When it was spun off from Sears Holdings a little more than five years ago, Seritage Growth Properties (NYSE:SRG) had a promising strategy. It paid $2.7 billion for Sears' interests in 266 properties, most of which were occupied by Sears or Kmart stores at the time. The idea was to redevelop those properties for higher-paying tenants as the REIT's former parent gradually closed some stores and downsized others. The business plan was so alluring that Seritage even attracted a personal investment from Warren Buffett.
Unfortunately for Seritage, Sears and Kmart fell into a rapid downward spiral following the spinoff and wound up closing stores much faster than the REIT could replace them. The situation has gone from bad to worse in 2020, as the COVID-19 pandemic has crushed a large swath of the retail sector. Seritage's recent third-quarter earnings report showed no sign of improvement.
Three months ago, Seritage reported total net operating income (NOI) of just $7.3 million for the second quarter, down from $14.6 million a year earlier. A new wave of Sears and Kmart store closures was one key driver of the NOI decline, offsetting tenant openings. The pandemic caused other tenants to fall into distress, too, including one notable bankruptcy filing: 24 Hour Fitness. Adjusted funds from operations (FFO) fell further into negative territory at minus-$27.2 million (minus-$0.49 per share).
Seritage's third-quarter results were equally awful. Total NOI declined further to $6 million, while adjusted FFO improved slightly on a sequential basis, reaching minus-$25.1 million (minus-$0.45 per share). Similar factors drove the poor results: Sears and Kmart store closures and write-offs of uncollectable rent. Increased legal costs also hurt adjusted FFO.
Separately, Seritage reversed $30 million of gains related to contributing its flagship property in Santa Monica to a joint venture. The property (known as The Mark 302) has been redeveloped for an office tenant on the upper floors and retail/dining on the lower floors, but remains completely unleased and vacant. The REIT also incurred an impairment loss upon selling two properties last quarter. These one-time charges (which were excluded from NOI and FFO) hint that Seritage's redevelopments haven't created as much value as previously expected.
Leasing activity remains stalled
Aside from Seritage's poor bottom-line results, the biggest red flag for investors is that leasing has ground to a halt. In its first four full years of existence (2016 through 2019), leasing activity was consistently strong. During that period, annual lease signings averaged $42 million of annual base rent. By contrast, in the first nine months of 2020, new lease signings totaled just $5.5 million of annual base rent.
It's not surprising that few potential tenants are willing to sign new leases now. In fact, Seritage has acknowledged that it isn't sure when many tenants with existing signed leases will be able and willing to open (and thus start paying rent).
The problem is that cash interest expense and overhead costs total about $150 million per year. Based on its Q3 NOI of $6 million, Seritage is burning over $100 million of cash annually before spending anything on capital investments. (This further assumes that Seritage collects all the rent it is owed; while collections have improved, the REIT still collected only 86% of contractual rents last quarter.)
As of Sept. 30, Seritage had signed leases worth $63.9 million of annual base rent from tenants that had not opened yet. Yet even getting all of these tenants open and paying rent would not get the retail REIT to cash breakeven. Seritage would need a huge rebound in leasing volume to reach cash breakeven over the next few years, and such a rapid recovery doesn't seem to be in the cards.
A slow-rolling liquidation
Even if Seritage were able to rejuvenate its leasing activity, it would cost hundreds of millions -- or even billions -- of dollars to complete all of the related redevelopment projects. However, the REIT ended last quarter with just $118 million of unrestricted cash on its balance sheet.
Seritage has been selling assets at an accelerating pace in recent quarters in order to offset its cash burn and fund redevelopment activity. While this solves the immediate problem, it is essentially selling its future. Sales of income-producing properties slow the process of reaching cash breakeven, while sales of vacant properties reduce future redevelopment opportunities.
In short, Seritage Growth Properties is trapped between a rock and a hard place. Unless leasing activity surges and the REIT shares a clear plan for funding future redevelopment spending, investors should stay away.