Most investors think of real estate investment trusts (REITs) as the exclusive province of retirees and other income-oriented investors. Under U.S. tax law, REITs are exempt from corporate taxes as long as they pay out at least 90% of their taxable income as dividends. As a result, they tend to pay high dividends while not retaining much capital to support growth.
Thus, the idea of a REIT growth stock may seem like an oxymoron. This is a big reason why investors are underestimating Seritage Growth Properties (NYSE:SRG) -- it is one of the rare REITs that has a modest (2.4%) dividend yield but significant growth opportunities.
The basics of the Seritage growth strategy
Seritage Growth Properties is a spinoff that was created from ailing retail giant Sears Holdings (NASDAQ:SHLD) in mid-2015. Seritage paid Sears $2.7 billion for 235 real estate assets, primarily occupied by Sears and Kmart stores, along with 50% interests in another 31 properties through joint ventures with several leading retail REITs.
The quality of Seritage's real estate covers a wide range. There are dozens of properties in small towns that aren't worth very much. However, Seritage also owns a number of trophy properties -- primarily in South Florida, Southern California, and the New York metro area -- that are extremely valuable.
Today, Sears Holdings is paying very low rent on the space it occupies: a little more than $4 per square foot, on average. Seritage has opportunities to redevelop much of this space and lease it to new tenants at much higher rents -- frequently more than quadruple what Sears is paying.
This redevelopment pipeline has two sources. First, Seritage has the right to "recapture" 50% of the square footage at all of its properties -- and 100% of the space in certain cases -- as well as outparcel space in the parking lots. Second, Sears Holdings has the right to terminate the leases for unprofitable stores (subject to certain limits) by paying one year of rent and estimated operating expenses.
Mixed results so far
Seritage Growth Properties stock has been stuck near the $40 mark since it became publicly traded in July 2015.
The main thing holding Seritage back is the poor performance of Sears Holdings. While Sears recently disclosed that its Q4 results were slightly better than expected, the company is closing stores at a rapid pace and could go out of business within a couple of years.
As Sears Holdings has terminated the leases for underperforming stores, Seritage's rental income has come under pressure. In Q3 2017, Seritage reported that company funds from operations (a measure of ongoing income) plunged to $17.6 million from $32.6 million a year earlier.
On the flip side, Seritage has made steady progress in designing redevelopment projects and signing up new tenants. By the end of 2017, Seritage had initiated projects involving more than $1 billion of new investment, which are expected to bring in approximately $118 million of incremental annual rental income. More than half of the projected rent from those redevelopment projects is already backed up by signed leases.
The Sears problem will go away
Seritage estimates that when it completes the 63 redevelopment projects it initiated between July 2015 and the end of 2017, those properties will produce annual income of $157 million, of which just $8 million will come from Sears Holdings. By contrast, Seritage's annualized rental income for its entire portfolio of more than 250 properties was just $169 million as of Q3 2017.
By the end of 2019, Seritage should have completed most of these redevelopment projects. This means that even if Sears were to collapse, Seritage would still be bringing in roughly the same amount of rent as it did in 2017 -- but from a fraction of its real estate portfolio.
Thus, Sears' disappearance wouldn't be nearly as devastating for Seritage as the bears seem to think. The biggest issue for Seritage is that it still relies on rent from Sears Holdings to help it cover the cost of its redevelopment work. However, Seritage ended 2017 with $240 million of unrestricted cash, plus $175 million of restricted cash, most of which is reserved to pay for redevelopment projects.
In other words, Seritage already has enough cash to fund at least a year of redevelopment work. As redevelopment projects wrap up, Seritage will start to replace some of the rental income it has lost from Sears since the beginning of 2017. It can also continue to sell joint venture interests in certain properties to raise additional cash to pay for its redevelopment activity.
As Seritage completes more redevelopments, rental income should at least double in the next five years -- with plenty of runway for growth. This type of upside isn't reflected in the stock price. That's why I bought shares of Seritage Growth Properties last week. I intend to hold them for many years, while the company executes its growth strategy.