Real estate investment trust (REIT) Seritage Growth Properties (SRG +1.80%) has two very prominent backers in Warren Buffett (with his own money) and Berkshire Hathaway (via a loan). But there's a material backstory here that investors need to understand before simply following the Oracle of Omaha's lead on this investment. In the end, Seritage might look like a buy to you, or it might look like a stock to avoid. Here are some key facts you need to know to decide.
Born to turnaround
Roughly five years ago, troubled retailer Sears Holdings spun off Seritage Growth Properties as a way to raise some much-needed cash. The basic idea was that Seritage, structured as a real estate investment trust, would effectively buy a collection of retail properties from Sears Holdings. That was great for Sears Holdings, but it meant that Seritage owned assets filled with struggling retail concepts Sears and Kmart.
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Seritage's goal from the very start was to get out from under its largest tenants' shadows by redeveloping and repurposing properties so it could find new tenants. The logic is pretty simple: Sears and Kmart paid very low rents. New tenants would end up paying much higher rents. In 2016, the company's first full year as a public company, the results show exactly how big a deal this is. Sears Holdings' rent rates in 2016 sat in the $4-to-$5-per-square-foot range, and new leases were getting signed at $18.55 per square foot on average. That's a very big opportunity and it helps explain why an investor like Warren Buffett, who has a notable value bias, would be interested in the Seritage story.
The whole process would go smoothly if there were a slow and steady shift from Sears Holdings to other retailers, allowing Seritage ample time to spread the cost of the effort out. But that's the fly in the ointment here.
Sometimes things go sideways
At first, the transition away from Sears and Kmart did go very well, with a slow and steady stream of redevelopments giving Seritage plenty of time to find new tenants. But then the so-called "retail apocalypse" started to gain speed, making it harder to find new lessees. This was the same issue hitting Sears and Kmart, but the impact of retailers (often with heavy debt loads) failing to adjust to changing customer buying trends seemed to be picking up speed.
That had the double impact of pushing Sears Holdings into bankruptcy in late 2018. That materially increased the speed at which Seritage would need to adjust. It was too much for the REIT to handle, leading it to eliminate its dividend in early 2019. It was the right move, as it preserved cash needed for redevelopment activities, but it wasn't a great sign for investors. In short, Seritage was struggling.
And then COVID-19 hit, closing non-essential businesses in an effort to slow the spread of the coronavirus. Without revenue coming in the door, retailers have been going out of business in alarming numbers. Many of those that look likely to survive without seeking court protections are looking to shut locations. Put simply, the headwinds Seritage faces have only gotten worse.
The REIT's first-half-2020 funds from operations (FFO), like earnings for an industrial company, show just how tough it is today. It lost $0.80 per share in the first six months of the year, compared to an FFO loss of $0.20 per share in the same period of 2019.
What's next?
The answer here isn't easy. Seritage has made material progress in shifting away from Sears and Kmart. But it still needs cash to redevelop properties so new tenants can move in at higher rent rates. Seritage has eliminated its dividend, it's selling non-core assets, and it's reworked debt agreements (notably with Berkshire Hathaway) to ensure it can keep moving forward. But even after five years as a stand-alone company, this is still a turnaround situation, and only appropriate for more aggressive investors willing to closely monitor their portfolios. There is notable turnaround potential, but it is far from certain that Seritage will be able to realize it given the current business environment. In other words, investors need to tread cautiously here, and most will probably be better off with a less risky investment situation.
