In mid-2015, Seritage Growth Properties (SRG -0.43%) was spun off from Sears Holdings in a rights offering, with the goal of redeveloping some of the latter's vast real estate portfolio for higher-paying tenants. Sears' subsequent downward spiral into bankruptcy has pressured the REIT's funds from operations (FFO) and cash flow over the past couple of years.

This dynamic ultimately led to Seritage's recent decision to suspend its dividend after the next payment. Furthermore, details from Seritage's fourth-quarter earnings report (released last Thursday) revealed that earnings trends will get worse before they get better.

More of the same last quarter

In the third quarter of 2018, Seritage Growth Properties' adjusted FFO turned slightly negative, after being solidly positive at $17.6 million or $0.32 per share a year earlier. This trend continued in the fourth quarter, as adjusted FFO fell to negative $4.4 million (negative $0.08 per share) from $11.5 million ($0.21 per share) in the fourth quarter of 2017.

These earnings declines can be traced directly to the rapid pace at which Sears and Kmart have closed stores within Seritage's portfolio. Sears Holdings exercised its termination rights to exit the leases for nine stores in August 2018, followed by another 22 stores later in the year.

As a result of this termination activity, Seritage Growth Properties reported that Sears Holdings contributed $61.3 million in rent on an annualized basis by the end of 2018. That was down from $90.8 million at the end of September and $102.6 million at the end of 2017.

The exterior of a Sears store

Sears has been closing stores at a breakneck pace in recent years. Image source: Sears.

The downtrend isn't over yet

It's also noteworthy that 20 of the 22 properties terminated from the master lease between Sears Holdings and Seritage last quarter had termination dates in November and December. In other words, Seritage Growth Properties was still receiving rent for that space for most of the quarter (as well as expense reimbursements). As a result, there will be another big step down in its rental income and FFO this quarter.

To make matters worse, Sears Holdings has begun the process of rejecting the Seritage master lease in bankruptcy court. That will soon allow it to stop paying rent on additional properties.

Seritage recently signed a new master lease with the successor to Sears Holdings, which plans to continue operating up to 425 Sears and Kmart stores. However, this new master lease only covers 51 locations within Seritage's wholly owned portfolio. That means more than two dozen Sears and Kmart stores on Seritage's real estate will close this quarter. Seritage also owns some properties through a handful of joint ventures; it is not yet known how many of the 19 Sears stores still operating at those joint venture properties as of Dec. 31 will remain in business.

The base rent for the new master lease covering these 51 stores will start at just $32.5 million for the first year -- far less than what Sears Holdings was paying Seritage recently. And that amount can be reduced by as much as $12 million annually for the first two years, to the extent that some of the 51 stores are EBITDA-negative. (In effect, Seritage is sharing some of the risk with the "new" Sears regarding the short-term profitability of the stores at its properties.)

The upshot is clear. Investors should expect Seritage Growth Properties to report substantial additional declines in FFO and other key operating metrics for the next couple of quarters.

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The long-term outlook hasn't changed

Based on its recent FFO trajectory, Seritage Growth Properties might seem to be in dire straits. But the good news for investors is that Seritage is redeveloping its real estate at a furious pace. During 2018, the REIT signed new leases covering more than 3 million square feet of space. Those leases will produce $45.2 million in base rent annually when they go into effect.

Including leases signed in previous years, Seritage now has 170 signed leases for future tenants that have not opened yet (and thus haven't started paying rent). These leases will be good for $83.3 million in annual rent -- more than enough to replace all of the rent lost from Sears since the end of 2017. Seritage also has ample room to sign up additional new leases at sites that it is currently redeveloping.

Some of these tenants will begin paying rent over the next few quarters, partially offsetting lost rent from Sears. However, most of Seritage's big redevelopment projects are scheduled for completion in the second half of 2019, with some continuing into 2020.

As a result, Seritage Growth Properties is on track for strong sequential FFO growth beginning near the end of this year. Within a couple of years, Seritage could be producing record rental income and FFO. But for most of 2019, the REIT's financial results will remain quite ugly.