Nearly six years ago, Sears Holdings spun off most of its real estate as a new REIT: Seritage Growth Properties (SRG 1.67%). Seritage's strategy was simple: It would use the cash flow from leasing most of its real estate to Sears and Kmart to gradually redevelop its properties for higher-paying tenants, driving strong long-term growth.
Seritage's overarching strategy was compelling enough to attract a number of high-profile investors, headlined by Warren Buffett. In late 2015, Buffett bought 2 million shares of the retail REIT with his own money. However, the rapid downfall of Sears and Kmart over the past five years and the COVID-19 pandemic have combined to decimate Seritage's business.
The REIT's latest earnings report provided yet more evidence that Seritage Growth Properties is fundamentally broken. It's time for Warren Buffett -- and other shareholders -- to sell and move on to better opportunities.
The earnings highlights
On Thursday, Seritage reported that it had collected 97% of billed rent for the first quarter and agreed to defer another 2%. Unfortunately, there wasn't much rent to collect. Seritage booked just $31.3 million of revenue for the quarter, down from $33.3 million a year earlier.
As a result, total net operating income (NOI) came to just $9.4 million for the first quarter, compared to $15.8 million a year earlier. This marked the fourth consecutive quarter that total NOI didn't even reach $10 million.
Assuming no changes to its debt levels, Seritage would need to generate quarterly NOI of about $40 million to cover its interest costs, corporate overhead, and preferred dividends. In short, the REIT is currently stuck with revenue far below its break-even level.
Moving in the wrong direction (again)
Seritage has been reporting negative funds from operations (FFO) -- a key earnings metric for REITs -- since late 2018. However, before the pandemic, it had a clear path to profitability. Seritage ended 2019 with $84.3 million of signed-not-opened (SNO) leases that had not yet converted to rent-paying status. Furthermore, it signed leases for at least $40 million of annual base rent every year from 2017 through 2019.
By contrast, over the past year, the backlog of SNO leases has been shrinking and new lease signings have been few and far between. Meanwhile, Seritage's in-place rent roll shrank due to store closings, tenant bankruptcies, and asset sales.
Seritage ended 2020 with in-place leases generating $96.1 million of annual rent, down from $107.7 million a year earlier. Furthermore, it had SNO leases for just $54.5 million of annual rent in its pipeline for future openings. The REIT signed just 30 leases during the whole year, covering 422,000 square feet of space and generating annual rent of $7.5 million.
The negative trends continued last quarter. In-place rent slipped to $93.4 million, while the backlog of SNO leases plummeted by a third to $36.3 million. Seritage signed only five new leases for 44,000 square feet and annual rent of $1.5 million during Q1.
Does management have a real strategy?
In recent months, Seritage Growth Properties lost its original CEO and its original CFO. Under new CEO Andrea Olshan, it has begun a full portfolio review. The REIT blamed its Q1 results in part on this management transition and portfolio review. It adopted "a more selective approach" to leasing while reevaluating its asset-by-asset plans. Seritage also chose to terminate a number of leases to reduce its exposure to weaker tenants and retain space that it may want to use for other purposes.
Going forward, Seritage "plans to optimize the value of its individual property assets through additional leasing to retail tenants, densification of sites, modifications and repurposing for other uses, large-scale redevelopments, partnerships and dispositions," according to a recent press release. This statement wasn't very enlightening, though, as the options encompass pretty much anything one could do with real estate.
It's not clear that the new management team has a real turnaround plan. As Seritage sells income-producing assets and terminates more leases than it signs, it drifts further from breakeven. The pipeline of SNO leases has shrunk dramatically. Meanwhile, the REIT's unrestricted cash balance of $138 million won't go very far toward redeveloping its properties. (In fact, it would only cover four or five quarters of cash burn with zero spending on redevelopment.)
This adds up to a bleak long-term outlook. While the stock trades for about half the price Buffett paid back in 2015, the Oracle of Omaha knows that it's better to cut your losses sooner rather than later if your investment thesis falls apart. For Seritage Growth Properties, it's time to throw in the towel.