Last Tuesday, Seritage Growth Properties (NYSE:SRG) took a huge step toward funding its transformation by locking down a term loan of up to $2 billion from Berkshire Hathaway. The new term loan refinanced all of the company's existing debt and will provide nearly $800 million of additional capital.
Two days later, Seritage reported results for the second quarter of 2018. Once again, most of the REIT's key financial metrics worsened on a year-over-year basis, due to the ongoing decline of its main tenant, Sears Holdings (NASDAQOTH:SHLDQ). Nevertheless, it continued to make progress in diversifying its tenant base away from Sears and Kmart.
Another down quarter
For the second quarter, Seritage Growth Properties reported a net loss of $8 million, or $0.23 per share, compared to a slight profit a year earlier. Funds from operations (FFO) -- a more meaningful earnings metric for REITs -- plunged to $0.12 per share from $0.43 per share a year earlier. That isn't even enough to cover Seritage's quarterly dividend of $0.25 per share.
These declines were driven primarily by rental income falling from $42.2 million in Q2 2017 to $35.8 million last quarter. Sears Holdings has terminated the leases for dozens of stores since the beginning of 2017, while Seritage has recaptured space in others to pave the way for redevelopment projects.
Additionally, as Sears has vacated space, tenant reimbursements have covered less and less of Seritage's property operating expenses. Seritage reported an expense recovery rate of 79.6% last quarter, down from 92.9% a year earlier. General and administrative expense has also risen significantly, due to an increase in headcount and higher stock-based compensation.
Asset sales cover the gap, while leasing activity continues
Seritage investors need to be prepared for the company's financial results to get worse before they get better. Sears Holdings is still shrinking and faces a significant risk of going out of business within the next two years. Indeed, just last quarter, Sears notified Seritage that it will exercise termination rights for another 18 properties, which together account for $10.7 million of annual base rent.
What really matters is that Seritage Growth Properties continues to find new tenants willing to pay significantly more for space previously (or currently) occupied by Sears Holdings and that it can fund the necessary redevelopment costs.
With respect to leasing activity, Seritage had a fairly successful quarter. It signed 43 new leases covering approximately 853,000 square feet of space: more than double its leasing activity for the prior quarter.
The one potential red flag was that the average rent for the leases signed last quarter was $14.19 per square foot. That compares to an average of $17.58 per square foot for new leases signed over the past three years. However, this was still 3.6 times what Sears Holdings was paying, indicating that these may have been lower-quality properties, on average. For example, Seritage signed a lease with University of Florida Health for the entire Sears store in Gainesville, Florida, last quarter -- quickly releasing one of its less-desirable assets.
Meanwhile, Seritage generated $134.6 million in proceeds during the first half of 2018 from selling joint venture stakes in a handful of properties and selling some others outright. (More than half of those proceeds came in last quarter.) These asset sales more or less covered the company's $142 million in development costs for the first half of the year.
Big changes coming
Looking ahead, Seritage's new $2 billion term loan facility means that it no longer faces near-term liquidity constraints. Indeed, the company disclosed that it now has more than $600 million of cash liquidity, plus another $400 million available to draw on the term loan.
This will be more than enough to fund the $818 million that Seritage estimates it will need to spend to complete its ongoing redevelopment projects. The leftover cash -- plus proceeds from other asset sales that should be completed in the next year or two -- can help fund additional redevelopment projects from among its 39 vacant or soon-to-be vacant properties.
Upon completion, the existing redevelopment projects are expected to generate more than $180 million of annual rent. This would more than replace all of the rental income Seritage derived from Sears Holdings at the time it was spun off.
Much of this new rent won't come on line until 2020, so financial results could continue to deteriorate in the near term. But Seritage now has adequate funding for the next two years, allowing shareholders to look forward to a more profitable future.