Sears Holdings (SHLDQ) was instrumental in the rise of the American shopping mall. Sears was a lead anchor supporting the development of many malls, and it even built dozens of malls itself, through its Homart Development subsidiary.
As Sears Holdings has tumbled toward bankruptcy in the past few years, its massive store base has become a huge liability for many mall owners. For some landlords, the problem was simply having a deadweight anchor that wasn't driving much traffic to the mall. In other cases, Sears has closed stores over the past few years -- or is poised to do so after filing for bankruptcy last week -- leaving a huge swath of vacant mall real estate in its wake.
Not too long ago, Pennsylvania Real Estate Investment Trust (PEI) would have been severely impacted by Sears' woes. However, the mall REIT has done a remarkable job of reducing its exposure to Sears in recent years. As a result, the Sears Holdings bankruptcy doesn't pose a major threat to PREIT's financial performance -- or its generous 9.3% dividend yield.
PREIT congratulates itself
A few days before Sears Holdings officially filed for bankruptcy, PREIT put out a press release highlighting how far it had come in untangling its fate from that of Sears. According to the REIT, there are just four active Sears stores left in its malls, excluding properties where Sears is already in the process of being replaced by other tenants and malls covered by nonrecourse mortgage loans. That's down from more than two dozen stores in 2012.
Management also noted in the press release that other mall REITs have an average of 30 Sears stores each. That's not a fair comparison, given that PREIT owns far fewer properties than most of its rivals. (In fact, it now owns just 21 indoor malls.) Nevertheless, it's true that several other REITs are in far worse shape, most notably CBL & Associates, which had Sears stores in nearly two-thirds of its malls at the beginning of 2018.
How PREIT got to this point
PREIT's No. 1 tactic for reducing its exposure to Sears has been selling less-promising properties -- and in some cases, handing the keys back to lenders. (Many REITs take out mortgages using individual properties, and nothing else, as collateral. If such a property's value falls below the amount borrowed, the REIT can walk away from both the real estate and the mortgage.)
This repositioning activity has removed 19 properties (mostly enclosed malls) from PREIT's portfolio since early 2013, 13 of which had Sears as an anchor tenant.
PREIT has also been proactive about replacing struggling anchors with better-performing tenants in recent years. Just in the past two years, it has redeveloped three Sears stores and a Kmart for smaller-box tenants. The REIT is also in the midst of redeveloping a former Sears in Michigan for several tenants including Von Maur (a small, upscale department store chain) and recently acquired a Sears store at one of its Maryland properties for future redevelopment.
No reason for fear
By the beginning of 2018, there were only eight Sears stores (and no Kmart locations) left in PREIT's portfolio. One of those stores was in a mall that was recently turned over to the lender. Amazingly, only one of the other seven stores is among the hundreds of Sears locations that have been or will be closed during 2018.
Furthermore, of these seven properties, one or two are potentially candidates for being turned over to their respective lenders if results take a turn for the worse. And at Willow Grove Park, PREIT's top-performing property in terms of sales per square foot, Sears has subleased a large piece of its store to British fashion retailer Primark.
This leaves only four or five malls where PREIT would have to worry about replacing Sears in the event of an outright liquidation. Nearly all of those properties would appear to be desirable sites for potential replacement tenants.
Finally, Sears has fallen off the list of PREIT's top tenants, and thus accounts for less than 1% of the latter's rental income. If Sears goes out of business, PREIT could experience a modest negative financial impact in the short term, but nothing significant enough to disrupt its long-term strategy to grow its funds from operations -- and ultimately, raise its dividend even further.