From the time Seritage Growth Properties (SRG -2.17%) was spun off by Sears Holdings (SHLDQ) in mid-2015, its strategy has been to replace Sears and Kmart stores in its portfolio with higher-paying tenants.

Seritage has had to move faster than planned, as Sears has closed stores at a phenomenal rate over the past few years due to financial distress. However, Seritage's strategy is finally on the verge of paying off. The REIT recently reported strong leasing activity for the final quarter of 2018, putting it in good position to weather the eventual disappearance of Sears and Kmart.

Ending 2018 on a good note

Sears Holdings' store closures have left Seritage with a substantial amount of empty space across its real estate portfolio. As of the end of the third quarter, 19.2% of its total square footage was vacant -- about 7 million square feet.

However, Seritage has been very active in releasing properties vacated by Sears and Kmart. Last quarter, it signed 31 leases covering 878,000 square feet. Those leases will generate $15.8 million of base rent annually once they go into effect.

The average rent for space leased to retailers -- as opposed to self-storage, auto dealership, and other non-retail tenants -- was $20.98 per square foot for leases signed in the fourth quarter. That's higher than the $17- to $18-per-square-foot rents that Seritage has averaged over the past three and a half years. This may indicate that Seritage is starting to lease up some of its premier projects, several of which are scheduled for completion in late 2019.

A rendering of Seritage's The Mark 302 development in Santa Monica, California.

Seritage may have started leasing up some of its best properties. Image source: Seritage Growth Properties.

For the full year, Seritage signed leases covering just over 3 million square feet of space. The average rent for retail space was $17.30 per square foot, and base rent for these leases will total $45.2 million annually.

The pipeline is full

Seritage's total annualized base rent from tenants other than Sears Holdings rose to $65.8 million by the end of last quarter, up from $61.6 million three months earlier. Yet that small increase was more than offset by a big drop in its annualized rental income from Sears Holdings.

As a result, Seritage is on track to post another sharp drop in its earnings for Q4. This downward trend is likely to continue for a few more quarters.

However, following its leasing activity last quarter, Seritage has $81.3 million of "signed-not-opened" (SNO) leases in the pipeline. These are binding contracts, but the rental income stream won't begin until these future tenants open their stores.

The vast majority of these SNO leases will open within the next year or so. Assuming that Sears Holdings is able to stay in business (albeit in a shrunken form), that will drive a sharp rebound in Seritage's funds from operations beginning in late 2019. And even if Eddie Lampert's rescue plan for Sears ultimately fails, Seritage's pipeline of SNO leases is already big enough to fully replace all of its remaining revenue from Sears Holdings.

Seritage has reached a turning point

Shares of Seritage Growth Properties have rebounded quite a bit from their recent lows but remain far below the all-time high reached in early 2016. Investors have been scared off by the rapid erosion of the REIT's profitability as its main tenant has closed stores at a breakneck pace.

Fortunately, Seritage has reduced its exposure to Sears Holdings by nearly half just in the past year. And with a large (and growing) pipeline of SNO leases, Seritage is on track to more than replace its lost Sears Holdings income over the next couple of years. As Seritage's strategy starts to demonstrate tangible results, the stock could finally take off.

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