Real estate investment trust Seritage Growth Properties (SRG 1.99%) has a huge opportunity to boost its rental income over time by replacing the numerous Sears and Kmart stores in its real estate portfolio with higher-paying tenants.
However, the Sears Holdings (SHLDQ) spinoff faces a quandary: It doesn't have nearly enough cash to pay for redeveloping all of its properties. Furthermore, Seritage's rental income has been declining due to Sears Holdings (its primary tenant) having closed a massive number of stores in the past year.
Sears Holdings is closing stores at a furious pace. Image source: Sears Holdings.
As a result, last year, Seritage began to raise cash by selling joint venture interests in certain properties. In the first few months of 2018, it has accelerated its efforts to sell off some of its assets in order to fund its redevelopment pipeline.
Asset sales take off
Seritage Growth Properties began its asset-sale process in earnest during 2017. In July, mall REIT GGP bought Seritage's 50% interest in eight properties previously held in a joint venture between the two companies. The two REITs also launched a second joint venture, with Seritage contributing five additional properties. Between these two transactions, Seritage Growth Properties raised $247.6 million.
The company undertook a similar transaction with Simon Property Group in October, selling its 50% stake in five properties for $68 million. These 2017 deals helped Seritage pay down debt and bolster its cash balance -- and also passed off future redevelopment costs to its joint venture partners.
Seritage Growth Properties continued implementing this strategy in the first quarter of 2018. In March, it sold a 50% joint venture interest in its flagship Santa Monica, California property to Invesco for approximately $50 million. Furthermore, in its first quarter earnings report, Seritage revealed that it had sold four vacant former Kmart stores for $13.5 million.
Seritage has sold a 49.9% stake in its Santa Monica, California property. Image source: Seritage Growth Properties.
More of the same in the future
Even after all of these asset sales, Seritage still needs a lot of additional capital to support its steadily growing redevelopment pipeline. As of the end of March, the company estimated that it will need to spend nearly $900 million over the next several years to complete the redevelopment projects it has announced thus far. It ended last quarter with just $135 million of unrestricted cash, plus another $141 million of restricted cash earmarked for redevelopment work.
Meanwhile, Seritage is facing a rising vacancy rate, due to Sears Holdings' store closures. This has reduced its operating cash flow to the point that it is not even fully covering Seritage's modest dividend, let alone funding any capital expenditures.
As a result, Seritage shows no sign of slowing the pace of asset sales. In recent weeks, it agreed to sell a Sears store in San Bruno, California to the adjacent mall owner for $42 million and formed partnerships to add residential developments on two of its other properties. Seritage has signaled that it will continue to pursue joint ventures for many of its larger-scale projects.
This is the best strategy for raising capital
Some investors are skeptical about Seritage's asset sales, arguing that it's foolish to sell properties that could be redeveloped for higher-paying tenants. However, it's not clear that the company has better options for raising capital. Seritage can't take on much more debt at the moment, given its weak cash flow. Issuing more shares isn't an attractive option, either, as Seritage Growth Properties stock has been trading at a depressed valuation.
Additionally, Sears has terminated the leases for 65 stores since late 2016. Seritage has only found new lead tenants for about a third of these sites. It has higher-priority projects at dozens of other (generally more valuable) properties. Limited management bandwidth creates a strategic rationale for shrinking its property portfolio.
As a result, it makes sense for Seritage to sell some properties -- or joint venture interests in properties -- as long as it can get decent prices for those asset sales.
A few years from now, Seritage will have redeveloped a substantial chunk of its portfolio, increasing its net operating income and dramatically reducing its dependence on Sears Holdings. At that point, it will be able to fund further redevelopment work with debt, rather than continuing to rely on asset sales.
