The Surprising Redevelopment Plans at Sears Holdings

The main theory for years has been that Sears Holdings (NASDAQ: SHLD  ) would eventually take the vast real estate holdings and turn the company into a profitable real estate investment trust to match the likes of General Growth Properties (NYSE: GGP  ) or Simon Property Group  (NYSE: SPG  ) . The shorts always focus on the weak retail operations and the longs forecast what the real estate would be worth under new tenants.

Most investors might be surprised to find that Sears is further along than they think on the path to redeveloping prime mall lots. The company has new concepts that involve greatly reducing the footprint of the existing Sears or Kmart stores while attracting new tenants that General Growth and Simon can't accommodate with prime malls nearly 100% leased.

Another surprising aspect to this story is that Sears might actually have been smart to not spend millions or even billions to redevelop existing stores as undertaken by J.C. Penney. By not wasting money on stores eventually planned to be redeveloped, the company isn't trapped into eating those costs. 

What is Seritage Realty Trust?
This subsidiary was formed in 2012 to limited publicity. The unit is headed by David Lukes, the ex-CEO of Mall Properties and COO at Kimco Realty. The website lists Seritage as a nationwide developer of commercial real estate with a portfolio containing more than 200 properties in 33 states totaling more than 18 million sq. ft. The website conspicuously fails to mention the connection to Sears Holdings.

While the total properties and square footage involved are small compared to the portfolio of around 250 million sq. ft., the company probably hopes to make substantial progress with these units to not flood the market with the full inventory at one time.

Incredible redevelopment examples
Remember that Baker Street Capital provided examples that the redevelopment potential for the top 350 properties could boost the value of those units to approximately $12 billion. One key to the plans is that Sears not only owns the parcel where the Sears store is located, but it typically owns the land for the parking lot and an outparcel that typically includes Sears Auto.

The surprising part about this story is that the company has undertaken significant efforts to redevelop the land whether dividing the anchor pad or the outparcel or planning to add high-rise office buildings to valuable properties. The company famously announced the plans for a 40,000 sq. ft. Forever 21 inside the Sears in the Costa Mesa, Calif. mall, but it has released very little news since that time period.

Below are a few examples of the redevelopment plans at some high profile locations:

Burlington Mall:  In the Burlington, Mass. mall, the company plans to divide the anchor pad and completely lease out the outparcel space. The plan includes leasing up to 85,000 sq. ft of new space into suites of between 4,000 sq. ft and 20,000 sq. ft. Sears will be left with a core store that likely sells the more popular items such as appliances and tools.

Woodfield Sears:  The Schaumburg, Ill. shopping center is the largest in the Chicago area and is listed as the ninth-largest shopping mall, with nearly 2.2 million square feet. Sears is working on redeveloping the auto center to provide 47,500 square feet. The company, though, owns 283,000 sq. ft. at the anchor pad where CalPERS recently paid roughly $900 sq. ft. for 50% of the mall. As a sanity check to the valuation used by Baker Street, this location was originally valued at $52 million and would quickly be worth $166 million if redeveloped or more if valued at the CalPERS rate.

Metropolis at Metrotown:  The plans at this mall location are the most spectacular in the list of redevelopments. The nearly 9-acre location is part of the Vancouver metro area and includes a project worth up to $1 billion. The plans include the reduction of the existing Sears store from 140,000 sq. ft to around 100,000 sq. ft and the addition of two office towers and five residential towers plus other projects involving parking garages.

In addition to these high-level plans, the company has already converted the Cupertino, Calif. Sears partially into a fitness center, converted a Kmart into a Rio Ranch Market, and surprisingly added a Whole Foods Market next to a smaller Sears. The ability to redevelop some of these non-mall locations is a very encouraging sign that all of the real estate could provide more value than expected.

Lack of prime mall space
The most interesting part about the thesis that the real estate holdings at Sears weren't as valuable as expected due to weakness in demand at malls has completely been shot down by the management teams of General Growth and Simon. Each company has used investor forums or earnings calls to proclaim the limited supply of quality mall space and the success of converting old Sears' stores bought in a few locations.

The General Growth CEO mentioned at an investor forum in June that virtually no supply is left. The company had more than 70 department stores in inventory two years ago that has now been whittled down to only six and that was three months ago. General Growth also sees mall rates higher today than the peak in 2007 and shockingly even admitted that the Sears locations in their portfolio are special.

Simon Property went so far on the Q2 2013 earnings call to suggest that retailers are more concerned about securing locations than the rents. The company listed the vacancy of department stores at only 1% from an inventory of 635 locations.

Bottom line
Lots of questions still exist on how successful some of these plans would be unless Sears creates an independent REIT. Surely the company doesn't plan or would even be able to borrow the $1 billion needed to develop the Vancouver mall location as part of the beleaguered Sears Holdings umbrella. The research continues to suggest that Sears brilliantly waited out the financial crisis to place locations on redevelopment plans just as the mall inventory shrinks.

Both Simon Property and General Growth should continue to benefit from the lack of inventory that will drive rental rates higher. If Sears plays it correctly, however, much the new demand will be absorbed by Seritage Realty, providing huge upside to a stock trading at a fraction of the real estate holdings' ultimate value if leased to stronger tenants. In addition, those mall owners could likely benefit from the higher mall traffic with higher-demand stores occupying the currently outdated Sears stores.

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