Seritage Growth Properties (NYSE:SRG) has taken investors on a wild ride in 2020. Shares traded for around $40 in January, reflecting shareholders' optimism about the REIT's plans to redevelop former Sears and Kmart stores for new tenants that would pay much higher rents.
Unfortunately, the COVID-19 pandemic severely disrupted Seritage's plans. Seritage Growth Properties stock plummeted at a breathtaking pace in March, briefly falling as low as $5 in mid-March. Seritage shares remained in single-digit territory for most of April and May. The stock then tripled in the first six trading days of June, peaking at $24, before giving up most of its gains and falling to around $13 on Thursday.
Seritage does own plenty of valuable real estate. However, most of it is vacant right now. As a result, Seritage is burning cash as it must continue to pay operating expenses and interest on a $1.6 billion term loan from Warren Buffett's Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B). Even if COVID-19 proves to be only a temporary headwind, the delays are eating away at the stock's value -- while Berkshire Hathaway continues to earn a handsome interest rate on its loan.
Mixed results from its redevelopment strategy
After being spun off from Sears in 2015 with a portfolio of 266 properties, Seritage developed a three-pronged strategy. The REIT aimed to sell dozens of smaller-market assets (plus a handful of major-market properties), gradually subdivide the majority of the Sears and Kmart stores in its portfolio to bring in new tenants paying higher rents, and redevelop three dozen trophy assets into mixed-use centers or premier retail destinations.
The asset sales have largely gone as planned. As of early June, Seritage had shrunk its portfolio to 203 properties, generating over $800 million of asset sale proceeds that it reinvested into its remaining properties. The mixed-use redevelopments have only just begun for the most part, due to the long timeline needed to get local approvals for major development projects.
The retail redevelopments have been a mixed bag, though. On the bright side, by the end of 2019, Seritage had executed leases totaling $181 million of annual base rent with tenants other than Sears and Kmart. However, many of these tenants haven't opened yet (and thus haven't begun paying rent). In-place annual base rent from this set of tenants totaled just $98 million entering 2020.
Meanwhile, Sears and Kmart have closed stores at a breakneck pace, both before and after Sears Holdings' late-2018 bankruptcy filing. As a result, annual base rent from Sears and Kmart fell from around $150 million in 2016 to barely more than $10 million today. The net result was that Seritage's FFO and cash flow plunged far into negative territory and have remained there.
Redevelopment activity stalls out
Entering 2020, there were signs of hope for Seritage. It had numerous redevelopments nearing completion, potentially enabling it to bring on line a majority of its $84.3 million of annual base rent from "signed-not-opened" leases by year-end. That would have gotten it to around cash breakeven. Assuming robust leasing activity during the year, Seritage also would have gained access to an additional $400 million of cash from Berkshire Hathaway (expanding its term loan from $1.6 billion to $2 billion), providing funding for future redevelopment work.
The pandemic scrambled these plans. Many of Seritage's tenants (and future tenants) have been hit hard by social-distancing rules. Entertainment, fitness, and movie theater tenants together account for 23% of in-place rent. They also account for a significant chunk of signed-not-opened leases.
Several key tenants face a meaningful risk of bankruptcy, including AMC Entertainment and 24 Hour Fitness. That would allow them to cancel or renegotiate leases. Even some of Seritage's stronger tenants may try to renegotiate lease terms or delay planned store openings.
In light of this uncertainty, Seritage paused most redevelopment projects in March but will continue some high-priority work. As tenants' plans become clear, Seritage plans to resume construction, with a focus on the most promising projects and those that are close to completion (and can begin generating cash flow soon).
Cash burn accelerates
Seritage was already burning $8 million to $9 million per month in February, prior to the pandemic. That made it critical to complete redevelopments quickly in order to bring more rent on line and get to breakeven. Instead, cash burn has accelerated due to some tenants not paying rent, while new tenants' projected opening dates are slipping further into the future.
As of last week, Seritage had collected 65% of contractual amounts for April and 52% of contractual amounts for May from tenants other than Sears. Meanwhile, Sears and Kmart plan to close 12 of their remaining 17 stores in Seritage's portfolio later this year and will pay a $5.3 million termination fee. As part of that agreement, Seritage will defer six months of base rent for the remaining five stores, with those amounts being repaid over 12 months beginning this October.
Increased cash burn threatens to eat away at Seritage's already-thin cash cushion. Soon after getting the loan from Berkshire Hathaway in late 2018, Seritage had nearly $600 million in cash. Yet its cash balance fell to just $97 million by the end of March, primarily due to its aggressive spending on redevelopment projects.
Seritage noted in early June that it had sold $45 million of assets since the beginning of the second quarter. It expects further asset sales this month, and this should fully fund Q2 cash burn. However, it's mainly selling income-generating properties, so these asset sales come at the cost of future income.
Bad for shareholders -- not so bad for Buffett
Despite the setbacks Seritage has encountered, it continues to pay 7% annually on Berkshire Hathaway's $1.6 billion term loan, plus a 1% commitment fee on the $400 million of potential additional funding. That's nearly $30 million a quarter in interest income for Warren Buffett's conglomerate.
Berkshire has agreed to allow Seritage Growth Properties to defer interest payments if its cash balance falls critically low later this year. However, it would have to pay a higher rate on any deferred interest payments.
Even if Seritage takes advantage of this option, Berkshire Hathaway faces little risk of incurring a permanent loss as it has the highest claim to nearly all of Seritage's assets in the event of bankruptcy. The REIT's properties are almost certainly worth more than $1.6 billion.
The problem for shareholders is that Seritage's asset sales and loan proceeds were supposed to enable quick redevelopment of its properties, so that it could start generating cash again. Instead, its redevelopments are on hold. Asset sales are now being used to keep interest payments flowing to Berkshire, while Seritage makes no progress on its long-term strategy.
This situation is just fine for Buffett and Berkshire Hathaway. However, it's getting hard to see a happy ending for shareholders. While I had been bullish about Seritage prior to the pandemic, I took advantage of the rally earlier this month to cash out. Even with the stock retreating to around $13, Seritage shares continue to offer a poor risk-reward trade-off.