Sears Holdings (SHLDQ) may finally be on the verge of bankruptcy. CEO Eddie Lampert -- who also owns a controlling stake in the iconic retailer and holds most of its debt through his ESL Investments hedge fund -- recently called for the company to restructure its debt within the next few weeks. He strongly hinted that if other creditors don't go along with his plan, ESL will stop providing financial support to Sears Holdings, forcing it into bankruptcy.
At first glance, this would appear to be bad news for Sears real estate spinoff Seritage Growth Properties (SRG -0.53%). However, due to its ongoing redevelopment work, a recent liquidity infusion, and the specifics of its relationship with its former parent, Seritage is well positioned to handle a potential bankruptcy filing by Sears Holdings.
Sears is still a major tenant
Over the past few years, Seritage has recaptured a substantial amount of real estate that was previously occupied by Sears and Kmart. Nevertheless, Sears Holdings is still by far its biggest tenant.
As of the end of June, Sears leased 21.3 million square feet of space from Seritage, representing more than half of the REIT's gross leasable area and more than 70% of its leased space. (Seritage has a substantial amount of vacant space in its portfolio right now, due to the rapid pace of store closures at Sears and Kmart.)
Seritage's third-party tenants pay much higher rents (on average) than Sears Holdings, so as of June 30, the latter accounted for "only" 43% of Seritage's annualized rental income -- including signed-but-not-opened (SNO) leases. However, since Seritage Growth Properties is in the midst of implementing an aggressive redevelopment plan, more than half of its reported third-party leases are not in force yet. Looking just at tenants that are paying rent right now, Sears Holdings is responsible for a solid majority of Seritage's rental income.
Seritage is redeveloping dozens of Sears and Kmart stores. Image source: Seritage Growth Properties.
Additionally, tenants at Seritage's properties reimburse the REIT for property operating costs and real estate taxes in proportion to the amount of space they occupy. Thus, Sears Holdings accounts for a large majority of Seritage's tenant reimbursement revenue.
In short, Sears Holdings remains Seritage Growth Properties' predominant source of revenue. But its demise still might not hurt Seritage very much.
Seritage Growth Properties is changing rapidly
The substantial amount of rental income that Seritage attributes to SNO leases highlights how quickly its tenant base is changing. The REIT's current redevelopment pipeline includes dozens of properties. Some of those projects are nearly complete, while others are just getting started; some are almost fully leased, while others have few (if any) tenants lined up so far.
As of mid-year, SNO leases totaled $70.6 million of annual rental income. As these tenants open their doors over the next two years or so, they will begin paying rent. The current roster of SNO leases is already nearly sufficient to replace Seritage's $96.6 million in annual rental income from Sears Holdings. (That said, these tenants will occupy a much smaller proportion of Seritage's portfolio, so tenant reimbursement revenue would be far lower.)
Furthermore, Seritage is just beginning leasing activity for several marquee properties that are being redeveloped. It estimates that its past and current redevelopment properties will generate $182 million of annual rent when fully stabilized, more than Seritage's total rental income today.
Thus, even with zero revenue from Sears Holdings, rental income would probably be higher by 2020 than it has been for the past couple of quarters.
A bankrupt Sears Holdings might keep paying rent
Fortunately, Seritage is unlikely to face this worst-case scenario. Even if Sears Holdings files for bankruptcy, there's a good chance that it would continue paying rent (and not just because Eddie Lampert is the biggest investor in Seritage Growth Properties).
The relationship between Sears Holdings and Seritage is governed by a master lease that covers all Seritage properties where Sears or Kmart is a tenant. The master lease gives Seritage the right to recapture some (but not all) of Sears' space, while Sears Holdings has the right to terminate the lease with respect to stores that are losing money, after paying a one-time fee.
Thanks to the latter provision, Sears can cheaply get out of the worst properties covered by the master lease -- and it has already terminated the lease for more than a third of the stores it sold to Seritage. Meanwhile, it continues to control a fair amount of valuable real estate at rock-bottom lease rates that are locked in for many years.
Sears has terminated the worst properties under its master lease with Seritage. Image source: Sears Holdings.
In the long run, Seritage would probably be better off if Sears defaulted on its lease and handed back the keys to all of the properties. But Sears is more likely to continue paying rent so that it can use the space itself or sell its leasehold interest to another party.
There's no cash crunch anymore
The underlying potential of Seritage's real estate is the foundation of its value. However, it wouldn't mean much if the company didn't have access to a massive amount of capital to pay for the redevelopment work needed to bring in new tenants. As of June 30, Seritage expected to spend more than $800 million just to complete its current redevelopment projects.
Fortunately, in late July, Berkshire Hathaway stepped up by offering a term loan of up to $2 billion. This allowed Seritage to retire the roughly $1.2 billion of debt it had as of June 30, while providing nearly $800 million of incremental liquidity and more than $1 billion of total liquidity.
In other words, Seritage has enough money to carry out its strategy for the next couple of years, regardless of what happens to Sears. By 2020, it will have a much more diversified tenant mix -- making it easier to raise the capital it will need for its future redevelopment work.
