund – ESL investment has a high net worth tied to Seritage. While Eddie’s character based upon his actions for sears employees is questionable, he will make every effort to save his investments in Seritage Growth Properties Stock for himself as well as his shareholders.
Eddie recently increased its stake through ESL investments in SRG in Q1 2020.
Management Compensation – Management sets internal targets each year that define annual compensation.
These targets are driven by their capital recycling via development, leasing, and asset sales.
While management is getting highly compensated for their efforts, they have cut down salaries due to the pandemic. Refer to appendix 3 – Management performance highlights from 2015 to 2020.
Sharon Osberg – Sharon leads the compensation committee at SRG and is a trustee on the board of the company.
In her professional capacity, she was executive vice president for the online services division at wells Fargo and was also a director in the popular sequoia fund for 13 years.
Sharon is one of the closest friends of Warren Buffet who has backed SRG with a $1600m debt via Berkshire Hathaway.
This provides a lot of comfort as she wouldn’t let Warren’s money go waste.
Case of Fraudulent Funds Transfer
Sears lenders have filed a complaint against SRG and Eddie Lampert for fraudulent funds transfer of Sears assets to form SRG.
Sears remained solvent till 2019 and has been bought back by Eddie Lampert who’s the major shareholder of Sears as well as SRG. I believe the litigation will have very low merit if any, due to the following reasons.
Definition – For a transaction to be constructively fraudulent it must meet both of two tests.
The first is that the asset(s) sold, or the obligation(s) incurred were not sold or incurred at a reasonably fair valuation.
The second is that the transaction was done at a time when the debtor was (i) already insolvent, (ii) became insolvent as a result of the transaction, or (iii) was left with insufficient capital to conduct its business. This concept is materially the same under both state and federal law.
A person is insolvent when the present fair salable value of his assets is less than the amount that will be required to pay his probable liability on his existing debts as they become absolute and matured.
Sears Market Cap – Immediately following the spinoff, Sears had a publicly-traded market capitalization of approximately $3.0 billion.
At the end of 2015, it had a market cap of $2.2 billion, and the market cap did not dip below $1.0 billion until 2017.
The publicly traded equity implied a significant market capitalization and its bonds did not trade at levels that would imply imminent default
Ongoing Monetization – Sears had been monetizing assets for some time and recognized $667 million in gains on sale in 2013 and $207 million in 2014.
The Seritage and associated JV transactions, for which Sears received $2.7 billion from SRG and $0.4 billion from SPG, GGP, and MAC, came with a $1.4 billion gain on sale ($508 million of which was recognized immediately and $894 million of which was deferred).
Additionally, $936M of corporate debt was reduced for Sears after receipt of $2.7billion from the SRG transaction.
Independent appraisals were prepared by nationally recognized firms (Cushman & Wakefield and Hilco) that each concluded in-place valuations for the wholly-owned properties of $2.3 billion.
Further, Duff & Phelps was retained to provide a fairness opinion that took into account not just the appraisals but also the unique features of the master lease agreements, which allowed Sears the right to terminate unprofitable stores at its election and Seritage the right to recapture space.
Poor financing – It’s also worth highlighting that Seritage wasn’t able to get attractive financing at the time of the spin-off.
At the appraised value, they were only able to get financing representing 51.6% LTV at market rates with market covenants.
If the true value of the property was materially higher, you would expect Seritage to have been able to secure a significantly higher LTV on the appraised value.
For deeper analysis, please refer to the value investors club post by rickey824 on November 1, 2018
Warren Buffet owns a 5% stake since 2015 whereas Mohnish Pabrai and Guy Spear own 12% and 1% stake respectively.
Warren, Mohnish, and Guy spear are great friends and have put in big faith in Seritage Growth Properties Stock and its management.
While they can be wrong, their combined ability to evaluate the business and management provides a certain margin of safety.
What can go Wrong in Seritage Growth Properties Stock?
CEO and CFO Departure – SRG had its CFO leave the company a month ago before the CEO decided to leave as well as of 12/10/2020.
This has definitely put some dent into the original thesis but does not devalue the properties SRG owns. If they could find an internal candidate with the lure of benefits and stock options.
SRG can still survive this transition but it will delay the execution which has brought the original price target of $57 to $30 per share.
Long Slow Death – Management has no incentives to liquidate and return the money to shareholders. They make a salary and would have to lay off a lot of employees.
Thus, it seems very unlikely SRG will liquidate willingly. One needs to pay attention to management actions to make sure they are trying to maximize the shareholder value.
Equity will keep reducing if they sell assets just to maintain their annual cash flow.
Retail Real estate and Poor choice of tenants – Commercial property transactions are down 68% y-o-y. The decline in rates has caused prices for retail real estate to plummet.
With retailers closing, demand and valuation for retail space can reduce as more properties remain vacant. While it is clear that mall space is going through a shake-out, Seritage needs to pick winners as its tenants.
The last thing investors want is SRG selecting poor tenants rushing to bring these properties online and end up with a real estate portfolio of class ‘B’ malls.
Cash Crunch – SRG’s properties are valuable due to their location and population density. To manage short-term needs, SRG has to sell their properties at a discount.
It is difficult to raise cash or sign leases during the current environment of a pandemic.
While they were signing leases close to 2M a year, only 221,000 sqft of new leases were signed for 9 months of 2020. SRG has enough cash to survive next year however, they will have to sell some of their assets to manage the cashflow while properties are being developed and leased.
Refer to figure 10 which shows SRG’s estimated cash flows for the next few years assuming asset sale and additional debt of $400m
Conflict of interest – There is a conflict of interest with complaints filed against Eddie Lampert that claims $700-800m from Seritage’s original transaction. Moreover, Eddie being the largest shareholder can highly influence the direction of SRG
Valuable properties in JV – Partners in JV’s are better capitalized and have not elected to start developing JV properties.
For example, Simon property group has not elected to start developing any of Sear’s boxes. They could very well be waiting to buy out those sites at fire-sale prices in case SRG gets into distress.
Key Drivers to Track
Access to Capital – The immediate goal for SRG is to access an additional $400M debt from Berkshire. This will require total annual base rents to increase from $165m to $200m.
SRG needs to invest another $250M and lease-up additional properties at 1.75m sqft that generate enough rent to make this difference.
Development – Seritage needs to develop at least 1.6-2.0 m sqft a year by keeping construction costs low which is difficult during this pandemic as construction costs are rising higher due to inefficiencies.
Leasing – SRG needs to lease at least 1m sqft of space annually or 300,000 sqft per quarter to keep up with the upcoming CAPEX in FY 2021.
Annualized in-place rents need to rise at a pace of $6-8m a quarter
Asset Sale – SRG will have to continue to sell its assets to generate cash for the short term but this shall not exceed more than 10M sqft as equity value decreases every time an income-generating property is sold.
They sold $284M of properties in nine months of FY20 which should cover their annual expenses, interest expense, and yearly CAPEX.
However, the sale of income-generating properties dampens their progress towards additional capital from Berkshire.
Seritage is a retail REIT that is currently depressed due to pandemic influenced retail outlook, solvency concerns, debt covenants, and litigation.
Moreover, Investors seem to have written off large portions of SRG’s real estate that, rather than dying is undergoing a meaningful transformation with a heavier emphasis on mixed uses featuring entertainment, fitness and food as well as multi-family housing.
While there are longer-term questions about brick-and-mortar retail in America and the impact of COVID-19 on retail sales and bankruptcies, Seritage continues to manage some of the most attractive properties in the country.
Seritage Growth Properties Stock seems well-positioned to weather the storm during this transition because of 3 key points that the market seems to put no value for
(i) assets sales have generated enough liquidity and will continue to do so
(ii) Location of SRG’s properties is in a densely populated area with a high household income population that continue to stay in demand
(iii) densification, as well as diversification into a residential and mixed-use, shall allow better stability of future cash flows. At $14 per share or a market cap of $800m, SRG is a low-risk but high uncertainty bet that can reward patient investors over the next 2 years as its shares could conceivably worth more than $30.
While the upside requires management’s execution of its goals, prevailing prices provide a significant margin of safety and an attractive rate of return for those who can look past the current temporary headwinds.