Sears Holdings (NASDAQ:SHLDQ) has been moving inexorably toward bankruptcy in recent years. Sears' management has touted some minor successes along the way, yet the company continues to bleed cash at a rapid rate. Meanwhile, its strategy of selling off assets to cover its losses is clearly unsustainable.

All of this would seem to be bad news for a landlord that leases more than 85% of its space to Sears Holdings. Yet Seritage Growth Properties (NYSE:SRG) is actually counting on Sears to continue downsizing and eventually disappear. As long as Sears can remain in business for a few more years, Seritage has very bright long-term prospects.

The Seritage strategy

Seritage Growth Properties is a real estate investment trust that Sears Holdings spun off in mid-2015 as part of its efforts to convert its real estate assets into cash. Seritage has interests in 266 properties. Most of these are owned outright, but 31 of the properties are owned by joint ventures.

Today, Sears and Kmart occupy the vast majority of Seritage's real estate. However, both sides want to change that over time.

The exterior of a Sears store

Sears and Kmart are the main tenants at most Seritage properties today. Image source: Sears Holdings.

Under the master lease between Sears Holdings and Seritage, Sears can pay a termination fee and get out of the leases for certain underperforming stores. Meanwhile, Seritage can gradually recapture space from Sears -- up to half of the square footage, for most properties -- allowing it to bring in more lucrative tenants.

This arrangement is mutually beneficial. Sears Holdings gets to keep operating at all of these stores while paying below-market rent. Meanwhile, Seritage has a temporary source of income while it works to redevelop its properties.

Good progress so far

Since late 2015, Seritage Growth Properties has made meaningful progress in redeveloping sites and reducing its dependence on Sears Holdings. As of the end of last year, Seritage had re-leased roughly 2 million square feet of space currently or formerly occupied by Sears Holdings. This represents about 5% of Seritage's total square footage.

The average base rent for properties that Seritage re-leased has surged from $4.20 per square foot to $18.62 per square foot. This highlights just how much Sears is underpaying relative to market value today.

Seritage has numerous additional projects in the pipeline as it works to replace Sears and Kmart with higher-paying tenants across its portfolio. This includes some high-profile properties in big, wealthy metro areas.

Based on the leases signed during 2016, Seritage increased its annual base rent from third parties (i.e., tenants other than Sears Holdings) from 24% to 36.1% of the company total. Because new tenants are paying dramatically higher rents, Seritage could probably replace all of the rent it currently gets from Sears Holdings by re-leasing just 20%-25% of its space.

A bumpy road with a big potential payoff

After a surge of investor enthusiasm in early 2016, shares of Seritage have tanked over the past year. Nearly 35% of its shares have been sold short as it has become something of a proxy for investors betting on Sears' demise.

SRG Chart

Seritage Growth Properties Stock Performance data by YCharts.

Indeed, if Sears folds in the next year or two, Seritage could be in trouble. For now, Seritage still gets the vast majority of its revenue from Sears. Furthermore, it wouldn't be easy for Seritage to raise enough capital to redevelop its entire portfolio at once. (And of course, there would be a glut of available space if Sears goes bust, driving down rents.)

However, Sears still owns hundreds of real estate properties, and it continues to sell them off at a steady pace to generate cash. It also hopes to monetize some of its big brands and ancillary businesses, such as Kenmore, DieHard, Sears Auto Centers, and Sears Home Services. Thus, while Sears may not be a viable business in the long run, it will probably be able to stumble along for a few more years before being forced into bankruptcy.

The longer Sears can hold on, the better off Seritage will be. Five years from now, Seritage will probably have diversified its tenant mix enough that even an outright liquidation at Sears wouldn't cause it undue trouble. Between now and then, it just needs to keep making steady progress toward replacing Sears and Kmart with new tenants paying higher rents.

In the long run, Seritage is likely to redevelop its entire portfolio, capturing much higher rents in the process. This would dramatically increase its earnings power, driving big gains for patient investors.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.