On Thursday, Seritage Growth Properties (SRG -1.56%) reported another quarter of negative funds from operations (FFO), as the bankruptcy of top tenant Sears Holdings continues to weigh on current results.

However, profitability is already starting to stabilize for the Sears real estate spinoff. Moreover, Seritage is making steady progress on its numerous redevelopment projects, which will allow it to replace all of the rent it has lost from Sears within a couple of years. This could pave the way for substantial capital appreciation for Seritage shareholders.

Another bad quarter -- but it could have been worse

In the first quarter, Seritage's adjusted FFO fell to negative $5.1 million (negative $0.09 per share) from $12.4 million ($0.22 per share) a year earlier. This was somewhat worse than its performance in the fourth quarter of 2018, when adjusted FFO per share was negative $0.08, but that's not surprising, given that Sears and Kmart have been closing stores left and right over the past year. Analysts were expecting adjusted FFO per share to fall to negative $0.13 last quarter.

The exterior of a Sears full-line store

Sears has closed more than half of its stores since the beginning of 2018. Image source: Sears.

Seritage Growth Properties has been working to replace Sears and Kmart stores in its portfolio with a diversified group of stronger tenants. It is still in the early innings of this process, but new tenants paying annualized base rent of $9.2 million opened in the first quarter alone. That's a sizable sum for Seritage, which brought in less than $44 million of total revenue last quarter.

During the quarter, Seritage raised $9.3 million by selling a 50% joint venture interest in a property in Maryland. It also sold seven vacant properties for $29.5 million, part of a broader strategy to sell several dozen smaller-market properties to free up capital for more promising opportunities. The REIT ended the quarter with $442.6 million of cash to fund its development pipeline, plus $400 million of incremental borrowing capacity. It also expects to raise another $34.3 million from assets under contract to be sold.

The tide is starting to turn

Fortunately for Seritage Growth Properties, while Sears Holdings filed for bankruptcy last year and closed hundreds of stores, it didn't liquidate entirely. The successor company to Sears -- which is owned by Seritage's chairman, Eddie Lampert -- will continue to lease more than 50 stores from Seritage.

Sears will pay $31.7 million of annual base rent for these stores. For comparison, just two years ago, Sears was generating $139.4 million in base rent annually for Seritage.

Over that period, Seritage has grown the annual base rent it gets from other tenants by 68%, from $44.5 million to $74.7 million. Obviously, that didn't come close to fully offsetting the more than $100 million decline in rental income from Sears -- hence the sharp plunge in Seritage's FFO.

A rendering of a redeveloped former Sears in Santa Monica, California

Image source: Seritage Growth Properties.

However, Seritage has also signed leases covering another $84 million in annual base rent for tenants that haven't opened yet. That total has been rising steadily in recent years due to strong leasing activity. During the first quarter, Seritage signed 29 leases for 365,000 square feet of space (including its share of joint venture properties), at average rents of $30.06 per square foot: 4.1 times what Sears had been paying previously.

Most of these tenants will open their doors within the next year or so, and virtually all will be in business within two years. As a result, Seritage is poised to deliver strong sequential growth in FFO starting later this year.

Plenty of opportunity ahead

In Seritage's 2018 annual report, CEO Benjamin Schall noted that the REIT is just scratching the surface of its potential so far.

Seritage has announced (and in most cases begun) redevelopment work on more than 80 of its 225 properties since becoming a separate public company in 2015. However, virtually all of its projects officially announced up until now have been pure retail redevelopments: In general, former Sears and Kmart stores are being carved up for other tenants.

But behind the scenes, Seritage has been working on plans for larger-scale projects at 36 premier properties. Schall believes that Seritage could more than double the density of these sites (from 7.4 million square feet of space today to more than 15 million square feet in the long run). Retail will be a piece of the equation, but Schall also envisions 6,000 to 8,000 residential units, as well as office space and other uses.

Last year alone, Seritage secured government approvals for 1,750 residential units, 1.4 million square feet of office space, and 500 hotel rooms across these 36 properties. It expects to break ground on the first of these large-scale mixed-use projects later this year.

Thus, Seritage has enough promising projects to keep its development pipeline busy for years. As a result, investors can look forward to ample FFO growth stretching well into the 2020s.